NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the Chicago Board of Education, IL's (the board) approximately $5.5 billion in ULTGO bonds to 'A-' from 'A'.
The Rating Outlook is Negative.
The bonds are general obligations, payable from unlimited ad valorem taxes levied against all taxable property in the City of Chicago (Chicago or the city). Most of the bonds are additionally secured by state aid revenue.
KEY RATING DRIVERS
DOWNGRADE REFLECTS CONTINUED FINANCIAL STRESS: The downgrade is based on continued difficulty in addressing Chicago Public Schools' (CPS') large structural budget gap. Recent operating results have exceeded estimates largely due to receipt of unanticipated non-recurring resources, with spending reductions narrowing the gap to a limited extent.
NEGATIVE OUTLOOK MAINTAINED: Fitch believes dramatic changes are necessary to support ongoing operating and fixed cost spending. Options within the board's control appear unlikely to be sufficient and non-recurring sources that have been available in recent fiscal years are no longer available. Problems are exacerbated by significant management turnover in the last two years.
PENSION PAYMENTS WIDEN BUDGETARY GAP: About 40% of the approximately $1 billion or 17% structural budget gap that CPS faced going into fiscal 2014 arises from a dramatic jump in pension costs to an actuarially-based contribution after deferrals for the teachers' plan in fiscal years 2011-2013.
PENSION LIABILITY WEAKNESS: Weak pension funded ratios were exacerbated by the three-year payment deferral. The city's plan in which non-teachers participate is even more poorly funded. Meaningful pension reform at the state level appears more remote as time passes with no resolution, and challenged labor-management relations make an independent solution unlikely.
UNFAVORABLE DEBT POSITION: The district's debt levels are above average with very slow amortization. Expectations for future capital spending are down significantly from prior plans, but Fitch believes maintenance-related needs may exceed planned spending.
ECONOMY RECOVERING SLOWLY: Chicago benefits from a large and diverse economic core whose employment base and housing market are nonetheless under substantial stress.
REVERSING STRUCTURAL IMBALANCE: CPS' conservative budgeting regularly results in better than projected bottom line performance, however, the structural imbalance continues to grow. Fitch will downgrade the rating into the 'BBB' category if there is not a clear and meaningful reversal in this trend over the near term. Fitch believes the possibility of sufficient action to improve the rating or Outlook over that period is remote.
MOUNTING FIXED COSTS: A notable increase to debt or unfunded post-employment liabilities would also likely result in a rating downgrade.
CPS' 23,290 teachers served 404,151 students in school year 2011/2012 in a district with 681 schools that is coterminous with the city. Enrolment trends are slowly declining and management reports its demographer projects continued declines of about 1% annually.
LIMITED OPTIONS TO ADDRESS LARGE BUDGETARY GAP
CPS faces a $694 million (12%) general fund gap for fiscal 2014 despite implementation of a far-reaching and controversial school closure plan, an increase in property tax revenues to the statutory cap, sizable reductions in non-education spending, and continued pressure on the state for pension reform. These actions reduced the gap from about $1 billion, although projected gaps for fiscal years 2015 and 2016 are close to that range.
The fiscal 2014 budget calls for the $694 million remaining gap to be filled with reserves, mainly from the general fund but partly from the tort and debt service funds. The latter will replace $54 million general state aid, usually used to make debt service payments, to free up the state aid for operations. The budget projects unrestricted general fund reserves to be depleted this fiscal year, although $195 million in debt service fund balance will remain.
The school closure plan implemented this fall resulted in the closure of 50 schools, projected to save $43 million, or 1% of annual operating costs. The savings in fiscal 2014 will be more than offset by an estimated $78 million in non-recurring operating investments in remaining ("welcoming") schools. The district estimates that the closures will avoid over $400 million in capital costs over 10 years.
Management's other efforts to reduce costs have yielded some savings, primarily in central office and other administrative spending. Additional savings in these areas appear to be limited.
Fitch believes the settlement of the 2012 CTU strike narrows the options for meaningful personnel savings as salary and wage increases are now built in. It also made apparent the poor working relationship between the board and the CTU. The settlement results in cost increases of about $103 million annually over the four-year term through fiscal 2016. The fourth year of the contract will be implemented at CPS's option, with CTU approval. CTU represents about 74% of board employees. The district announced in July layoffs of 2,000 teachers, although many will likely be reinstated as vacancies arise.
REVENUE TIMING YIELDS BUDGET OUTPERFORMANCE
Fiscal 2011 and 2012 both ended with large unanticipated operating surpluses after transfers, yielding a sound unrestricted general fund balance of $903 million or 18.5% of spending at the end of fiscal 2012. Fiscal 2013 is projected to have ended with a sizable operating deficit (after transfers) of $273 million, but less than the budgeted $432 million gap. Fitch estimates these results will yield an unrestricted general fund balance of 10-12% of spending, assuming a similar amount of restricted balance as in fiscal 2012.
