“We believe an unbiased look at the city’s credit profile supports the view that Chicago’s general obligation pledge is not investment grade,” wrote Nuveen analyst Shawn O’Leary

Chicago's downgrade to junk sharpened attention on the splits among rating agencies, sparking a spirited debate in the municipal market far beyond the struggles of the Windy City.

Moody's Investors Service dropped Chicago two notches to Ba1 May 12, citing the strain of $20 billion in pension underfunding and an Illinois Supreme Court ruling that appears to have complicated any efforts to change the state's public employee retirement systems.

As the sting of the downgrade impacted the value of other troubled credits far from Chicago's border, conversation turned to the implications of divided ratings and whether Chicago truly belongs in speculative grade territory, along with growing awareness of the role of political risk in credit assessment.

"Not surprisingly, Moody's action has restoked the ongoing debate about the role of rating agencies in the post-financial crisis world," Triet Nguyen, a managing director at the independent financial services advisory firm New Oak, wrote in a commentary.

"No local government's split credit ratings have—in recent memory—spurred as passionate of a debate as Chicago's," Municipal Market Analytics partner Matt Fabian writes in the firm's Monday outlook. "It strikes us that underlying this debate may be a discrepancy between what ratings are and what the industry ideally wants them to be."

Even before the Moody's junk downgrade, Chicago's ratings ranged from Moody's Baa2 to A-plus from Standard & Poor's, with Fitch Ratings and Kroll Bond Rating Agency in the middle at A-minus.

"In actuality, ratings are the product of objective information and subjective assessments made by private companies and scored against their internally developed methodologies. There is no single scale, uniform methodology or consistent interpretation of data across the agencies," MMA said in the outlook piece.

The potential liquidity crisis triggered by the Moody's downgrade prompted Standard & Poor's to move its rating down two notches to A-minus, while Fitch lowered it one notch to BBB-plus. Kroll affirmed. That still leaves a four-notch rating spread among the four agencies.

Chicago was rated Aa3 by Moody's when Mayor Rahm Emanuel took office four years ago, but the rating fell swiftly after Moody's implemented methodology revisions that altered its assessment of pension obligations.

The Fallout

Debate ensued over the timing of the Moody's downgrade or whether it was appropriate at all. Emanuel delivered a stinging rebuke, highlighting the disparity in ratings, calling Moody's out of step and accusing it of trying to force the city's hand on increasing property tax rates.

Market chatter over the downgrade was underscored by Moody's release six days later of a special report to address "questions we are receiving concerning last week's downgrade."

Moody's senior analyst Rachel Cortez took center stage that week at a long-scheduled discussion of city finances hosted by the City Club of Chicago.

"To us it was pretty clear that benefit reductions under any circumstances are impermissible and in violation of the Illinois constitution," Cortez said of Moody's reaction to the state Supreme Court's decision, which voided changes to state pension systems. Chicago officials say the city has stronger legal arguments than the state government did as a challenge to an overhaul of two of the city's funds proceeds.

Market analysts agree Chicago faces severe fiscal stress from its pension woes, but Fabian and Richard Ciccarone, president of Merritt Research Services, have suggested that Moody's acted pre-emptively especially given that the legal challenge its reforms hasn't been resolved.

"I don't think at this point there is a material risk of the city defaulting," Fabian said after the downgrade.

Ciccarone believes the rating agency should have given the city more time to complete the restructuring of its floating-rate bonds to ease liquidity pressures.

New Oak said the city's proximity to such a liquidity crisis speaks for itself. "Let's face it, any issuer who is susceptible to this kind of short-term liquidity crisis just cannot be viewed as investment grade," Nguyen wrote.

Nuveen Asset Management LLC weighed in on the rating gaps, supporting Moody's, saying such volatility could be expected for credits like Chicago's.

Nuveen highlighted the long term trend of diverging ratings between Moody's and Standard & Poor's since 2008 by comparing upgrades of tax-supported and appropriation ratings since 2002. Standard & Poor's upgraded 1.01 municipal ratings for every Moody's upgrade from 2002 to 2007, but that ratio jumped to 6.66-to-1 for the period from 2008 to 2014, according to the report authored by Nuveen senior research analyst Shawn O'Leary last week.

"The municipal bond market has treated Chicago bonds as being of speculative credit quality since before the Moody's downgrade," O'Leary wrote. "Nevertheless, we believe an unbiased look at the city's credit profile supports the view that Chicago's general obligation pledge is not investment grade."

