CHICAGO — Chicago Mayor Rahm Emanuel hosts the investor community Friday with a mixed bag of news to share a year after its last meeting was marred by a rare triple-notch downgrade.

The city has some good news to share with bond buyers after making strides toward structurally balancing its books, based on fiscal projections released last week, and it's shored up two of its pension funds that were headed to insolvency.

The positive news is muffled by daunting pension challenges ahead that threaten to further damage the city's general obligation credit. Since its last investor conference, the city has been hit with further credit dings and has drawn comparison to bankrupt Detroit, because of its pension and debt strains.

Market participants who scrutinize the city's finances dismiss such comparisons.

"If you look at the city's mid-year financial report, you see the Emanuel administration is making significant progress in closing the structural budget imbalance," said Laurence Msall, president of the Civic Federation of Chicago, which tracks city finances. "It's a great improvement from what they faced when they first came into office" in 2011.

"But the failure to get police and fire pension reforms enacted runs the risk of swamping all the success they've had to date," he added.

Since last August, the city received a second triple-notch downgrade as Fitch Ratings in November delivered the same ratings blow as Moody's did in July. Fitch lowered the rating to A-minus and assigns a negative outlook.

Standard & Poor's shifted the city's outlook on an A-plus rating to negative in September. Moody's earlier this year then pushed the city's GO rating down one more level to Baa1 and assigned a negative outlook. Any future Moody's downgrade could trigger swap and letter of credit events.

Chicago's challenge is to overhaul the city's pension and fire funds and deal with a $550 million spike in contributions due in 2016 under a prior state mandate. Local governments across the state face the same mandate.

Though the payment isn't due until 2016, the city has long warned the reckoning would come in 2015, when it must submit its tax levy request to cover the higher contributions. The city punted on offering a firm funding solution when it released its 2015 fiscal projections last week.

Instead, the administration is banking on its ability to reach an agreement with its unions that the General Assembly and Gov. Pat Quinn will sign off on. Any reform plan probably would ramp up contributions gradually to an actuarially required contribution level. Any changes are threatened by a legal challenge, and a recent state Supreme Court ruling assigning constitutional protections to state retiree healthcare benefits has raised concerns over the legality of any reforms that cut benefits.

Investors give high marks to Emanuel's financial team, led by chief financial officer Lois Scott, for pursuing a more open relationship with them.

"The city had a number of very distinct challenges when this administration took over — and they have been much much more open than the past administration — but they still have a lot of wood to chop," said Dennis Derby, senior research analyst at Wells Capital, which manages funds that hold Chicago GOs.

The Chicago Public Schools' own pension and budgetary woes further burden the city, as they rely on the same tax base. The schools will also participate in the conference Friday.

"My biggest concern is inaction on the part of the state," Derby said, noting pension benefits and contributions are set in state statute. "The city has taken good steps with its budget but there's still a lot of negative headline risk."

In its annual financial analysis, Chicago stresses its strides while acknowledging its challenges. The city projects a $297.3 million gap in its corporate fund that must be closed before Emanuel releases the 2015 budget in October.

The gap is down $104 million from the previous projection in 2015 and $40 million below the deficit the city faced heading into the 2014 budget a year ago. The gap heading into 2015 is half what the city faced when Emanuel took office in 2011.

"Structurally, you can see the decline in the gap over the last three years," said city budget director Alexandra Holt. "We obviously have more to do, but the structural changes on the cost and revenue side have really all resulted in a decline in the structural deficit."

The city has reduced some long term cost pressures by renegotiating contracts, including healthcare deals, introduced managed competition for some services, and switched to grid-based garbage collection. It has also raised various fines, fees, and taxes.

Holt said a property or sales tax increase is off the table to close the looming budget gap.

The laborers and municipal pension reform package initially relied on a $50 million property tax hike next year, but instead the city raised its emergency services surcharge on phone bills which will free up general fund revenue to cover the pension contribution.

The goal is to hold the line on the use of non-recurring revenues that contributed to the growth in the city's structural budgetary woes. They were driven by former Mayor Richard Daley's heavy use of reserves, debt restructuring and other one-shots in his final years.

The city's 2014 budget relied on just $97 million of non-recurring revenues, or 3% of the corporate fund, and it's "absolutely" the city's goal to limit their use, Holt said.

The review presents a more comprehensive picture of the city's fiscal landscape. It includes revenue and expense patterns over the last decade, data on city debt, reserves, pension funds, capital spending, and a three-year fiscal forecast.

A big driver of the city's increasing costs is employees. The workforce fell from 39,654 positions in 2004 to 32,280 positions this year, but costs per employee have soared to $94,551 in 2013 from $59,714 in 2004 in large part due to rising healthcare expenses.

