Fitch Downgrades Chicago, IL's ULTGOs and Sales Tax Bonds to 'BBB+'; Ratings on Negative Watch

NEW YORK--()--Fitch Ratings has downgraded the ratings on the following Chicago, Illinois obligations:

--$8.1 billion unlimited tax GO bonds to 'BBB+' from 'A-';

--$546.5 million (accreted value) sales tax bonds to 'BBB+' from 'A-';

--$200 million commercial paper notes, 2002 program series A (tax exempt) and B (taxable) bank bond ratings to 'BBB' from 'BBB+'.

At the same time, the ratings have been placed on Negative Watch.

SECURITY

The ULTGO bonds are payable from the city's full faith and credit and its ad valorem tax, without limitation as to rate or amount.

The sales tax bonds have a first lien on the city's 1.25% home rule sales and use tax and the city's local share of state-distributed 6.25% sales and use tax. Additionally, there is a springing debt service reserve, funded over a 12-month period that would be triggered if coverage fell below 2.5x.

The bank bond rating for the commercial paper (CP) notes is based upon the city's general obligation pledge payable from any legally available funds without an ability or obligation to levy additional taxes.

KEY RATING DRIVERS

DOWNGRADE DUE TO HEIGHTENED PRESSURES: The downgrade reflects increased fiscal pressures on the city following last week's Illinois Supreme Court decision severely limiting the ability to modify pension benefits in the state and a subsequent downgrade of the city's credit to below investment grade. Fitch does not believe that the Supreme Court decision has a direct effect on the prospects for the city's enacted pension reform, which relies on a different legal argument. However, the events of the last week have amplified the city's numerous fiscal challenges and are likely to further limit the city's investor/lender base, resulting in a risk profile that Fitch believes is no longer consistent with a rating in the 'A' category.

WATCH REFLECTS NEAR-TERM EXECUTION RISKS: The Negative Watch stems from the near-term uncertainty regarding the city's liquidity position due to the effects of the recent downgrade, which constituted a termination event under the city's GO and sales tax swap agreements as well as an event of default for its short-term borrowing program and bank support agreements for variable rate GO and sales tax debt. Fitch believes that the city's plans to deal with these developments are reasonable and manageable, but inherently carry execution risks. Failure of the city's efforts could result in a significant rating downgrade.

STATE PENSION RULING EFFECT LIMITED: The recent Illinois Supreme Court ruling striking down the state's pension reform legislation (SB1) has only a marginal immediate effect on the city's plans to reform its own pension plans. The city's legal argument supporting its reform plan for the Municipal and Laborers' pension plans is different than that of the state and therefore the decision does not directly affect the outcome of the legal challenge to the city's pension reform legislation. The outcome of that litigation is still unknown and an adverse decision could cause a further downgrade.

UNDERLYING CREDIT FUNDAMENTALS REMAIN SOUND: The 'BBB+' rating recognizes the city's role as an economic hub for the Midwestern region of the United States with a highly educated workforce and improving employment trends. Aside from its pension funding challenges, Chicago's financial profile has markedly improved in recent years. The city's independent legal authority to raise revenues remains a key credit strength.

RATING SENSITIVITIES

NEAR-TERM LIQUIDITY: The city is currently negotiating with the GO and sales tax banks/counterparties and is requesting forbearance and/or changes of terms to the defaulted agreements. Failure to reach agreements with existing or new banks that restore access to short-term borrowing facilities and allow the city to avoid immediate repayment of the obligations would impair liquidity and alter the city's financial profile and therefore trigger a downgrade.

EXECUTION OF MODE CONVERSIONS: The city is in the process of converting all of its GO and sales tax variable-rate debt to fixed rate and as such, had already issued mandatory tender notices which otherwise would have been triggered by the rating downgrade. Failure of the city to successfully remarket its variable-rate debt in fixed-rate mode would likely trigger a downgrade.

ADEQUATE RESERVE MAINTENANCE: The city's reserves, including those in the general fund as well as the long-term reserve funds, are an important aspect of the city's overall credit quality. Drawing upon those reserves could trigger a downgrade.

LONGER TERM RISKS REMAIN: Addressing near-term liquidity issues would result in removal of the Negative Watch, but the rating would likely remain on Negative Outlook pending implementation of pension solutions that move all of the city pension plans towards a clear path towards adequate funding while preserving sustainable budgetary balance.

RATING CAPS: The ULTGO rating serves as a ceiling to the sales tax rating. The CP (bank bond) rating is capped one notch below the ULTGO rating. A downgrade of the ULTGO rating, therefore, would result in a downgrade to both the sales tax and CP (bank bond) ratings.

CREDIT PROFILE

VRDO MODE CONVERSION AND SWAP TERMINATIONS

The city faces large payments as a result of the recent downgrade to below investment grade, which put the city's GO rating below rating thresholds on various swaps, variable-rate debt agreements and commercial paper/lines of credit. The city was already in the process of terminating its GO and sales tax swaps and converting its GO and sales tax variable-rate debt to fixed rate. It plans to continue with that conversion, which should be accomplished in the near term, albeit at potentially higher rates than originally anticipated.

The city has issued and rescinded mandatory tender notices in the recent past. A mandatory tender notice for all GO-related variable-rate debt was issued in connection with the most recent effort to remarket the debt in fixed-rate mode. Failure of the city to successfully accomplish the mode conversion that is already in process would likely trigger a mandatory tender under the variable-rate debt bank support agreements and expose the city to onerous accelerated repayment schedules and penalty bank bond rates.

