Chicago Public Schools’ Chief Executive Officer Barbara Byrd-Bennett Says Ratings Slide Underscores Need for State Help on Pensions

CHICAGO — The cracks in Chicago Public School system's fiscal foundation deepened as a new credit blow triggered swap termination events that could force payments of more than $260 million to counterparties.

"CPS has been in contact with each of the swap counterparties and is working with them to renegotiate terms and reduce any potential payments," the district's administration said in a statement Friday.

The fresh downgrade from Fitch Ratings puts the school system on the lowest investment grade rung of two rating agencies. The rating reviews come ahead of $550 million in new money and refunding unlimited tax general obligation bond sales planned in the coming weeks. The bonds also carry a pledge of state aid.

Fitch socked the school district with a three-notch downgrade, lowering its rating to BBB-minus from A-minus. The rating service warned of the potential for further weakening by assigning a negative outlook.

"The downgrade reflects the limited progress the Chicago Public Schools has made in addressing a structural budget gap approximating 20% of spending for the upcoming fiscal year," analysts wrote. "Following substantial drawdowns in the prior and current fiscal years, reserves will likely to be fully depleted by the end of fiscal 2016."

The negative outlook reflects analysts' concerns that substantial changes are necessary to support ongoing operating and fixed cost spending. "Options within the board's sole control are limited and Fitch believes meaningful solutions would have a notable impact on educational programs," analysts wrote.

The district faces rising pension payments that are straining its books. The administration of chief executive officer Barbara Byrd-Bennett must tackle a $1.1 billion deficit in its fiscal year 2016 budget. She has said the district has almost run out of one-time maneuvers and has limited reserves remaining.

The district closed past gaps through debt restructuring and the use of reserves. Last year it extended its revenue recognition period, counting additional property tax dollars collected in the new fiscal year toward the previous year's balance. The district has limited revenue raising ability as it bumps up against state imposed property tax caps. It has already cut spending and closed schools.

Standard & Poor's recently lowered the district's rating by two notches to A-minus and assigned a negative outlook. Kroll Bond Rating Agency on Friday issued a first-time rating to the district of BBB-plus with a stable outlook. The actions followed Moody's Investors Service's decision earlier this month to lower its rating two levels to Baa3 with a negative outlook.

The district has 10 derivatives on a notional amount of $1.1 billion, including $905 million of synthetic fixed-rate interest swaps and $187 million of basis swaps that combined carried a negative valuation of $215 million as of June 30, according to the district's offering statement. A termination event is triggered when rating agencies lower the district's GOs to below the mid-triple B level, which occurred with the Fitch action.

Under a termination event, the board would be required to pay any negative valuation on the swap, according to its offering statement. The board's swap counterparties include Loop Financial Products LLC, Merrill Lynch Capital Services LLC, Royal Bank of Canada LLC, Bank of America NA, Goldman Sachs Bank, Goldman Sachs Capital Markets LP. Market participants said it's in the banks' favor to enter a forbearance agreement or renegotiate terms, as they all have underwriting relationships with the district.

Fitch reported a more current negative valuation of $263 million and raised concerns over the district's ability to cover the payments, given its lean cash reserves on hand. "Fitch believes the district will have to either renegotiate the terms of the swaps with the counterparties or bond for the funds, as cash balances appear inadequate to cover both termination payments and operations," the report said.

The district's balance sheet is also strained by high debt levels at 9.5% of market value, with slow amortization of 29% in 10 years, the result of long-dated debt and restructurings as the district overhauled schools over the last two decades.

Fitch said it views positively a reduction in variable rate debt to 17% from 49% in the last several years, although the current ratio is still above norms for the sector.

Pensions remain a daunting challenge. The district has $9.5 billion of unfunded pension obligations for a funded ratio of 52% and is banking on state help on reforms.

"It is not a secret that Chicago Public Schools has long faced serious fiscal challenges that are primarily driven by a broken pension system," Byrd-Bennett said in a statement after the new downgrade. "Without reforms, CPS will be forced to decide between funding the pensions of retirees and funding the education of its students."

The current administration — picked by Mayor Rahm Emanuel — inherited skyrocketing pension payments that will hit $700 million in the next budget. The growth accelerated in fiscal 2014 due to the expiration of a partial, three-year pension holiday won by the administration in place under former Mayor Richard Daley.

Fitch also views as unfavorable the district's poor working relationship with the teachers union, underscored by a 2012 strike. CPS serves almost 400,000 students in 664 schools.

Fitch issued a direct warning tied to the upcoming budget. "Fitch will downgrade the rating further if there is not clear and meaningful progress in reducing the large structural imbalance," analysts wrote. "A notable increase to debt or unfunded post-employment liabilities would also likely result in a rating downgrade."

On its line of credit debt, a downgrade by Fitch, Moody's or Standard & Poor's below investment grade would trigger a default event that could result in the district's tax-exempt interest rate rising to 9% and its taxable rate growing to 13.5%. The district doesn't face any threat of acceleration under its credit terms.

The board of education issued an updated offering statement late Friday disclosing the information on the swap termination events, telling potential investors it has sufficient liquidity from reserves, including its debt service stabilization fund, and through credit lines to cover any payment demanded.

"No assurance can be given, however, regarding the board's future liquidity position," the document said. It reported the negative valuation at $228 million as of March 19.

School officials had already been seeking to ease the terms, according to the offering statement. "Prior to the downgrades, the board began discussions with the counterparties to amend the existing swap agreements to modify the triggering events," the document said. "While those discussions are expected to continue, there can be no guarantee that amendments will be successfully negotiated with any of the swap counterparties."

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