The city's unfunded liabilities dropped in 2013 to 19.2 billion from $19.5 billion for a collective funded ratio of 37%.

Pension payments will rise from $478 million this year to $1.1 billion next year, although that total reflects the higher police and fire payments the city has not accounted for in its preliminary budget figures.

The administration defends the decision to put off any decisions on how to deal with the contribution spike as it works towards an agreement with unions and state lawmakers.

"The reality is we need reforms, then we can talk about the revenue package" to fund higher contributions, Holt said. She adds the city can't afford either the deep cuts or the tax increases needed to stabilize the funds without benefit changes.

The municipal fund closed out 2013 at a 39% funded level with $8.4 billion of unfunded obligations. The laborers fund was 61% funded with $933 million of unfunded obligations, the fire fund was 27% funded with $3 billion of unfunded liabilities, and the police fund was at 32% with $6.8 billion of unfunded liabilities.

Under the laborers and municipal fund reforms, the city's contributions will increase to $267 million in 2015 from $177.7 million this year and then grow by 22% annually until they reach an ARC level of $590 million in 2019.

The reform package relies on higher contributions and benefit cuts to fully fund the plans by 2055. The higher police and fire contributions are due under a 2010 state mandate to reach a 90% funded ratio by 2040. Local governments across the state also face higher payments. "It's a statewide problem that requires a statewide solution," Msall said.

Debt and Reserves
The city's $8.7 billion five-year capital program through 2018 relies primarily on a mix of $680 million of general obligation bonds, $1.1 billion of federal funds, $2.2 billion of aviation backed revenue bonding, $3.8 billion of water and sewer revenue borrowing, and $242 million of state funds.

The city issued $880 million of bonds earlier this year to raise new money and pay down shorter term debt instruments used to finance capital projects last year. The city has paid a steep price for its credit deterioration. The spreads on its 10-year tax-exempt maturity in its sale earlier this year widened to 145 basis points over the Municipal Market Data benchmark from 84 basis points on a 2012 sale. The state retiree healthcare ruling last month has further impacted trading levels, according to data from Interactive Data and others.

"Illinois GO and other city of Chicago credits have widened as much as 35 basis points relative to triple-A benchmark moves since the Supreme Court ruling," said Matt Posner, a managing director at Municipal Market Advisors. "We believe this is actually an entry point for investors willing to take on what we expect to see continued volatility in the state and city's credits in the medium-term."

The city closed out 2013 with $21 billion of total debt. Debt service has almost doubled from $793 million in 2004 to $1.56 billion in 2014 and is projected to rise to $1.7 billion in 2017. The bulk of the debt financed capital projects, but the city has also used debt to cover working capital expenses such as equipment, union settlements and judgments.

The Emanuel administration said it has made strides in reducing borrowing for such expenses, but it has come under criticism for continuing the practice. The city is also strained by slow amortization as its delays principal repayment to smooth out its debt service schedule and its undertaken an ongoing restructuring with similar goals.

Swaps and letter of credit support tied to its debt portfolio provide strong incentive for the city to stave off any further credit deterioration. The city has one LOC agreement that includes a downgrade to Baa2 or the equivalent by any rating agency as a default event. Triggers on all other LOCs and standby bond purchase agreements are Baa3 or below, according to past bond documents.

The city has 19 interest rate swap agreements tied to its GOs with default events on 17 triggered at a rating below the Baa1 level - the city's current Moody's rating. A downgrade below Baa2 would trigger a default event for the remaining two. Moody's reported the negative valuation earlier this year on the 17 at $139 million and the other two at $33 million but said the city's liquidity is more than sufficient to cover.

The city has worked over the last several years to amend its LOC and swap agreements with more favorable terms and banks that do underwriting business with the city have strong incentive to cooperate.

The city closed out 2013 with $628 million in reserves, Daley dipped deeply into reserve funds that came from the city's parking meter lease. Emanuel halted the practice and has made small deposits totaling $35 million over the last two years with another $5 million slated to be deposited this year.

The city closed out 2013 with a $33 million unassigned balance. The city's 2014 budget performance is tracking well with projections and a narrow balance is expected. Most economically sensitive taxes are showing strong growth, but the city's share of state income tax revenues is down as are non-tax revenues. The corporate fund is part of the city's larger $7 billion budget.

Next year, the city projects corporate fund revenues of $3.22 billion with expenses projected at $3.52 billion. The revenue estimates rely on modest economic growth and a return to normal trends in revenues, which were affected by the severe weather this past winter.

Under mid-level economic projections, the city faces deficits of $430 million deficit in 2016 and $588 million in 2017. Those figures include increases required to fund the laborers' and municipal funds' reform law but don't include the spike in police and fire pension payments. Under a negative scenario, the gap rises to $1 billion in 2017.

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