Districts stir as Texas once again anticipates growth.

As the only national bond analyst based in Texas, Don Karlberg of the Kemper Securities Group offers a unique perspective on the nation's second largest tax-exempt market.

During a recent interview in his downtown Houston office, Mr. Karlberg said the future is mostly good for Texas credits; surpassed only by California issuers, they have sold more than $12 billion this year. Already, he noted, the state is well into a recovery from the mid-1980s oil bust that triggered downgrades and worried some bond buyers.

But as the state recovers from its economic troubles, he said, lawmakers face challenges that may force Texas to lose its status as one of only six states without a personal income tax.

Like others who have studied state finances, Mr. Karlberg argued that Texas officials must face the increasing expense of local education, a state prison system undergoing the largest expansion in U.S. history, and the growth that is expected to make Texas the second most populous state by mid-decade.

At the same time, in his interview with Southwest Bureau Chief John Racine, he offered guidance on how to study the state's heavily regulated and generally sound special district bonds. Considering that he has studied the finances of many of the state's 1,000 districts, Mr. Karlberg may be uniquely suited to give that advice.

Q: The Texas municipal utility districts are seeing a resurgence in the market after a few years of being dormant. How would you explain that?

A: The Houston City Council and the Texas Water Commission made it easier for MUDs to do refundings, and that is a fairly recent development. Not only can they do refundings, but the city ordinance allows them to extend maturities out another few years. So there has been a large number of refundings over the last couple of years. I think this means there were a lot out there that were getting very close to being bad situations, but they were bailed out. That's not to say there aren't some out there that still have problems, but there are not as many as there used to be.

Q: Can you quantify the districts that could not work out their problems? Why weren't there defaults on the scale of, say, Colorado?

A: There are really only nine that have actually defaulted or filed for Chapter 9. That's really a remarkable record. I believe we have that kind of history because since MUDs were first formed in Texas, they were regulated.

Q: Are you saying that regulation or oversight can be a good thing?

A: I'm saying it is and that's been proven. In effect, we have several levels of regulation on MUDs, but that doesn't mean you don't have a few that slip through the cracks. But it does indicate that, over all the Texas system of regulation has been quite effective.

Q: Municipal utility districts and other development-style districts have historically been a major part of the growth in the Houston area, where most of them are located. What role will they play in the future here?

A: We are seeing an occasional new MUD formed outside the city limits, but certainly we're not going to see them formed in the numbers they were in the '60s and '70s. There is a new thing that is very recent, and that is the formation of MUDs within the city limits. Houston sort of leapfrogged over much of its development when it was annexing every year.

Q: What lessons have been learned from troubles in the districts?

A: We learned something about how you judge a MUD. Hopefully, you can see the danger signals ahead of time. When you look at a MUD, the first consideration is its location. Is it in the path of a city's growth? What is the highway accessibility? And what is the general outlook for the area? Secondly and just as importantly is, who is the developer? What kind of history does he have and how deep are his pockets?

Q: The restart of issuance by MUDs is considered an indicator that the economy is finally rebounding. What do you see ahead in Texas?

A: Texas had its Depression back in the 1980s and it was a bad one, but it survived well. There are still pockets where the effects of the energy debacle are lingering. It is doing really well when you compare it to the West Coast and the East Coast.

Q: Are we going to see a repeat of the Sunbelt-style boom again?

A: No, God forbid. It is just too much to digest in a short time. I think we're going to see a very gradual broadening of the Texas economy. There will be a diversification away from the energy sector.

Q: As Texas moves toward becoming the second most populous state in the nation, what kind of growing pains should we expect?

A: Texas is going to have some problems because we have some social infrastructure that demands attention. Number one is education. The school funding equalization is the single largest problem facing Texas at the moment. We are talking about a huge amount of money that is just not going to be available from the state sales tax. There's just not a lot more available from [local] property taxes, either.

Q: So what does that mean for the state's tax structure?

A: This state is, sooner or later, one way or another, going to have to have a state income tax because the present tax system is just a hodgepodge and it is terribly regressive. I think the school finance case alone will force the state to take a step in that direction.

Q: If lawmakers adopt an income tax, what would that mean for retail buyers and the Texas bond market in general?

A: People who are in the right tax bracket are going to very quickly develop an interest in Texas tax-exempt bonds. There are already some Texas tax-exempt mutual funds in place in anticipation of that. It cannot help but influence the market.

Q: As Texas finances some of its needs with debt, how is that going to affect state government and budgets?

A: Texas is fortunate that we are starting from rather low levels. It hasn't been that long ago that Texas was a pay-as-you-go state. We have some big needs, but we still have a moderate burden.

Q: While the general sentiment about Texas is good, are there any specific areas of the state you are watching?

A: What's going to be interesting is the [South Texas] Valley and the border, and what happens to places like Brownsville, Laredo, and Del Rio and El Paso and Harlingen. I'm very excited about the [North American] Free Trade Agreement. Even if it is thrown out by Congress, the things that have already happened are very impressive. I think the possibilities along the border are just tremendous.

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