NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded to 'BBB-' from 'BBB+' the ratings on the following Chicago, Illinois obligations:
--$9.8 billion unlimited tax general obligation (ULTGO) bonds;
--$486 million sales tax revenue bonds.
The Rating Outlook is Negative.
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.
KEY RATING DRIVERS
PENSION RULING HEIGHTENS PRESSURE: Fitch believes last week's Illinois Supreme Court ruling striking down pension reform legislation for two of the city of Chicago's four pension plans was among the worst of the possible outcomes for the city's credit quality. Not only did it strike down the pension reform legislation in its entirety, but it made clear that the city bears responsibility to fund the promised pension benefits, even if the pension funds become insolvent.
CITY STRATEGY ANTICIPATED: The city expects to present a strategy to address the increased burden resulting from the ruling in the next several weeks. Given the lack of flexibility to alter the liability, Fitch believes the plan must rely on meaningful use of revenue and expenditure controls to meet much higher annual payments.
UNDERLYING 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 issues, Chicago's financial profile has markedly improved in recent years, although full structural balance remains a challenge. The city's independent legal authority to raise revenues remains a key credit strength.
RATING SENSITIVITIES
PATH TO PLAN SOLVENCY: The rating could stabilize at 'BBB-' if the city presents a realistic plan that puts the pension funds on an affordable path toward solvency. The lack of such a plan would likely result in a downgrade as it would raise the risk that plan assets will be depleted and pension benefit payments would be made on a paygo basis, severely impairing financial flexibility.
RATING CAPS: The ULTGO rating serves as a ceiling to the sales tax rating. A change of the ULTGO rating, therefore, would result in a change to the sales tax rating.
CREDIT PROFILE
LONGER-TERM LIABILITIES A CHIEF CONCERN
The city continues to face credit challenges related to critically-underfunded pension obligations and rising associated costs. The Outlook for the city's credit quality cannot be considered stable until such challenges are met in a sustainable fashion. Since last week's ruling appears to eliminate the option of reducing the liability, the city will need to rely on its ability to increase revenues and control spending. Fitch will evaluate the direction of the rating and Outlook as their level of ability to do so becomes more apparent.
The weight of the city's extremely large unfunded pension liability is compounded by the high (8.7% of market value) debt burden, which is the product of substantial borrowing by the city as well as overlapping jurisdictions. Many of these overlapping governments also maintain underfunded pensions, and Fitch remains concerned that the funding requirements for all of these long-term liabilities will pressure the resource base in the coming years.
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. In fiscal 2014, the combined actual pension contribution amounted to just a quarter of the actuarially determined requirement. The combined unfunded liability for all four plans is reported at approximately $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.
PENSION REFORM CHALLENGE DECISION
Last week's court ruling struck down pension reform legislation covering two of the city's four pension plans (Municipal and Laborers). The legislation included some changes to the benefit structure that reduce the liability, as well as a multi-year ramp up in contributions.
The city contended its reform would preserve and protect benefits, rather than diminishing or impairing them. The basis for this contention was 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.
The ruling struck down the benefit changes and confirmed the city's responsibility for providing promised benefits. If the city does not implement a plan to increase funding, those funds face depletion in 10-13 years. The Municipal plan is the largest of the city's four pension plans.
POLICE AND FIRE PLANS REQUIRE INCREASED PAYMENTS
The Police and Fire pension plans also faced increased funding requirements. The existing formula requires a contribution that would be sufficient to bring both systems to a 90% funding level by 2040. The state legislature passed a bill that would change the amortization period to 40 years and allow for a ramp up period to the 90% actuarially based funding level in 2020.
Those two changes are estimated to lessen the increase in the first year's (2016) payment from $550 million to $330 million. The legislature has not sent the bill to the governor for his signature. Once the legislature sends the bill to the governor, if not signed, it would become law 60 days. The city has arranged to fund the full, higher contribution for 2016, using short-term borrowing proceeds to fund the difference.
