Fitch Ratings has placed the following Chicago, IL bond ratings on Rating Watch Negative:

--$8 billion unlimited tax general obligation (ULTGO) bonds currently rated 'AA-';

--$497.3 million sales tax bonds currently rated 'AA-';

--$200 million commercial paper notes, 2002 program series A (tax exempt) and B (taxable) currently rated 'A+'.

SECURITY

The ULTGO bonds are secured by the city's full faith and credit and its ad valorem tax, without limitation as to rate or amount. The sales tax bonds are secured by a first lien on the city's 1.25% home rule sales and use tax and the city's local share of state distributed 6.25% sales and use tax. Additionally, there is a springing debt service reserve, funded over a 12-month period, that is triggered if coverage falls below 2.5x. The commercial paper (CP) notes are secured by the city's general obligation pledge payable from any legally available funds without an ability or obligation to levy additional taxes.

KEY RATING DRIVERS

LACK OF PENSION SOLUTION PRESENTS NEAR- & LONG-TERM RISKS: The Rating Watch Negative reflects Fitch's growing concern over both near-term and long-term risks associated with the large and growing unfunded pension liability. These concerns overshadow recent improvement in other aspects of the city's credit profile.

LONG-TERM RISKS: The unfunded liabilities recorded in the city employees' pension funds continue to rise without a corresponding increase in funding. The combined reported funding ratio for the four plans has declined steadily, reaching a low 35.2% at Dec. 31, 2012. Fitch estimates the funding ratio to be a weaker-still 32.9%, assuming a more conservative 7% rate of return.

NEAR-TERM RISKS: Any solution to the funding problem would likely involve a very large increase in the annual contribution, as current statutorily-based contributions seriously underfund the actuarially required contribution (ARC). The amount that would be required to amortize the unfunded liability grows larger as time passes, both in nominal terms and as a percent of governmental spending, threatening to crowd out other city spending priorities.

MANAGEMENT'S OPTIONS LIMITED: The current administration has attempted to address the pension liability through direct negotiation with labor unions and by lobbying the state legislature, which ultimately controls the benefit formula; neither approach has succeeded thus far.

RATING SENSITIVITIES

PENSION REFORM: Fitch will assess the impact of any state legislated pension reform and/or city-generated pension strategies that emerge during the next six months. Lack of meaningful solutions to both the near and long-term problems presented by the poorly funded systems would lead to a downgrade of the ratings.

ULTGO RATING SERVES AS A CAP TO THE SALES TAX AND CP RATINGS: The ULTGO rating serves as a ceiling to the sales tax rating. The commercial paper rating is capped at one notch below the ULTGO rating. A downgrade of the ULTGO rating, therefore, would result in a downgrade to both the sales tax and CP ratings.

CREDIT PROFILE

PENSION RISKS OVERSHADOW RECENT FISCAL IMPROVEMENT

Fitch recognizes the current administration's notably improved financial and budgetary management which has brought the city closer to structural balance, following the prior administration's long-term trend of reliance upon asset sales and other non-recurring items to fund operations. The improvement, however, does not offset concerns regarding the pension situation and Fitch notes that recent positive results would not have materialized if full pension ARC funding had occurred.

Fitch believes the combination of the low funded ratios and a statutorily-based contribution requirement that funds approximately one-third of the ARC is unsustainable. The imbalance grows larger with continued inaction and the passage of time.

MANAGEMENT'S OPTIONS ARE LIMITED

Management has presented a plan to address the pension problem but lacks the legal authority to implement it unilaterally. Direct negotiations with labor groups have failed to yield a solution and attempts to lobby the legislature for benefit changes which would reduce the unfunded actuarially accrued liability (UAAL) have been unsuccessful thus far.

Any changes to the benefit structure would require an act of the state legislature, which is currently struggling to address its own pension funding issues. Fitch also notes that Illinois law affords strong legal protection to pension benefits and expects that any such changes would face legal challenges.

Any solution to the pension funding problem is likely to require significantly higher annual contributions from the city. Fiscal 2011 carrying costs for pension, OPEB and debt service would have amounted to a high 31.4% of governmental fund spending if the ARC were fully funded; well above the 17.6% burden under the current statutorily-based payment structure.

State law requires dramatically increased annual funding requirements for two of the city's four pension systems beginning in 2016, which would need to be addressed in the fiscal 2015 budget.

The new formula requires a contribution that would be sufficient to bring both the police and fire systems to 90% funding level by 2040.

The city estimates its annual requirement will rise by $580 million as a result, an amount that will raise carrying costs to above average levels and threatens to crowd-out other city spending priorities; the higher figure may still not rise to the level of full ARC funding. Legislation to extend the deadline has been introduced, but prospects for passage are uncertain. Deferral of the increased actuarially based requirement would exacerbate the problem absent a meaningful reduction in the UAAL.

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