Chicago Credit Rating Plummets After Pension Ruling

by | May 13, 2015

By Hal Dardick and Heather Gillers

Chicago took yet another hit Tuesday when a major credit rating agency downgraded much of the city's debt to junk status, making it more difficult for Mayor Rahm Emanuel to fix the financial mess without a major tax increase.

The double downgrade by Moody's Investors Service leaves Chicago and Detroit as the only U.S. cities of more than 500,000 with such low ratings, according to one municipal bond analysis firm.

The move came four days after the Illinois Supreme Court tossed a law aimed at cutting costs in four state government worker pension funds. The unanimous ruling made it far less certain that the city could withstand ongoing legal challenges to changes Emanuel engineered for two of the four city worker pension systems.

"We believe that the city's options for curbing growth in its own unfunded pension liabilities have narrowed considerably," Moody's stated in its report.

Emanuel attacked Moody's decision to downgrade the city's credit, but his remarks illustrate the grave financial situation the city faces.

"This action by Moody's is not only premature, but it is irresponsible to play politics with Chicago's financial future by pushing the city to increase taxes on residents without reform," said Emanuel in a statement, just hours after appearing on the South Side to bask in the formal announcement that President Barack Obama's presidential library would be built in Chicago.

One analyst was sympathetic to the mayor's argument that Moody's acted too quickly, but noted the message being sent about Emanuel's leadership as he enters a second term.

"A cut below investment grade is a major statement, implying that there is material risk to the city not paying its bondholders on time or in full," said Matt Fabian, a managing partner at Municipal Market Analytics. "To have gone there without waiting to see the city's approach to the current budget gap, or whether or not they will raise revenues is clear demonstration of a lack of confidence in city management. In other words, they see little reason to wait because they expect little in the way of a management response."

Moody's lowered the city's rating two notches on all debt backed by property, sales and gas taxes to Ba1, a level it defines as carrying "substantial credit risk." In financial parlance, Chicago has hit junk status.

The practical impact is that investors typically demand higher interest payments because of the risk they are taking. That could make it more expensive for the city to borrow money. And Emanuel was planning to do just that as part of a financial restructuring plan he unveiled late last month as he tried to get out in front of the state Supreme Court ruling on pensions and the potential downgrade that could follow.

As part of that, Emanuel planned to go to market in the coming weeks to convert $900 million the city had borrowed at fluctuating interest rates into fixed-rate debt and to borrow $200 million on the city's credit card to pay off related transactions known as interest-rate swaps. Now the city could be forced to pay higher interest costs.

"The downgrade by Moody's has the potential to derail the city's debt refinancing plan," said Richard Ciccarone, president and CEO of the municipal bond analysis firm Merritt Research Services. "This throws a wrench into the engine."

The Moody's report also gave the city a "negative" outlook, indicating further downgrades could be coming. In addition, the ratings agency indicated the downgrade could prompt lenders to demand up to $2.2 billion in immediate principal and interest payments.

Emanuel is seeking to eliminate about half that risk with his financial restructuring. City finance officials are hoping to keep deals tied to the other $1.1 billion in place by negotiating new agreements with banks. That amount includes about $500 million in variable-rate debt tied directly to specific city revenues -- such as water and sewer payments -- meaning banks may be more confident in the city's ability to repay it.

The other $600 million in question takes the form of outstanding short-term borrowing, a practice Emanuel has relied on repeatedly to circumvent budget constraints.

The Emanuel administration said it hopes to talk to lenders about keeping in place full access to short-term credit, but even if that doesn't happen, the city could find money in reserves to pay off the interest rate swaps and keep that part of its plan in place.

Ciccarone noted that his firm's data showed Chicago's junk status rating is a level only reached in recent history by one other major city: Detroit, before it filed for bankruptcy in July 2013.

Earlier market analyses have indicated that Chicago, unlike Detroit, has a varied economy and options for raising the needed revenue for righting its financial ship, but it won't be painless. "Raising taxes is going to have to be part of the solution," Ciccarone said.

Emanuel and city financial officials tried to downplay the action by Moody's, noting other major debt rating agencies had not downgraded city creditworthiness to such troublesome low levels. Budget Director Alex Holt called Moody's rating "an outlier."

For years, Moody's has warned the city about not addressing its pension problems, maintaining an intense focus not shared by other rating agencies, and also warned about city debt practices that Emanuel recently vowed to change.

Even so, Emanuel and the City Council last year put off making a decision on whether to enact a significant property tax increase to help cover the city's ballooning pension costs. That deferral came as Emanuel and aldermen prepared to run for re-election this spring.

Under state law, the city must put an additional $550 million into the pension funds for police and firefighters. That is a major part of a looming $1 billion shortfall in next year's budget. Chicago Public Schools faces a similar shortfall driven by pension pressures, and the Emanuel administration tried to manage that issue by warning that it expects Moody's will downgrade the school district's credit rating "in the next 24 hours."

The mayor has long maintained that it's unwise to commit additional funding to pension fund without "reform," which he defines as a commitment by unions to lower the city burden through reduced benefits or additional employee payments.

But the state Supreme Court ruling Friday was clear that the Illinois Constitution holds that pension benefits can't be "diminished or impaired" once they're granted. Emanuel has maintained that pension changes he engineered for the workers and laborers funds can withstand lawsuits, but legal analysts are far less optimistic, as was Moody's, which quickly downgraded the city's credit.

Some financial analysts said they were caught off guard by the downgrade, which came less than three months after another significant Moody's downgrade of Chicago's debt. Those analysts said they weren't sure if the Moody's action would increase city borrowing costs, given that other agencies have given the city higher ratings and the city's already paying relatively high interest rates.

"The downgrade is a surprise to me, because I see no reason to give up on management yet," Fabian said. "There is still time for them to formulate a plan and, over time, fix their budget issues."

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