NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the following Chicago, IL bond ratings:
--$8 billion unlimited tax general obligation (ULTGO) bonds to 'A-' from 'AA-';
--$497.3 million sales tax bonds to 'A-' from 'AA-';
--$200 million commercial paper notes, 2002 program series A (tax exempt) and B (taxable) to 'BBB+' from 'A+'.
The Rating Outlook is Negative.
SECURITY
The ULTGO bonds are secured by the city's full faith and credit and its ad valorem tax, without limitation as to rate or amount.
The sales tax bonds are secured by 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 is triggered if coverage falls below 2.5x.
The commercial paper (CP) notes are secured by the city's general obligation pledge payable from any legally available funds without an ability or obligation to levy additional taxes.
KEY RATING DRIVERS
LACK OF PENSION SOLUTION; LIMITED OPTIONS: The downgrade reflects the lack of meaningful solutions to both the near- and long-term burden. The city has been unsuccessful in its attempts to negotiate a solution with labor unions and lobby the state legislature, which ultimately controls the benefit formula.
OTHER IMPROVEMENT EVIDENT; BUDGET STILL TIGHT: Pension concerns overshadow recent improvement in other aspects of the city's credit profile. Recent budgets have been narrowly balanced with lesser reliance upon one-time items. Maintenance of significant long-term reserves is an important element of financial flexibility.
WEAK DEBT PROFILE & OVERLAPPING PENSION BURDENS EXACERBATE PRESSURE
Pension stress exacerbates the already weak debt profile, which features above-average debt burden and slow payout.
Several overlapping area governments also have underfunded pension systems, which will require some measure of increased funding, presenting a stacked burden on residents and taxpayers.
ECONOMIC HUB; SLUGGISH RECOVERY: Chicago serves as a regional economic hub for the Midwest region and maintains good prospects for long-term stability if not growth. Growth in cyclical revenues reflects a measure of economic recovery; however, high unemployment persists and property tax base recovery has been elusive.
RATING SENSITIVITIES
PENSION REFORM: Maintenance of the 'A-' rating requires implementation of an attainable plan to put all city pension plans on a clear path towards adequate funding. Fitch believes a pension solution that enhances funding levels while preserving sustainable budgetary balance is necessary to stabilize the credit. Inaction, or affirmative steps to avoid a solution leading up to the looming pension cost increases scheduled for fiscal 2016, will have a negative impact on the rating.
ULTGO RATING SERVES AS A CAP TO SALES TAX AND CP RATINGS: The ULTGO rating serves as a ceiling to the sales tax rating. The CP rating is capped one notch below the ULTGO rating. A further downgrade of the ULTGO rating, therefore, would result in a downgrade to both the sales tax and CP ratings.
CREDIT PROFILE
PENSION RISKS OVERSHADOW RECENT FISCAL IMPROVEMENT
Fitch recognizes the current administration's notably improved financial and budgetary management which has brought the city closer to structural balance, following the prior administration's long-term trend of reliance upon asset sales and other non-recurring items to fund operations. This improvement, however, is inflated by the making of statutorily-based pension payments, which severely underfund the ARC. Fitch considers full ARC funding a necessary component of structural balance.
MANAGEMENT'S PENSION OPTIONS ARE LIMITED
Management has presented a plan to address the pension problem but lacks the legal authority to implement it unilaterally. Direct negotiations with labor groups have failed to yield a solution and attempts to lobby the legislature for benefit changes which would reduce the unfunded actuarially accrued liability (UAAL) have been unsuccessful thus far.
Any changes to the benefit structure would require an act of the state legislature, which is currently struggling to address its own pension funding issues. The legislature recently recessed without taking action that would address the city's pension issues and, absent a special session, will likely continue negotiations in the next session, which begins in January. Even if the legislature were to pass comprehensive pension reform, Illinois law affords strong legal protection to pension benefits and Fitch expects that any such changes would face protracted legal challenges.
LONG-TERM PENSION RISKS
The combination of low funded ratios and a statutorily-based contribution requirement that funds approximately one-third of the ARC is unsustainable. Each year of sub-ARC funding results in an increase in the ARC for the subsequent year, and a widening distance between statutory and ARC payment.
The amount that would be required to amortize the unfunded liability grows larger as time passes, both in nominal terms and as a percent of governmental spending, threatening to crowd out other city spending priorities. The combined reported funding ratio for the four plans has declined steadily, reaching a low 35.2% at Dec. 31, 2012 and down from 57.3% five years ago. Fitch estimates the funding ratio to be a weaker-still 32.9%, assuming a more conservative 7% rate of return.
NEAR-TERM PENSION RISKS
Management is focused on reducing the size of the unfunded liability, but any meaningful solution to the pension funding problem is likely to require significantly higher annual contributions from the city. Fiscal 2012 carrying costs for pension, OPEB and debt service would have amounted to a high 35.0% of governmental fund spending if the ARC were fully funded, well above the 19.5% burden under the current statutorily-based payment structure.
State law requires dramatically increased annual funding requirements for two of the city's four pension systems beginning in 2016, which would need to be addressed in the fiscal 2015 budget. The new formula requires a contribution that would be sufficient to bring both the police and fire systems to 90% funding level by 2040.
