CHICAGO – Chicago is closer to losing another investment grade rating after Fitch Ratings dropped the city two notches Monday.
Fitch lowered Chicago’s general obligation and sales tax rating to BBB-minus, leaving it on the lowest rung of the investment grade scale following the Illinois Supreme Court’s decision last week tossing its overhaul of two pension funds.
Fitch warned of the potential for further downgrades by assigning a negative outlook, amplifying the pressure on the city to move quickly on an alternative plan to save the two funds from insolvency, which looms in the next 10 to 13 years.
“The outlook for the city's credit quality cannot be considered stable until such challenges are met in a sustainable fashion,” Fitch said.
The action marked the first ratings fallout from Thursday’s Illinois Supreme Court ruling voiding the city’s 2014 overhaul of two of its four funds, which account for half of the city’s massive $20 billion unfunded pension burden.
The downgrade from BBB-plus impacts $9.8 billion of GOs and $486 million of sales tax-backed bonds, which are capped at the city’s GO rating.
The city carries a junk-level rating of Ba1 and a negative outlook from Moody's Investors Service; a BBB-plus rating and negative outlook from Standard & Poor's; and an A-minus rating with a negative outlook from Kroll Bond Rating Agency.
Fitch said the Supreme Court ruling represented one of the worst of the possible outcomes for the city's credit quality.
“Not only did it strike down the pension reform legislation in its entirety, but it made clear that the city bears responsibility to fund the promised pension benefits, even if the pension funds become insolvent,” analysts wrote.
The state's high court upheld Cook County Circuit Court Judge Rita Novak's July ruling that declared the 2014 overhaul of the city's municipal employees' and laborers' funds unconstitutional because of benefit cuts imposed on retirees and employees. The court’s opinion, like one issued last May on reforms that cut benefits to four of the state’s five pension funds, rested on the strength of the state constitution’s pension clause.
The court rejected the city’s argument that members benefit from the reforms because they save the funds from future insolvency and make clear the city is on the hook for payments. The court cast doubt on the city’s future ability to argue that it’s not responsible to save the funds based on the current statutory funding formula that falls short of what’s needed to keep the funds healthy.
“As we have explained, the Illinois Constitution mandates that members of the funds have 'a legally enforceable right to receive the benefits they have been promised' — not merely to receive whatever happens to remain in the funds," the court said.
Mayor Rahm Emanuel’s administration told Fitch and Standard & Poor’s, according to reports from the two agencies, that it will outline a new strategy to address the increased burden resulting from the ruling in the next several weeks.
Emanuel’s chief financial officer, Carole Brown, did not shed any light on the timing or details of what the city will offer. The city is evaluating various reform proposals, she said, stressing that the administration is seeking a path that is fair to taxpayers while preserving the pension funds, protecting the city’s financial stability and limiting the burden on taxpayers.
“Mayor Emanuel has demonstrated the resolve necessary to address our financial challenges head on and put Chicago on a path to long-term financial stability from passing the 2016 Budget to converting the city’s variable-rate debt to fixed-rate debt,” Brown said in a statement. “The decision by the Illinois Supreme Court is disappointing, but the city’s ability to pay our debt and meet our current commitment to the pension funds has not changed,” Brown said.
Fitch said a realistic plan that puts the pension funds on an affordable path toward solvency is required to stabilize the rating.
“Given the lack of flexibility to alter the liability, Fitch believes the plan must rely on meaningful use of revenue and expenditure controls to meet much higher annual payments,” its analysts said. “The lack of such a plan would likely result in a downgrade as it would raise the risk that plan assets will be depleted and pension benefit payments would be made on a pay-go basis, severely impairing financial flexibility.”
The city has long argued it needs state legislation to increase its payments, but it could put the funds in escrow as it pursues legislation to change the statutory formula for city contributions which is based on a percentage of employee contributions.
Market participants say a mix of tax increases and spending cuts would be needed to address higher contributions. While any funding schedule can’t rely on benefit cuts without running afoul of the state pension clause, the city could seek other concessions from unions to ease the fiscal burden on its balance sheet.
The city’s total unfunded tab is $20 billion for its four systems which are just 34% funded. When Fitch adjusts the figures applying a 7% assumed rate of return, lower than the assumptions the funds use, the funded ratio drops to 32%.
The weight of the city’s pension strains are worsened by its high 8.7% of market value debt burden due to its borrowing and that of overlapping local governments, many of which are also struggling with sizable pension obligations.
The city’s pension burden overshadows sound economic fundamentals.
“Aside from its pension funding issues, Chicago's financial profile has markedly improved in recent years, although full structural balance remains a challenge. The city's independent legal authority to raise revenues remains a key credit strength,” Fitch wrote.
Moody’s and Standard & Poor’s issued statements after the court ruling that did not include any credit action.
“In the near term, the city's credit quality could weaken unless it identifies a funding mechanism to address the unfunded liabilities in the municipal and laborers plans and prevent further destabilization of the city's budget,” S&P said Thursday.
Moody's will continue assessing Chicago's actions to address unfunded pension liabilities, Moody's analyst Matthew Butler said in a statement after the ruling, "including any initiatives specifically aimed at the plans affected by today's court decision."
Kroll has not issued a commentary on the ruling’s impact.