Chicago Warns Investors on Impact of Battered Credit

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CHICAGO — Using language Mayor Rahm Emanuel is unlikely to replicate in campaign brochures, Chicago's latest bond documents lay out for investors in stark terms the risks posed by its steep credit deterioration and hazards should it slip further.

The city - after multiple recent downgrades — is as little as one more downgrade away from potential swap termination events, the document says.

The city — in a reoffering statement for 2003 floating rate general obligation bonds that were recently remarketed with a new letter of credit — added to its table of contents a segment titled "Effect of Rating Changes" that hadn't appeared in previous offering documents.

In addition to disclosure included in previous offering documents on the city's ratings triggers tied to its finance contracts, the new section provides more information about the consequences if such triggers are pulled.

The section on page four of the document chronicles the city's credit slide, and with a negative outlook assigned by three rating agencies, warns that "further reductions …could affect its relationships with creditors and financial counterparties."

Also, "further reductions in the city's general obligation debt credit rating could have significant adverse effects on the city's financial condition, including its ability to borrow and service its debt obligations," it continues.

The section is followed about 10 pages later with details on the GO rating thresholds that can trigger default events on the city's GO swaps, liquidity facilities, letters of credit, commercial paper, and lines of credit, information that was previously included in city disclosure.

The additions to the table of contents section come amid heightened market sensitivity about disclosure and after the Securities and Exchange Commission has shown that it will aggressively charge issuers who are less than forthcoming with investors.

Section 10b-5 of the Securities Exchange Act of 1934 makes it illegal to make any untrue statement of fact or to omit a material fact in connection with the purchase or sale of securities. If an issuer goes to market without disclosing important information to investors, it could face fraud charges.

The city did not immediately comment on the motives behind the latest additions to its reoffering statement, but Chief Financial Officer Lois Scott has won praise for stepping up investor relations through disclosure and investor conferences.

Several market participants praised the city for its prominent disclosure placement while also stressing that the city is meeting a disclosure obligation.

Many market participants believe the city's financial counterparties would not actually act on termination or debt acceleration penalties if triggered, instead agreeing to compromise terms, but say the warnings are nonetheless warranted.

"This is material information," said Richard Ciccarone, president of Merritt Research Services LLC. "The city is doing what they should especially in light of the heightened scrutiny of the SEC. They are closer to the ratings threshold triggers and it is more of a clear and present danger."

Issuers who "say up front what their risks are" in their disclosure can benefit from both regulatory and investor fronts, and the proof has been in ongoing market access for struggling credits, said Ernie Lanza, an attorney at Greenberg Traurig who is a disclosure specialist and recently left the Municipal Securities Rulemaking Board.

The city's last new-money GO offering in March, after two triple-notch downgrades, did not include a similar listing in its table of contents although it clearly outlined the city's ratings deterioration and thresholds tied to its swaps and liquidity support.

The city attributes its downgrades over the last year and a half to its "pension liabilities and uncertainty over the means of funding these liabilities" that has offset the city's strides in structurally balancing its budget.

The section chronicles the latest hit delivered by Moody's Investors Service on March 4 that lowered Chicago's GO rating to Baa1 with a negative outlook from A3 with a negative outlook. It followed the agency's three-notch downgrade from Aa3 in July 2013.

On Nov. 8, Fitch Ratings downgraded Chicago GOs three notches to A-minus from AA-minus and assigned a negative outlook. In September 2013, Standard & Poor's revised its outlook to negative from stable while affirming the city's A-plus rating.

The city's GO LOCs and lines of credit are at risk due to provisions that permit banks to accelerate debt repayment based on reductions in the city's credit ratings. GO derivatives are at risk due to provisions that allow the counterparties to terminate the agreements if the city falls below a ratings threshold.

If the city's ratings are reduced below trigger levels and counterparties exercise their rights, the city says in the section it could result in "significant" termination payments due on swaps, acceleration of the repayment of bank notes on its commercial paper program, and acceleration of payment obligations. The city could also lose its borrowing capacity under its CP program and lines of credit.

The city also warns investors that any further credit blow "may lessen the demand for the city's debt, prevent the city from issuing GO bonds, notes, or commercial paper or substantially increase the city's cost borrowing," which could harm the city's capital program.

Chicago reports ongoing discussions with its creditors and financial counterparties to lower the ratings thresholds and reports success on some fronts but warns no assurance can be given that the city will be successful in negotiating with all of its creditors or financial counterparties, or that its ratings won't further slide.

Termination events would be triggered on 10 of the city's swaps if hit with another Moody's downgrade.

The city recently terminated two of its swaps on a notional principal amount of $206 million from a 2002 issue, drawing $36.3 million from its short-term borrowing program to cover a termination payment. The city intends to convert the paper to a fixed-rate structure, according to the reoffering statement.

