Fitch Rates $426MM Chicago Board of Education (IL) ULTGOs 'B+'; Outlook Negative

NEW YORK--()--Fitch Ratings has assigned a 'B+' rating to the following Chicago Board of Education, IL (CBOE) unlimited tax general obligation bonds (ULTGOs):

--$46.4 million ULTGO refunding bonds (dedicated revenues) series 2016C;

--$94.8 million ULTGO refunding bonds (dedicated revenues) series 2016D;

--$141.2 million ULTGO bonds (dedicated revenues) series 2016E;

--$122.0 million ULTGO bonds (dedicated revenues) taxable series 2016F;

--$21.9 million ULTGO bonds (dedicated revenues) series 2016G.

Fitch has also affirmed the 'B+' rating on the following CBOE obligations:

--Long-Term Issuer Default Rating (IDR);

--Approximately $7.1 billion of outstanding ULTGO bonds.

The Rating Outlook is Negative.

The bonds are scheduled to sell via negotiation the week of Nov. 14. Proceeds will refund various series of outstanding bonds, finance reimbursement of previously paid swap termination payments, finance capital improvements, fund capitalized interest and pay the costs of issuance of the bonds.

SECURITY

The bonds are unlimited tax general obligation bonds payable from dedicated CBOE revenues. The bonds are payable in the first instance from unrestricted general state aid and are also general obligations of the CBOE, payable from unlimited ad valorem taxes levied against all taxable property in the city of Chicago.

KEY RATING DRIVERS

The 'B+' rating reflects CPS's chronic structural imbalance, slim reserves and weak liquidity position which are exacerbated by rising long-term liability costs, an historically acrimonious labor relationship and the lack of an independent ability to raise revenues.

Economic Resource Base

The Chicago Board of Education provides preK-12 education to over 390,000 students within the city of Chicago. Its taxing jurisdiction is coterminous with the city of Chicago. The Chicago Public Schools (CPS) manages the school system which is composed of 673 school facilities. Chicago serves as the economic and cultural center for the Midwestern region of the United States. The city'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. CPS derives about a third of its revenues from the state of Illinois (rated 'BBB+'/ Negative Watch). State-wide economic growth through the current expansion has lagged that of the U.S. as a whole.

Revenue Framework: 'bbb' factor assessment

Fitch expects natural revenue growth, absent new revenue action, to keep pace with inflation. CPS has no independent legal ability to raise revenues.

Expenditure Framework: 'bbb' factor assessment

Fitch expects the natural pace of expenditure growth to exceed that of revenues, necessitating ongoing budget management. CPS has made significant cuts in recent years, and Fitch believes that the practical ability to cut spending throughout the economic cycle is limited.

Long-Term Liability Burden: 'a' factor assessment

The long-term liability burden is elevated, but still in the moderate range, relative to the resource base.

Operating Performance: '< bb' factor assessment

Financial operations are strained, structurally imbalanced and reliant upon year-round cash flow borrowing. Fitch expects budgetary imbalance to persist despite the district's intention to rein in spending and its expectations that state aid will grow. Reserve levels are narrow despite low expected revenue volatility and given limited budgetary flexibility Fitch believes financial operations are poorly positioned to absorb even a mild economic downturn without further impairing liquidity.

RATING SENSITIVITIES

Structural Imbalance: A lack of progress towards resolving CPS's large structural imbalance would put further negative pressure on the rating.

Market Access: Reliable market access is important to near-term stability. Fitch will monitor the district's ability to access external financing for both liquidity and capital purposes.

CREDIT PROFILE

Chicago acts as the economic engine for the Midwestern region of the U.S. The city's residents are afforded abundant employment opportunities within this deep and diverse regional economy. The city also benefits from an extensive infrastructure network, including a vast rail system, which supports continued growth. The employment base is represented by all major sectors with concentrations in the wholesale trade, professional and business services and financial sectors. Socioeconomic indicators are mixed as is typical for an urbanized area, with average per capita income and educational levels, but also elevated individual poverty rates.

CPS relies on state funding for a significant amount of support. Illinois is a large, wealthy state with a diverse economy centered on the Chicago metropolitan area. The state's operating performance, both during the most recent recession and in this subsequent period of economic growth, has been very weak. The state's extended budget stalemate has continued into a second fiscal year and has resulted in a marked deterioration in the state's finances during this time of economic recovery.

Revenue Framework

Property taxes provided 46% and state aid 32% of general fund revenues in fiscal 2015.

Growth prospects for revenues are slow, without taking into account potential revenue-raising measures. Actual revenues are budgeted to rise significantly in the current fiscal 2017 as the result of both local and state policy action. The city of Chicago approved a $250 million increase in property taxes (equivalent to 4.5% of general fund spending) beginning in fiscal 2017 to be used for pension payments. State aid is budgeted to rise by $317 million including $102 million in state poverty grants. The remaining $215 million represents a state pension contribution which has not yet received state approval. This represents a fairly large budgetary vulnerability as the governor has stated that his support is contingent upon the passage of a comprehensive pension reform plan.

Independent legal ability to raise revenues is limited, like many school districts in the U.S. Annual growth in the property tax levy is limited by the Property Tax Extension Limitation Law to the lesser of 5% or the rate of inflation.

Expenditure Framework

The district devoted 50% of fiscal 2015 governmental fund spending to instruction, 15% to general support services, 10% to pensions, 8% to debt service and 6% to capital outlay.

Fitch expects the natural pace of spending growth to be above natural revenue growth, given rising pension contributions and labor costs. Management has actively managed expenditure growth, with a series of substantial cuts over the past several years including administrative cutbacks, school closures and layoffs.

