By Bob Secter and Ameet Sachdev

Chicago's bond rating has taken a big hit, suffering the first downgrade in the two-year tenure of Mayor Rahm Emanuel, who was warned by financial analysts of the need to take drastic -- even politically daring -- actions to get his city's fiscal house in order.

The revision late Wednesday by Moody's Investors Service dwelled heavily on the drag created by high levels of pension debt accumulated over many years, not just by the city but the state.

But the assessment went beyond that, suggesting that "unrelenting public safety demands" and an unwillingness to raise taxes also contributed to Chicago's financial plight.

The development is a fiscal double whammy for the city, where the $6.5 billion budget for this year is balanced on a razor's edge and borrowing for showcase projects is significant. The ratings drop means that future credit for the city may get tighter and loan costs could go up, running the risk of squeezing out funding available for public services.

"There's no way to sugarcoat this," said Brian Battle, director at Chicago-based Performance Trust Capital Partners, an investment adviser specializing in fixed-income products. "This is bad for Chicago."

In its analysis, Moody's found Chicago's pension plight much more severe than the city has estimated. Rachel Cortez, the lead analyst on the Chicago report, said Moody's calculates that the city's pension funds at the end of 2012 possessed only 22 percent of the assets they needed to meet obligations. The city pegged the amount at 35 percent.

Emanuel addressed the downgrade in a prepared statement.

"This confirms what I have been saying for more than a year," he said. "Without comprehensive pension relief from Springfield, municipalities such as Chicago will continue to receive negative reviews from rating agencies."

The mayoral statement did not mention other important pieces of the Moody's analysis that appeared to lay some of the city's problems at Emanuel's doorstep regardless of what pension relief, if any, comes from Springfield.

In short, the ratings service said it was not enough for Emanuel to rely on lawmakers to bail him out of the city's pension mess. Any legislative reforms will almost certainly be bottled up in lengthy legal challenges, analysts said as they dropped strong hints that the mayor and City Council need to have a Plan B at the ready -- most likely involving significant spending cuts and tax increases.

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In the arcane language of Wall Street, Moody's dropped its quality assessment of the city's general obligation bond debt by three notches, from Aa3 or what is considered the lower end of "high grade, high quality" to A3. That is the lower end of what is termed "upper medium grade."

Moody's also slapped a "negative" label on the future outlook for Chicago's rating.

The Chicago downgrade is part of a broader review of how pension liabilities are affecting local government finances that was launched by Moody's in April. In all, the ratings service looked at 29 government bodies across the nation, including cities, counties and school districts, and has completed the assessment for most. Many cities are struggling to cope with mounting pension debt, but Moody's found Chicago to be an outlier.

So far, the only other city receiving a downgrade was Cincinnati, which lost its top-notch credit rating but still is considered high quality. Chicago's downgrade means that Moody's thinks it faces stronger financial head winds than most other big cities.

Before this week, Chicago's credit rating was only one notch below that of New York and Los Angeles. Now Chicago is four investment grades below those cities and also trails other big and sometimes troubled Midwest cities such as Milwaukee and Cleveland.

Chicago has four pension funds for its municipal employees, and as of the end of 2012 the city reported that collectively they were $19 billion short of the amount needed to cover future obligations, Moody's said. But the firm estimated the underfunding could be as high as $36 billion.

In 2012 alone, the analysts said, the city shorted payments into its pension funds by more than $1 billion, worsening their fiscal plight. More alarming yet, Moody's noted, current state law mandates an enormous balloon payment into city pension plans for police and firefighters -- from $467 million in 2014 to $1.2 billion in 2015.

"Fixed costs -- namely pension contributions and debt service payments -- may soon comprise more than 50 percent of Chicago's operating budget," the report warned, referring to the critical portion of the budget that covers day-to-day expenses.

The latest fiscal headache for Chicago comes against the backdrop of a separate but similar crisis facing state-run pension funds that have amassed a crushing debt topping $100 billion.

Gov. Pat Quinn, the Democrat-controlled legislature and public employee unions have been tied in knots trying to reach a compromise solution to that problem, which some argue can be achieved only through significant benefit cuts that others contend are illegal. Emanuel sees benefit cuts as a key element in fixing Chicago's pension problems.

But Moody's indicated that relying on such a remedy could prove iffy, given strong protections for pension benefits embodied in the Illinois Constitution. "In order for the city to realize any significant alleviation in pension costs, the Illinois General Assembly would need to enact pension reform that ultimately withstands inevitable litigation," the ratings agency said.

There are no easy fallbacks. "It would be difficult, we believe, to make public safety budget cuts," Cortez said Thursday, noting that the police budget is currently being stretched to accommodate significant overtime costs.

Emanuel took over City Hall pledging to improve police efficiency while improving safety. But homicides soared after he shifted policing strategies, leading to more changes and heavy overtime spending that eventually helped dial back the violence. Moody's suggested that tax increases could be part of any mix to ease fiscal problems, noting however that they carry a big political downside and could require up to a doubling of property tax levies.

Even so, a recent report released by Cook County Clerk David Orr found the combined property tax rate paid by taxpayers in the city was the lowest of any municipality in Cook County.

"The prior and current administration's unwillingness to avail itself of its full taxing authority to stave off burgeoning pension liabilities is, in our view, a clear credit negative," Moody's said.

Emanuel has relied on new and increased user fees to help fund his budgets but has resisted increases in sales tax or the city portion of property taxes, though he has allowed property taxes to rise for public schools.

(c)2013 the Chicago Tribune