Fiscal 2012 ended notably better than projected primarily because property tax and state aid revenue came in earlier than expected. The variance in fiscal 2013 was also affected by reduced expenditures throughout the year. About $249 million of the fiscal 2012 positive variance was the result of on-time property tax billing by Cook County. This allowed for the reporting of an extra six months of revenue on a one-time basis. In fiscal 2013 the district may also recognize a higher level of property taxes than assumed, although this is not included in the projected $273 million operating deficit. Property taxes comprise about 42% of projected fiscal 2013 spending.
There is potential for some additional year-to-year variance in property taxes, positive or negative, depending on the timing of collections. Although the county's prompt billing yielded a notable improvement to the board's liquidity profile, differences in timing of a few days would not influence Fitch's assessment of credit quality even though they could have a notable effect on year-end fund balance. The fiscal 2014 budget assumes the county will continue to bill on time, with collections received on the same schedule as projected for fiscal 2013. Prior to fiscal 2012 billing was routinely delayed. State aid, long on a delayed schedule, is now caught up, and the budget assumes it will remain so.
GAPS GROW IN FISCAL 2015 and 2016
The board's projections show budget gaps of $914 million and $961 million (16%) for fiscal 2015 and 2016, respectively. Proposed solutions rely on pension reform, the impact and timing of which are uncertain. Management estimates annual savings could be as much at $125 million but Fitch discounts the probability of effective pension reform in time to meaningfully reduce the very large budget gap before reserves are all but depleted.
Other potential solutions, yielding far less gap reduction, include recurring measures such as continuing to increase the property tax levy to the inflation-adjusted cap (estimated to generate $50 million annually), and implementing a capital improvement tax that requires only city council approval and would free up state aid now being used for debt service ($20 million). Non-recurring actions that Fitch considers more detrimental to credit quality include use of some remaining debt service fund reserves and debt restructuring.
MANAGEMENT TURNOVER A CONCERN
Continued financial management turnover is an additional challenge for the district. The CEO, CFO, and treasurer have been replaced within the last year and the debt manager recently resigned. Fitch believes this lack of continuity, if it persists, will make addressing budgetary and pension-related problems even more challenging.
PENSION LIABILITIES CONSISTENT WITH WEAK REGIONAL NORMS
Pension funded ratios have dropped significantly in the last several years due to a combination of lower-than-expected investment returns and payment deferrals for the CTU plan granted by the state for fiscal years 2011-2013. As of June 30, 2012 the plan was 60% funded, or approximately 54% using a 7% return rate, compared to 80% and 72%, respectively, in fiscal 2008. The unfunded actuarial liability totaled $6.8 billion in fiscal 2012, up over 130% since fiscal 2008. District non-teachers participate in even more poorly funded city plans.
The increased pension payment beginning in fiscal 2014 is needed to bring payments up to the level required to increase the CTU plan's funded ratio to 90% by fiscal 2059. Fitch does not believe this is an aggressive goal with respect to addressing the unfunded liability but still expects the district will be challenged to meet it. Carrying costs are currently estimated to be a moderate 18%. Costs will likely stay relatively controlled due to the slow amortization of the pension obligation.
Pension reform being discussed at the state level could have a meaningful impact on the board's liability but so far there are no solid indications of when, if, or how it would be implemented. Other post-employment benefits (OPEB) are similarly underfunded but annual payments are capped at $65 million. Fitch is concerned about not only these plans but other city, Cook County, and State of Illinois plans which are all poorly funded.
DEBT CONSTRAINTS MAY HINDER ABILITY TO ADDRESS FUTURE CAPITAL NEEDS
The district's overall debt levels are above average at 7.7% of market value, with very slow amortization of 29% in 10 years, the result of long-dated debt and restructurings. Fitch views positively a reduction in variable rate debt to 21% from 49% in the last several years, although the current ratio is still above norms for the sector. Management has worked to stagger liquidity facility expiration dates to reduce rollover risk. There are no expirations until December 2014.
Planned capital spending has been reduced to $100-200 million annually through fiscal 2017, compared to $500-700 million spent in each fiscal year between fiscal 2009 and fiscal 2012. Fitch views positively management's attempts to reduce its debt burden but is concerned that slated amounts will be insufficient to keep up with essential capital maintenance needs on the district's vast and aging facilities.
ECONOMY SHOWING SOME IMPROVEMENT
Chicago ('AA-', Rating Watch Negative) serves as the economic and cultural hub for the Midwest region, and maintains good prospects for long-term stability if not growth. The city gained over 20,000 jobs or 2.2% in 2012 primarily in professional and business services despite reductions in both manufacturing and public service. Chicago's population totaled 2.7 million in 2012, down 7% from the 2000 census, but still accounts for 21% of the state's population.
Socioeconomic indicators are mixed with elevated unemployment and individual poverty rates, slightly below average per capita income levels, but strong educational attainment levels. As of July 2013, the city's unemployment rate was 11.2%, an increase from 10.8% in July 2012. Employment during this period was flat.
Additional information is available at 'www.fitchratings.com'
In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS Global Insight, Zillow.com, National Association of Realtors.
Applicable Criteria and Related Research:
--'Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. Local Government Tax-Supported Rating Criteria' (Aug. 14, 2012).
Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
U.S. Local Government Tax-Supported Rating Criteria