The city estimates the resultant annual requirement will rise by $580 million as a result, an amount that will raise carrying costs to above-average levels, potentially crowding-out other city spending priorities. Legislation to delay the implementation and require property tax increases to fund it has been introduced, but the legislature has not acted on it. Fitch believes deferral of the increased actuarially-based requirement would exacerbate the problem absent a meaningful reduction in the UAAL.
LONG-TERM LIABILITY PRESSURE HEIGHTENED BY OVERLAPPING STRESS
The city's weak long-term liability profile is underscored by its underfunded pensions combined with its above-average overall debt burden of 8.3% of market value. Payout is slow at 34% and annual 'scoop and toss' restructurings continue to marginally weaken debt structure.
The widespread use of statutorily-based pension contributions for single employer plans in Illinois results in multiple underfunded Chicago area pension plans, placing stress on the city's residents and taxpayers. As a home rule entity, the city has a variety of revenue-raising options available to it, but typically, such plans are funded from the property tax levy. If the city were to raise its property tax sufficient to fully fund the ARC (2012 level) with no offsetting revenue increase or liability reduction, the tax levy/rate would rise a dramatic 136%.
The city's property tax comprises 20% of the overall property tax bill, so the increase to an individual property owner would be materially less at approximately 15%. Fitch estimates that if each area government including the city raised its property tax rate to cover the ARC (2012 level) with no corresponding reduction in the liability, the overall impact to an individual payer would be a 35% tax increase. Fitch believes such an increase could present stress to the local economy, which has been slow to recover from the recession. Both the city and the overall increase required under this scenario will rise each year as funding levels fall and the ARC grows.
ECONOMIC HUB; SLUGGISH RECOVERY
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. The city's highly educated work force supports its status as a major financial and business services center. Educational attainment levels are strong, with nearly 33% achieving a bachelor's degree and 13% an advanced degree, compared with the U.S. averages of 28.2% and 10.5%, respectively.
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. However, unemployment remains elevated. The August 2013 unemployment rate of 10.9% was marginally higher than the 10.5% recorded a year prior, reflecting an expanded labor force outpacing growth in employment. This compares unfavorably to the August 2013 rate of 9.0% recorded by the state and 7.3% by the U.S.
Overall income and wealth indices are mixed. Per capita income is at 95% of the state and 100% of the U.S. levels; however, the poverty rate remains elevated at 21.4%, much higher than the U.S. average of 14.3%. Economically sensitive tax revenues have recovered to pre-recession levels. The tax base, down 30% over the past four years, has not yet shown signs of recovery, due in part to the lagging assessment cycle.
NON-PENSION FINANCIAL PERFORMANCE IMPROVING
Management has made significant progress toward matching ongoing revenues with non-pension annual expenditures. Fitch views positively the city's stated commitment to ending the practice of using the corpus of its long-term reserves to balance the operating budget. Other recurring improvements over the past two years include a hiring freeze for non-essential positions, the elimination of 2,000 vacant positions and a marked reduction in retiree health care costs, although the latter is subject to litigation.
REVENUE FLEXIBILITY A STRENGTH
Fitch views the city's home rule status as a credit positive, fostering revenue independence and flexibility. The general fund derives support from utility taxes, state sales taxes, transaction taxes, 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 city's home rule status also exempts it from the state's Property Tax Extension Limitation Act. A self-imposed limit matches that of the state, limiting increases in the levy to the lesser of 5% or the CPI. In recent years, the city has kept its levy flat, without accessing the allowable growth. Fitch believes the self-imposed levy limit is relatively flexible and that increased property taxes may provide an important source of funding for potential future increases in pension payments.
FY2012 AUDITED DEFICIT; FY2013 ESTIMATES FAVORABLE
The general fund recorded a $101 million operating deficit after transfers reflecting -3.3% of spending in fiscal 2012, the first full year under the current mayor. This compares favorably to the budgeted appropriation of $143 million of general fund balance, supported by some recurring solutions and the use of reserves from other funds. Fiscal 2012 unrestricted general fund balance dropped to 6.8% from 10.2% of spending a year prior.
Fitch views approximately $625 million, or 20.1% of fiscal 2012 general fund spending, in the service concession and reserve fund as an important element of financial flexibility. The sum includes the remaining amount of the Skyway lease proceeds.
Published preliminary fiscal 2013 results show revenues outperforming budget. Expenditure detail is not yet available, but early indications are encouraging. The preliminary fiscal 2014 budget seeks to appropriate $50 million of identified surplus from fiscal 2013, to be used toward increased police overtime expenses.
FY2014 BUDGET BALANCED WITH RECURRING AND ONE-TIME ITEMS
The $3.1 billion proposed fiscal 2014 budget seeks to close the previously identified budget gap of $338.7 million through a variety of recurring and one-time measures. Revenue measures include an assumed $101 million growth in economically sensitive revenues, $53 million of general fund and $35 million other fund balances, and $34 million of increased taxes and fees. Expenditure measures include $66 million of savings, including $20 million of savings from the elimination of retiree health care for certain retirees, which is subject to litigation.
Fitch believes that these identified measures are achievable given the city's recent history of budgetary adherence; however, Fitch will not consider the city's financial operations to be structurally balanced until recurring revenues support recurring expenditures, including actuarially-based pension costs.
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=807562
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