CPS's practical ability to make future expenditure cuts is limited. While politically difficult, such cuts could include those for efficiency, programs, and labor costs. Further cuts may become necessary in the near term, particularly if the entire amount of budgeted state aid is not realized. Carrying costs for debt service and actuarially-determined pension contributions are currently moderate at 19% of governmental spending in fiscal 2015; however, increasing pension and debt service costs will likely raise carrying costs to elevated levels over the next several years.

Long-Term Liability Burden

The long-term liability burden is elevated but still moderate relative to the resource base. The net pension liability plus overall debt represents about 25% of personal income. Overlapping debt accounts for almost half of the long-term liability burden, with net pension liability representing a third and direct debt approximately 20%. Amortization of direct debt is slow with 25% of debt scheduled for retirement in 10 years. Fitch anticipates that the long-term liability burden will remain solidly within the 'a' category

Pension benefits for teachers are provided through the Public School Teachers' Pension and Retirement Fund of Chicago (CTPF), a cost-sharing multi-employer defined benefit plan in which CPS is the major contributor. Under GASB 68 reporting, the plan reported a 51.6% asset to liability ratio as of June 30, 2015. Fitch estimates the ratio to be slightly lower at about 48% when adjusted to reflect a 7% return assumption. The weak ratios stem from several years of pension payment holidays and poor investment returns. The district dramatically increased pension funding in fiscal 2014 to comply with a state law requiring payments sufficient to reach a 90% funding level by 2059.

Pension benefits for other personnel are provided through the Municipal Employees' Annuity and Benefit Fund of Chicago (MEABF), a cost-sharing multi-employer defined benefit plan, whose major contributor is the city of Chicago. The MEABF plan also has a weak asset to liability ratio of 20.3%, or an estimated 19% when adjusted by Fitch to reflect a 7% return assumption. CPS does not directly contribute to the plan and its proportionate share of the net pension liability is $0

Other post-employment benefits (OPEB) are similarly underfunded but annual payments are statutorily capped at $65 million. The OPEB liability represents an additional 1.4% of personal income.

Operating Performance

Financial resilience is the key credit concern, as CPS's narrow and declining reserves provide insufficient cushion against a potential revenue stress. The fiscal 2016 budget included a $185 million appropriation of general fund balance, but preliminary fiscal 2016 results show a larger draw of $367 million. The negative budgetary variance was largely due to a $480 million state aid payment for pensions that was budgeted but not realized. The fiscal 2017 budget includes an additional $81 million use of fund balance which will bring reserves close to zero. The lack of an adequate financial cushion leaves CPS ill-prepared to withstand even a moderate economic downturn.

The fact that CPS still struggles with structural budgetary balance is particularly concerning this far into an economic recovery. Much of the imbalance stems from the shift in fiscal 2014 from statutory to actuarially-based pension payments, which presented a dramatic rise in spending without a corresponding revenue increase. Recent budgets have also relied upon unsustainable practices including appropriated reserves, scoop and toss restructurings for budgetary relief and optimistic budgeting of revenues. The fiscal 2017 budget represents a measure of improvement, incorporating a mixture of expenditure controls and increased revenues; however, budgeted expenditures still exceed revenues by $81 million and receipt of the budgeted $215 million state payment for pensions remains speculative.

The district has closed $95 million of its identified $300 million budget gap and expects to cover the increased costs associated with a new labor contract (discussed below) with TIF surplus in fiscal 2017.

Liquidity is extremely weak, with 12 days of cash on hand at the end of fiscal 2015. CPS' cash position declined dramatically from $1.1 billion at the close of fiscal 2013 to $150 million at the end of fiscal 2015. The decline was exaggerated by the use of cash to pay for capital projects that were subsequently reimbursed by issuance of long-term bonds and the acceleration of vendor payments that were partially reimbursed in fiscal 2015.

CPS remains highly dependent upon market access for short-term borrowing. The district's reliance on external sources of liquidity is increasing. Cash flow borrowing will rise from $1.065 billion in fiscal 2016 to $1.55 billion in fiscal 2017. The district's updated cash flow forecast for fiscal 2017 and the first two months of fiscal 2018 shows August 2016 as the only point when end-of-month cash is positive net of cash flow borrowing. The cash flow forecasts include the $1.55 billion of borrowing; a $475 million line of credit is in place with the remainder under negotiation.

Current Developments

The teachers' contract was recently settled on terms less favorable than the district budgeted for, but more favorable than the previous contract. The contract covers fiscal years 2016 through 2019 and avoids retroactive payments for fiscal 2016. The district was not able to achieve the proposed elimination of the district's practice of paying 7% of the teachers' 9% pension contribution (pension pickup) for existing teachers, but the contract does eliminate this benefit for new employees with an offsetting increase in starting base salary. Wage increases are 0% for fiscals 2016 and 2017, 2% for fiscal 2018 and 2.5% for fiscal 2019. There are no step or lane increases for fiscal 2016 but these resume for fiscals 2017-19. Some savings are derived from heath care plan design changes.

The current-year cost of the new teachers' contract is approximately $55 million more than the original fiscal 2017 budget of approximately $5.5 billion. CPS anticipates funding the incremental labor contract cost with a one-time revenue source: supplemental TIF surplus funds from the city.

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

In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

Applicable Criteria

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/site/re/879478

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Senior Director
+1-212-908-0554
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Amy Laskey
Managing Director
+1-212-908-0568
or
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Laura Porter
Managing Director
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or
Media Relations:
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Arlene Bohner
Senior Director
+1-212-908-0554
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Amy Laskey
Managing Director
+1-212-908-0568
or
Committee Chairperson
Laura Porter
Managing Director
+1-212-908-0575
or
Media Relations:
Elizabeth Fogerty, +1-212-908-0526
elizabeth.fogerty@fitchratings.com