Chicago stands apart from its peers in terms of its debt and pension costs with its combined cost to service both consuming 44.8% of fiscal 2013 governmental revenue. That's far ahead of the next closest -- San Jose at 27.8%, according to Nuveen.

Nuveen considers an assessment of pension funding status an "imperative" for investors, given the bankruptcy cases of Detroit and Stockton, Calif. in which pension obligations were treated as senior to bond obligations.

"Even if one believes a Chicago bankruptcy is a minimal risk, the outcome could be quite bleak for Chicago bondholders," Nuveen wrote.

The junk-level downgrade also shone a light on default risks. Moody's sought to tamp down concerns, highlighting its analysis that Ba-level credits show just a 5% likelihood of default in the coming years.

"It is also important to note that a below investment grade rating doesn't necessarily mean Chicago will default on its obligations," Nuveen said. "Indeed, Chicago still has options and can avert such an outcome."

Pricing and Timing

"Split ratings highlight the subjectivity implicit in any rating assignment and, we argue, reasonably reduce the pricing relevance of ratings in general," MMA wrote in its outlook. "This worsens already growing uncertainty over idiosyncratic default risk, heightens systemic exposure to headline credit events, and is detrimental to generic market liquidity."

Several reports have highlighted the impact on pricing across the market following the downgrade -- especially on credits saddled with sizeable pension burdens.

"In our view, this development has resulted in a feedback loop with negative implications for the broader market," Citi wrote in its May 21 municipal market piece.

"Investors are growing more concerned about municipalities which have burgeoning pension problems. While the credit spreads for long dated issues which were downgraded by Moody's and S&P have widened by 20 - 50 basis points, other states which have underfunded pensions have also witnessed their GO debt" widen, said the report from Citi's municipal research team of Vikram Rai, George Friedlander, and Jack Muller.

Illinois GO spreads jumped 30 basis points after the state Supreme Court's May 8 ruling while New Jersey saw its spreads widen by 40 basis points. "We expect other states such as Pennsylvania and cities that are in the crosshairs owing to their pension situations will witness a similar increase in their cost of debt," Citi said.

Chicago's GO paper had for some months already been trading at speculative grade levels, with the spread on its 10-year paper to the Municipal Market Data benchmark hitting 200 basis points last November, dropping some and then rising to 250 basis points in April. It's steadily climbed upward, hitting 300 basis points after the downgrade.

The city saw a 145 basis point spread on its 10-year in a primary market outing in March 2014. That penalty doubled to nearly 300 basis points on its 10 year in a refinancing last week.

While New Oak believes Chicago's credit profile supports Moody's position, the report delves into the timing issue and whether Moody's should, as some have suggested, have held off until after Chicago completed its refinancing of variable-rate debt to shed bank credit risks.

"By waiting until after the issue had come to market, Moody's would have run the risk of sand-bagging the investors who may have bought into the deal," the report said. "Also, an after-the-fact downgrade would've come across as a retaliatory move for not being hired to rate the new issue."

Nguyen raised the specter that Chicago could be paying for the sins of Puerto Rico which carried an investment grade rating as recently as February 2014 yet now stands at a Moody's Ca2, just two notches from default level. "In Puerto Rico's case, all the rating agencies were woefully late in recognizing the island's deteriorating economic conditions and perennially suspect deficit financing practices," he wrote. "Furthermore, we can speculate that the Puerto Rico situation has sensitized the rating agencies to a new risk factor in munis: liquidity and market access risk."

Political Risks

"The Chicago downgrade to below investment grade put political actors and voters across the country on notice, whether they realize it or not," wrote Janney municipal credit analyst Tom Kozlik.

"Political risk in the municipal bond market is no longer theoretical. There are steps investors can take right now to insulate themselves from political risk," his report for Janney said.

"We expect to see a widening differentiation of credit circumstances for some (not all) state and related issuers," the report said. "There are certain regions, states, and sectors more susceptible. Investors can limit this risk now, before it is much easier to distinguish the good from the bad." Many market participants suggest that the rating differential is healthy and makes the case for independent analysis.

"A healthy difference of opinion not only provides competition among the rating companies but is also central to the making of markets," Nuveen writes. "That said, we believe that investors are well served to be skeptical of any single rating company rating" and they don't serve as "an adequate substitute for independent, bottom-up credit research."

"The true problem once again lies in the fact that agency ratings have become so woven into the fabric of our financial markets that they have become risk factors in and unto themselves. Having been through the 'Great Financial Crisis', we certainly don't need to beat on that dead horse," New Oak wrote.

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