PENSION CHALLENGES OVERSHADOW IMPROVED FINANCIAL PERFORMANCE
Management has made significant progress toward matching ongoing revenues with non-pension annual expenditures. Fitch will not consider the city's financial operations to be structurally balanced in the absence of a sustainable, actuarially-based pension funding structure. Successful execution of the city's plan toward financially sustainable practices would be considered a positive rating factor. Remaining plan elements include the elimination of scoop-and-toss refundings by 2019, the use of current funds to pay legal settlements or judgments, and growth of the 'rainy day fund.'
The city ended the practice of appropriating reserves beginning with fiscal 2015. The $3.5 billion fiscal 2015 general fund budget was balanced with a reduced but still significant amount of one-time measures, including scoop-and-toss refunding. The city expects to end fiscal 2015 on budget, with no use of fund balance anticipated.
The $3.6 billion fiscal 2016 general fund budget closed the previously identified budget gap of $232.6 million through a variety of recurring and one-time measures and no appropriation of general fund balance. Fitch believes the budget target is achievable given the city's recent history of budgetary adherence. Despite the progress made, the city's budget still requires some non-recurring measures for balance, which is concerning several years into an economic recovery.
REVENUE CONTROL AND RESERVES KEY
Fitch views the city's home rule status as a credit strength, fostering revenue independence and flexibility. The general fund derives support from utility taxes, state sales taxes, transaction taxes, and recreation taxes among others. The general fund does not rely upon property taxes for operations, as they are earmarked for pensions, library expenses and debt service.
The audited fiscal 2014 unrestricted general fund balance dropped to 3.6% from 4.6% of spending a year prior. Fitch views the approximately $626 million, equivalent to 19.4% of fiscal 2014 general fund spending, in the service concession and reserve fund as an important element of financial flexibility. A draw on reserves would signal an increasing reliance on non-recurring measures and could trigger a rating downgrade.
ECONOMIC FUNDAMENTALS SOLID
Chicago serves as the economic and cultural hub for the Midwest region, and maintains good prospects for long-term stability if not growth. The city has gained almost 50,000 jobs since 2010 primarily in professional and business services despite reductions in both manufacturing and public service.
Chicago's population totaled 2.7 million in 2014, down 6% from the 2000 census, but still accounts for 21% of the state's population. Socioeconomic indicators are mixed with elevated individual poverty rates, average per capita income levels, but strong educational attainment levels.
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, Lumesis, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS Global Insight, National Association of Realtors.
Fitch recently published exposure drafts of state and local government tax-supported criteria (Exposure Draft: U.S. Tax-Supported Rating Criteria, dated Sept. 10, 2015 and Exposure Draft: Incorporating Enhanced Recovery Prospects into U.S. Local Tax-Supported Ratings, dated Feb. 2, 2016). The drafts include a number of proposed revisions to existing criteria. If applied in the proposed form, Fitch estimates the revised criteria would result in changes to less than 10% of existing tax-supported ratings. Fitch expects that final criteria will be approved and published in the beginning of the second quarter of 2016. Once approved, the criteria will be applied immediately to any new issue and surveillance rating review. Fitch anticipates the criteria to be applied to all ratings that fall under the criteria within a 12-month period from the final approval date.
Applicable Criteria
Exposure Draft: Incorporating Enhanced Recovery Prospects into US Local Tax-Supported Ratings (pub. 02 Feb 2016)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=875108
Exposure Draft: U.S. Tax-Supported Rating Criteria (pub. 10 Sep 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=869942
Tax-Supported Rating Criteria (pub. 14 Aug 2012)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015
U.S. Local Government Tax-Supported Rating Criteria (pub. 14 Aug 2012)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=685314
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
https://www.fitchratings.com/creditdesk/press_releases/content/ridf_frame.cfm?pr_id=1001583
Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1001583
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.