Fitch Rates City & County of Honolulu, Hawaii's Wastewater Revs 'AA-'/'A+'; Outlook to Negative

Business Wire, July 12, 2007

SAN FRANCISCO -- Fitch rates the City and County of Honolulu, Hawaii's wastewater system revenue bonds as follows:

--$160.1 million senior series 2007A 'AA-';

--$8.5 million senior series 2007B 'AA-';

--$68.9 million senior series 2007C 'AA-'.

In addition, Fitch affirms the 'AA-' rating on the system's approximately $556.5 million in outstanding senior revenue bonds and 'A+' rating on the system's outstanding $460.0 million of junior revenue bonds. The proceeds of the senior series 2007A bonds will be used to finance a portion of the system's capital improvement plan (CIP). The senior series 2006B and 2006C bonds will refund existing debt for restructuring and savings. The bonds are expected to price on July 23 in a negotiated sale; UBS is the senior manager on the transaction. The Rating Outlook on all bonds is revised to Negative from Stable.

The Rating Outlook change to Negative from Stable reflects the recent rapid escalation in the utility's CIP and the likelihood of significant additional mandated capital costs that may be imposed by the U.S. Environmental Protection Agency (EPA). Further capital cost escalation could cause deterioration in the utility's financial operations and limit future rate flexibility. To date Fitch notes that financial performance is favorable as a result of rate increases adopted in 2005 and 2007 that maintain fiscal margins in light of extensive capital costs. However, a downgrade may result in the event of:

-- Sizable further increases in the CIP, including additional regulatory mandates,

-- Any erosion in either political or community support for rate increases necessary to execute the CIP, or

-- Deterioration in the utility's strong current and projected financial position.

These rating concerns are balanced by the proactive steps taken by the current political leadership and management team to address many years of delayed spending on capital infrastructure, including adoption of two multi-year rate packages that extend through fiscal (FY) 2011. Financial results remain strong, bolstered by the first round of rate hikes, and near- to medium-term projections indicate continued strong performance as adopted future rate adjustments take effect. To date, the community appears to be accepting and supportive of the double-digit annual rate increases needed to invest in the system's aging infrastructure. Additional credit strengths include the strong regional economy and a stable residential customer base.

The Honolulu wastewater system faces intense capital cost pressure stemming from years of deferred investment. The majority of the ten-year $2.4 billion CIP is driven by mandatory projects outlined in multiple consent decrees with the EPA. The overall cost of the ten-year CIP has increased by $850 million since estimates provided last year, resulting from construction cost escalation, better cost estimates as designs are finalized, and additional requirements imposed by a regulatory settlement, as well as a change in the assumptions to a more conservative inflation rate. To support these cost increases, the city passed additional rate increases in June 2007 beyond those already adopted in 2005. As a result, the average annual rate hike over the next five years has risen from 10% to 18%.

Potentially increasing capital costs further, the EPA recently issued a tentative decision to deny the city's request for a renewal of its 301(h) waiver for the utility's second largest wastewater treatment plant (WWTP). The EPA has additionally indicated that it expects to deny the city's other 301(h) waiver on its largest WWTP later this year. The waivers exempt these WWTPs from compliance with the federal Clean Water Act, permitting treatment of effluent to primary standards instead of the more costly secondary treatment. If the city is required to convert these two WWTPs to secondary treatment the capital costs would be substantial; preliminary staff estimates are as high as $1.2 billion. These costs have not been included in the city's current CIP projections.

Fitch acknowledges that any conversion to secondary treatment would likely occur over an extended timeframe. However, Fitch is concerned that the ongoing substantial rate increases needed to support the existing CIP significantly reduce the utility's rate affordability, including its ability to respond to an event of the magnitude of moving to secondary treatment, if required. Also, the scope of such additional regulatory requirements may divert capital spending and resources away from the much needed infrastructure investments that currently comprise the bulk of the CIP, which could be expected to impact the system's strong financial performance. As a result, a key credit concern over the near term will be the potential denial of the 301(h) waivers, or any further escalation in the CIP, and its impact to utility operations and the need for additional rate adjustments beyond those contemplated.

The system's financial position is sound, with FY2006 senior lien debt service coverage of 6.1 times (x) and total debt service coverage of 2.2x, including junior lien bonds, general obligation bonds, and state revolving fund loans. Coverage and liquidity was exceptionally strong in FY2006 due to a 25% rate increase implemented to support debt service that will ramp up over the next couple of years. Senior debt service coverage is projected to remain strong at over 2.0x, based on approved rate increases through FY2012 and assumed annual rate increases thereafter. Total debt service coverage on all bonds is projected to range between 1.3x and 1.8x.