Another Credit Blow Adds to Chicago Schools' Woes

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CHICAGO – The Chicago Public Schools' cash crisis triggered a fresh rating blow this week that market participants say could scare off some buyers and further drive up its already steep spread premiums.

Moody's Investors Service downgraded the Chicago Board of Education one more notch into junk territory, to B1 from Ba3. Moody's kept the credit is under review due to headwinds bearing down on the district over the next 90 days.

The downgrade "reflects the precarious liquidity position of the district," said the Moody's report published Monday. "CPS has increasingly relied on market access and cash flow borrowing to maintain ongoing operations."

The action affects $5.5 billion of the district's $6 billion in debt.

The district released a brief consultant's report earlier this month warning that it could exhaust operating cash as soon as January, making its ability to get a $1 billion sale done and tap a new credit line before then the more urgent.

The school district's lack of progress in convincing state leaders to provide the $480 million in pension or other funding support assumed in its $6.4 billion fiscal 2016 budget also contributed to the new downgrade. The school system's chief executive officer, Forrest Claypool, has warned of major layoffs if the state doesn't come through with the requested assistance.

The Chicago schools' crisis is low on the priority list in the state capital, where a feud between the legislature's majority Democrats and Republican Gov. Bruce Rauner has left the state without a budget for almost six months.

While Rauner did sign school aid appropriations, grant funding of $150 million has been delayed.

More recently, Chicago teachers gave their union authorization to pursue a strike, which could occur as soon as late February if a new contract can't be brokered.

CPS acknowledged its fiscal situation and said it continues to pursue action to help ease its strains. “It’s no secret that CPS’ $1.1 billion budget crisis is putting the district in a precarious position, as Moody’s notes,” the district’s top fiscal officer, Ron DeNard, senior vice president of finance, said in a statement. “We’re continuing to make every effort toward balancing our budget, whether it’s further streamlining central office or pursuing our fair share of funding from the state, which provides CPS with only 15 percent of its education funding despite our students making up 20 percent of the enrollment.”

The district's risk of default rises to 2.92% in the first year of holding a B level rating, compared to .28% at the Ba level, according to Moody's cumulative default rates averaged between 1970-2014.

The new downgrade and escalating market concerns over the district's precarious liquidity position come as CPS plans to enter the market late next month with $1.16 billion of general obligation paper.

The deal will push off $229 million in debt principal for budget relief, provide another $275 million to convert floating-rate bonds to fixed and pay the cost of terminating interest-rate swaps now in default due to CPS' previous credit deterioration. The remainder will fund capital projects.

JPMorgan is the senior manager.

CPS also intends to raise $130 million through a credit line authorized by the board this month in the form of tax anticipation notes.

Market participants contacted for this story expect the district will retain market access but it will come at an even more costly price than previously estimated, unless CPS gets good news from the state.

"The severity of the borrowing penalty grows exponentially each time it happens as the potential investor demand base narrows," Richard Ciccarone, president at Merritt Research Services, said of the downgrade's impact.

"Doing a billion dollar financing won't be easy even with the help of yield-hungry investors. How they structure the security will matter a lot," Ciccarone said.

"There should be enough demand but the yields will be high," said Matt Fabian, partner at Municipal Market Analytics. "It will depend on what exactly is happening at the time of sale. A strike is not good news."

A B1 rating "severely restricts the public buyer base," said Brian Battle, director of trading at Chicago-based Performance Trust Capital Partners.

He suggested a private placement might work better for the district. The bond resolution the Board of Education approved last week allows for either a public offering or private placement.

"They will have access, and there will be a premium," Battle said.

Investors typically look favorably on the district's pledge of state aid and the city's diverse property base but the district's prospects are dim given the ongoing state budget impasse and its lack of a "structural plan and reform agenda" and plan should it succeed or fail with the state, Battle said.

Market jitters over Puerto Rico could also spill over and dampen some interest in the CPS paper.

Puerto Rico's travails have spooked some non-traditional crossover municipal buyers who assumed defaults never actually happen, said Michael Johnson, head of research at Gurtin Fixed Income Management LLC.

"In the end, there are likely enough distressed debt or traditional high yield investors that will participate, but with a heavy yield premium," he said.

The district has paid heavily to borrow on recent issues and credit lines. It paid a rate of 70% of one-month LIBOR plus 2.75% on a recent short-term $250 million credit line and LIBOR plus 3.25% on another. The top yield of 5.63% on the 25-year maturity in the district's April sale landed 285 basis points over the Municipal Market Data's triple-A benchmark.

The lower rating further reflects elevated debt levels and escalating pension contributions because the district is saddled with $10 billion of unfunded pension liabilities, and also reflects its recent use of reserves to fund recurring contributions and its elevated debt levels, Moody's said. The only prominent positive feature of the district's credit profile noted was CPS' position as a beneficiary of a large tax base and diverse economy.

The district faces a series of hurdles in the next two months that Moody's said drove its decision to put the rating on review.

The district is slated to receive $150 million of state block grants in January 2016, which could be delayed, and the district needs the successful completion of the bond sale to ease debt service demands. On February 15, the district is scheduled to deposit with bond trustees debt service payments due between June 2016 and March 2017.

"Finally, the state may finalize its budget and determine the amount of aid to appropriate to CPS in the current fiscal year," analysts wrote. "Alternatively, the absence of a final state budget could put further pressure on the district as it approaches the latter part of its own fiscal year without clarity on state funding."

CPS's GOs are ultimately secured by the district's pledge to levy a property tax but much of its debt is further backed by other dedicated revenues such as state aid. The district also uses its personal property replacement taxes, intergovernmental agreement revenue, and tax increment financing revenue to repay debt.

The warning on the district's cash flow crisis was outlined in a recent letter from consultant Ernst & Young LLP.

"The near-term cash flow shortfall is expected to be addressed by issuing additional debt, thereby further increasing CPS' liabilities and future debt service obligations," the letter to Claypool said.

In addition to the potential delay of the $150 million state block grant payment, the consultants' letter attributes the current cash crisis to the district's ongoing $1 billion structural deficit and the increased burden put on the operating fund to cover capital costs as a result of the bond sale's delay. It was originally expected to sell in November or December.

In addition to its use of credit lines, the district is deferring some large vendor payments to preserve cash. The district anticipates tens of millions in savings through administrative cuts under a planned reorganization and an additional $100 million in non-personnel cuts and efficiencies.

Fitch Ratings and Standard & Poor's have also pushed the board's $6 billion of general obligation debt down to junk. S&P and Fitch have the rating on negative watch. The district retains the lowest investment grade level rating from Kroll Bond Rating Agency.

The district's ratings, at the low-double-A level just a few years ago, have plummeted since a partial pension contribution holiday expired and the district turned to one-time revenues like accounting maneuvers, reserve use, and debt restructuring to wipe out growing deficits.

Some market participants believe the district could be headed toward some form of state takeover or oversight as occurred in the late 1970s. Rauner has suggested the district is a candidate for bankruptcy although the state has no statutes that would permit it to file Chapter 9.

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