May 22, 2015
Recently, Moody’s Investors Service downgraded the City of Chicago, Chicago Park District and the Chicago Board of Education’s general obligation bond ratings below investment grade, with a negative outlook. Soon after, Fitch Ratings and Standard and Poor’s Ratings Services both followed suit by downgrading Chicago’s general obligation bond rating one notch to BBB+ from A- and to A- from A+, respectively, with negative outlook, but keeping Chicago’s rating at investment grade.
These downgrades were expected in the wake of the Illinois Supreme Court’s ruling that the State’s pension reform legislation was unconstitutional.
On February 27, 2015 Moody’s downgraded the City’s General Obligation Bond rating one notch to Baa2 from Baa1, which triggered the termination clauses of several of the derivative instruments tied to the City’s variable rate bonds, also referred to as swaps. In Moody’s February rating action report, it cited a number of factors that may further lower the City’s bond rating, which included the Illinois Supreme Court issuing its ruling that the State’s pension reform package was unconstitutional. You can read more about that downgrade here.
Before the most recent downgrade, Chicago Mayor Rahm Emanuel announced a five-point plan to improve the City’s debt profile and end financial practices that have long been highlighted by the Civic Federation as unsustainable. The announcement was made to the Federation’s Board of Directors at a meeting on April 29, 2015. The plan for reforming the City’s debt profile has not been provided in a formal ordinance or policy document, but the elements of the Mayor’s plan include:
- Reducing the use of scoop and toss to $75 million in FY2014 and eliminating the practice all together by 2019;
- Paying termination costs totaling roughly $200 million to end all outstanding swaps using the City’s line of credit;
- Refinancing the swap termination costs and all outstanding variable rate debt using long-term general obligation bonds;
- Reducing the use of bonded debt for the payment of judgments, settlements and legacy liabilities; and
- Restoring funding to the rainy-day funds.
As a result of the recent downgrades, it has been reported that the City of Chicago has postponed its planned bond issuance, which would have allowed the City to convert its variable-rate debt to fixed-rate debt, until the terms of the bond issuance are more favorable towards the City. It has also been reported that the City has been working financial institutions to establish forbearance agreements, which would allow the City to move forward with the bond issuance so long as the rating agencies do not further downgrade Chicago’s bond rating.
The rating agencies focused on three key factors as the basis for downgrading the Chicago area governments.
Illinois Supreme Court’s Ruling on the State’s Pension Reform Legislation
According to Moody’s most recent rating action report, the Illinois Supreme Court’s ruling that the State’s pension reform legislation was unconstitutional limits Chicago’s options for dealing with its own unfunded pension liabilities, which are expected to continue to grow and put greater pressure on the City’s finances. However, Fitch Ratings believes that the Supreme Court’s decision will have “only a marginal immediate effect on the city’s plan to reform its own pension plans.” Fitch notes that the City’s legal argument for the pension reforms made to the Municipal and Laborers’ pension funds is “different from the state and therefore does not directly affect the outcome of the legal challenge to the city’s pension reform legislation.” However, Fitch warns that if the City’s reforms to two of its four pension funds are overturned, the City may face further downgrades.
Growing Unfunded Pension Liabilities and Increased Contributions
The City of Chicago negotiated pension benefit and funding reforms with many of its unions and then worked with the Illinois General Assembly to pass legislation that would make the City’s Municipal and Laborer’s Funds more sustainable. The legislation is currently being challenged in Cook County Circuit Court. You can read more about Chicago pension reform litigation here. The City’s Police and Fire Funds are also dangerously underfunded and are tied to a legislative requirement passed in 2010 that the City increase its funding to the Police and Fire Funds. The change to the funding requirement will result in an increase in the City’s contribution to those two funds of approximately $550 million in 2016. Including increased funding associated with the Municipal and Laborers reforms, the City’s total required contributions to public pensions are expected to grow from an anticipated $478.3 million in 2015 to $1.1 billion in 2016. This is an increase of approximately $627 million for all four of the City’s pension funds. As a result of the growing unfunded pension liabilities and increased pension contributions, Moody’s warns of “increased pressure on the city’s operating budget.”
Near-Term Liquidity Pressures
All three major rating agencies have cited the near-term liquidity pressures that the City faces if it is unable to renegotiate terms related to its swap deals. Moody’s Investors Service decision to downgrade the City of Chicago’s bond rating in February and again in May triggered the termination clauses tied to the City’s letters of credit, standby bond purchase agreements, lines of credit, direct bank loans and swaps. The rating triggers, if not renegotiated, may cause additional near-term liquidity issues for the City and possible further ratings downgrades.
All three ratings agencies similarly noted in their reports that the City of Chicago has a strong, well-educated and diverse economy with the legal authority to increase revenue along with good policies and a management team to help address the city’s financial challenges moving forward.
The Civic Federation will continue to monitor the City of Chicago and other major local governments’ plans to address their financial challenges.