The city has already recently terminated three of the GO-related swaps and one remains outstanding (with a mark-to-market of approximately negative $70 million). The city plans to pay that termination payment with cash on hand. The city also plans to convert the sales tax variable-rate debt and terminate the associated swap agreements in the near term.

SHORT-TERM BORROWING PROGRAM STATUS

The rating downgrade qualified as an event of default under the city's commercial paper and line of credit agreements that comprise its short-term borrowing program. Until recently, the city had $900 million of facilities in place, with $580 million drawn, although only $600 million were active. Two facilities, for $100 million and $200 million, expired last week and extensions were in place for two new $100 million facilities but not yet finalized/activated. All lines are now frozen and subject to immediate repayment in accordance with their terms. The city is in discussions with the banks, exploring the possibility of forbearance agreements and/or changes of terms that would avoid immediate repayment and/or restore access to the lines. Total lines cannot exceed $1 billion according to the authorizing ordinance.

The city expects to be able to restore or replace its short-term borrowing facilities over the near-term. Inability to do so could place significant pressure on the city's financial position, as it could lose access to external short-term borrowing facilities and also face immediate repayment of the obligations. The Negative Watch reflects Fitch's concern that there is considerable execution risk involved in renegotiating those agreements in a way that minimizes risk to the city.

LONGER-TERM CREDIT CONCERNS REMAIN

The city continues to face credit challenges related to critically-underfunded pension obligations and next year's large required payment increases, for much of which the city has not yet identified funding. The outlook for the city's credit quality cannot be considered stable until such challenges are met in a sustainable fashion.

The city maintains four single-employer defined benefit pension plans, all of which are poorly funded due to a statutory funding formula which has fallen far short of actuarial requirements. The combined unfunded liability for all four plans is reported at $20 billion, yielding a very low funded ratio of 34% or an even lower estimated 32% when adjusted by Fitch to reflect a 7% rate of return assumption.

SB1 DECISION NOT NECESSARILY APPLICABLE TO CITY'S REFORM

The state Supreme Court's recent decision striking down the state's pension reform package (SB1) represents a marginal impediment to the city's efforts to reform its own pensions.

Last year, the state legislature passed pension reform legislation covering two of the city's four pension plans (Municipal and Laborers). That legislation has been challenged in court. The SB1 decision specifically struck down the state's argument that there is a 'police powers' exception to the state constitution's pension protection clause, which prohibits diminishing or impairing benefits. The city acknowledges that the pension reform package for its Municipal and Laborers' pension funds is not supported by a "police powers" argument.

The city contends its reform should pass constitutional muster because the reform preserves and protects benefits, rather than diminishing or impairing them. The basis for this contention is that prior to the pension reform legislation, under Illinois statute, the city was not legally responsible for the unfunded liability of the Municipal and Laborers' pension funds. Without reform, those two funds faced depletion in 10 - 13 years.

Under SB 1922, the city assumed that legal burden only as part of the overall pension reform package legislation, and, it contends, thereby is preserving the benefits rather than impairing them. Given the nature of this argument, Fitch does not believe that last week's Supreme Court decision provides clear direction on whether the court will find that the city's reform is constitutional.

The legal challenge is expected to be litigated expeditiously and a final ruling from the state Supreme Court is anticipated by the end of the year. If the pension reform changes to the COLAs and employee contributions are struck down, the city would likely revert to the lower, statutorily based payments, as the city likely would consider annual payments on an actuarially sound basis to be unaffordable. Under this scenario, the related liability could be expected to continue to rise and the rating would likely be downgraded.

POLICE AND FIRE PLANS REQUIRE INCREASED PAYMENTS

The SB1 decision has had some effect on the city's efforts to renegotiate the sharp increase in Police and Fire pension plan payments in 2016. Under Illinois statute, the city is legally responsible for the unfunded liability of those plans, and following the decision has no option to invoke the "police powers" argument to change benefits to lower the actuarial liability. Consequently, the city's focus is now on easing the transition to the statutorily-imposed, much higher, actuarially based payments.

The new formula requires a contribution that would be sufficient to bring both systems to a 90% funding level by 2040 - a 25-year amortization schedule that is more aggressive than the city's other plans. The city continues to negotiate with the police and fire unions to: 1) change the current 25-year amortization period to a 40-year one that would match those of public safety plans in the rest of the state, 2) increase employee contributions, and/or 3) implement a 2-3 year ramp up period to actuarially based funding. Any of those changes would require action by the state legislature. The city estimates that changing the amortization period, alone, would reduce next year's required payment increase from $530 million to $430 million.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in Fitch's 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, 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
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685314

Additional Disclosure

Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=984754

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Contacts

Fitch Ratings
Primary Analyst
Arlene Bohner, +1-212-908-0554
Senior Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eric Friedman, +1-212-908-9181
Director
or
Tertiary Analyst
Richard Raphael, +1-212-908-0506
Managing Director
or
Committee Chairperson
Jessalynn Moro, +1-212-908-0608
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Arlene Bohner, +1-212-908-0554
Senior Director
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eric Friedman, +1-212-908-9181
Director
or
Tertiary Analyst
Richard Raphael, +1-212-908-0506
Managing Director
or
Committee Chairperson
Jessalynn Moro, +1-212-908-0608
Managing Director
or
Media Relations, New York
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com