The negative valuation on the city's 15 swaps as of June 30 was $147 million. The city does not face any collateral posting requirements based on its rating levels. Moody's, citing an even higher prior valuation, said the city's liquidity is more than sufficient to cover such swap termination payments.

The city has 11 bank liquidity facilities or letters of credit. They include four from JPMorgan Chase Bank with a default triggered at a rating below the triple-B minus level, two from Barclays Plc triggered below the BBB level, although the threshold may be lowered by one level if all other parties involved in a GO-related city credit agreement agree to a similar reduction.

Defaults on a support facility from Bank of Montreal and one from Northern Trust are triggered one notch below a BBB-minus level. One from RBC and two from the Bank of New York carry BBB thresholds.

The city has four swaps tied to $200 million of floating rate securities from a 2007 issue, with a negative valuation of $55.5 million. The counterparties include Deutsche Bank, Morgan Stanley, and Wells Fargo.

Termination on the Deutsche Bank and Wells Fargo swaps could be triggered by a subsequent downgrade from Moody's, with the Standard & Poor's trigger at below BBB-plus. The city has more breathing room on the Morgan Stanley swap which is triggered should the city's ratings fall below the BBB-minus level.

The city has six swaps on $223 million from a 2005 issue with swap counterparties including Goldman Sachs, BMO Harris Bank, the Bank of New York Mellon, PNC Bank, and two with Deutsche Bank.

The BMO, Deutsche Bank, and PNC swaps all carry thresholds at the BBB-plus level, meaning one more downgrade from Moody's would trigger a termination event. The Goldman Sachs swap has a threshold should the rating fall below the BBB-minus level and the Bank of New York triggers below BBB. The swaps had a negative valuation of $60.4 million at the end of June.

The city has five swaps tied to $193 million from its 2003 issue, two with counterparty PNC, and one with Wells Fargo Bank, one with JPMorgan, and one with the Bank of New York. The negative valuation on the swaps totaled $31.4 million as of June 30.

The Wells Fargo and PNC swap termination events would be triggered at a rating below the BBB-plus level, the Bank of New York swap is triggered should the city rating fall below a BBB rating, and the JPMorgan termination is triggered below BBB-minus.

The city's lines of credit with Morgan Stanley, Barclays Bank, Bank of America, and JPMorgan have a mix of rating default triggers. All but the Morgan Stanley line, which is triggered at a rating below BBB-minus, carry thresholds that trigger defaults at a rating below a BBB level. If all banks agree, the threshold can be moved to the BBB-minus level. The CP program thresholds are set at the BBB-minus level by Moody's and Standard & Poor's.

"I think it's something as a buyer of bonds we appreciate. The issue for an investor is headline risk and what can lead to a loss of liquidity with the city's paper," Doug Benton, senior municipal credit manager at Cavanal Hill Investment Management, said of the city's warnings on the impact of rating changes.

Benton added it pays for an issuer like Chicago to be proactive and up front with negative news, or it won't "have credibility with the Street" when it comes to market because the city is dealing with "sophisticated buyers."

John Mousseau, portfolio manager at Cumberland Advisors, agreed.

"It's absolutely better to be up front, better the devil you know" for investors, he said.

While investors continually clamor for more timely disclosure, heightened regulatory scrutiny such as the SEC's Municipalities Continuing Disclosure Cooperation initiative has helped, Benton said.

The MCDC program offers reduced settlement terms to issuers and underwriters who voluntarily report instances over the past five years in which their official statements falsely claimed compliance with continuing disclosure obligations. Since April, there have been 12,000 more filings than during the same period last year, according to market reports.

The city remarketed its $193 million of B-1, B-2, and B-3 floating rate paper from 2003 with a new letter of credit provided by JPMorgan Chase Bank. The new LOC took effect Sept. 25. Duane Moris LLP and Cotillas and Associates were co-disclosure counsel on the reoffering with Katten Muchin Rosenman LLP and Quintairos, Prieto, Wood & Boyer PA as co-bond counsel.

Chicago has paid steep penalties to borrow amid investors' concern about the city's pension mess, underscored by $19 billion of unfunded liabilities. State lawmakers passed the city's plan to overhaul two of its four pension funds, but it could face a legal challenge.

The city faces a $600 million spike in payments to its police and fire funds in 2016 under a prior state mandate but it hoping for action on those plans in a future state legislative session.

The city's penalties extended recently to even its highest rated bonds issued earlier in September under its water and wastewater revenue credits that carry ratings from the single-A to double-A category.

The water bonds paid a yield on the 10-year of 3.15 %, 92 basis points more than the Municipal Market Data benchmark, and the 30-year bond paid a yield of 4.01%, 84 basis points over MMD.

The wastewater bonds paid a yield of 2.99% on the 10-year, 74 basis points more than the MMD benchmark, and the 30-year bond paid 3.92 %, 72 basis points over MMD.

The spreads were higher than similarly rated credits in the market although they have recently tightened in secondary market trades.

Kyle Glazier contributed to this story.

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