March 6, 2014
Four weeks ago, the Civic Federation blogged about the Chicago City Council granting the City authority to issue general obligation (GO) bonds for the payment of various capital projects and legal judgments, as well as refunding and restructuring debt. As part of that plan, the City is expected to sell $388.0 million in GO bonds on March 6, 2014. In anticipation of this bond sale, Moody’s Investors Service downgraded the City’s credit rating from A3 to Baa1, giving Chicago a lower credit rating than any major U.S. city except Detroit. The other two agencies, Fitch Ratings and Standard & Poor’s, affirmed their existing ratings last week.
According to Moody’s, an A3 rating reflects an upper-medium grade subject to low credit risk. The new Baa1 rating reflects a medium grade subject to moderate credit risk and possibly possessing speculative characteristics. It is important to note that Moody’s recently made modifications to the way it assesses local governments’ credit risk. These changes include an increase in the weight attached to measurements of debt and pension obligations (from 10% to 20%) and a decrease in the weight attached to measurements of the economy and tax base (from 40% to 30%). The City’s debt and pension obligations and diverse tax base were discussed in Moody’s rationale for the downgrade.
Moody’s identifies the following major financial issues as contributors to the ratings downgrade:
- Unfunded Pension Liabilities: Chicago has large and growing unfunded pension liabilities that threaten the City’s fiscal solvency. According to the ratings report, Chicago is an extreme outlier using at least one indicator: the City’s FY2012 adjusted net pension liability, as calculated by Moody’s according to their methodology, is eight times the City’s operating revenue, the highest of any rated U.S. local government.
- Underfunding Pension Contributions: The City’s pension contributions have consistently been significantly less than the Governmental Accounting Standards Board (GASB) reporting standard. Moody’s notes that in FY2012, the City’s pension contribution was equivalent to 10% of its operating revenue. Had the City made a pension payment equal to the actuarially determined amount of $1.5 billion, or 32.0% of operating revenue, the City would have needed to deplete the entirety of its General Fund fund balance – $231.3 million, including nonspendable fund balance and fund balance already assigned to the FY2013 budget – and its remaining asset lease reserves of $624.9 million.
- Additional Revenue and Budgetary Adjustments: The City needs substantial new revenue and other budgetary adjustments. Moody’s opines that the City is “unwilling” to utilize its full taxing authority to adequately fund pensions and says that is credit negative. The ratings agency goes further to say the near doubling of the City’s property tax that would be required to fund pensions at an actuarially determined amount could be absorbed by the City’s tax base. However, Moody’s also cautions that the City has overlapping needs with similar pension and budgetary crises at Chicago Public Schools.
- Large and Growing Debt Obligations: The City’s high debt levels continue to grow, placing an additional burden on the City’s tax base. As stated in our previous blog, the City’s net bonded debt per capita has grown from $1,565 per resident in FY2002 to $2,886 per resident in FY2012, an increase of 84.3%. At $2,886 per resident, the City’s bonded debt burden is second only to New York when compared to thirteen other large U.S. cities.
Throughout the ratings report, Moody’s does note the fact that the General Assembly did pass pension reform for the State of Illinois and the Chicago Park District and that pension reform is therefore possible for the City. However, the analysts also cite Illinois’ strong constitutional protection of pension benefits and the likelihood of litigation should such legislation be passed.
Moody’s last issued a rating change for the City on July 17, 2013 in an unprecedented triple-downgrade from Aa3 to A3. Fitch Ratings followed on November 11, 2013 with a triple downgrade from AA- to A-. Between July and September of last year, each of the six local governments monitored by the Civic Federation with GO bond debt experienced downgrades to their bond ratings by at least one rating agency.
The following chart shows the City’s current GO bond ratings. The City’s revenue bonds have different ratings. The different rating scales and definitions used by major credit rating agencies are outlined here.
What does this mean for Chicago?
The recent downgrades by the major ratings agencies reflect the continued deterioration of the City’s financial outlook. Although the City has reduced its reliance on borrowing for operational expenses, it has not eliminated this practice: the City has borrowed for litigation settlements and annual Aldermanic Menu items, and has pushed current debt obligations into the future at a higher overall cost. The lower credit ratings will likely make future borrowing more expensive for the City and more burdensome for taxpayers.
The agencies cite growing, unsustainable pension liabilities and debt obligations as the major contributors to Chicago’s credit risk. Although pension reform is an immediate and essential short-term objective, it is likely that even comprehensive pension reform packages, such as those passed for the State of Illinois and the Chicago Park District, will not be enough on their own to restore the City’s financial health. To be financially sustainable, the City must have pension reform that reduces its unfunded liabilities and establishes a funding plan based on an actuarially sound method. The City also needs a long-term financial plan that accommodates expenditure reductions and revenue enhancements to balance its budget.