Fitch tax-supported criteria revision drives cut to Chicago securitization credits

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Chicago’s Sales Tax Securitization Corp. lost its top rating from Fitch Ratings under newly minted tax-supported debt criteria that caps ratings to six notches off a borrower’s general obligation credit.

Fitch cut the rating on $2.6 billion of senior-lien bonds issued between 2017 and 2019 by three notches to AA-minus from AAA and assigned the same rating to Chicago’s STSC second lien. The city is selling about $1.1 billion under the newly established junior lien this week.

“The ratings for both liens would be higher absent the rating cap,” Fitch said.

Kroll Bond Rating Agency rates the senior AAA and the second lien AA-plus. S&P Global Ratings rates both liens AA-minus under criteria that also links the rating to the sponsoring government. S&P revised it priority-lien criteria in 2018 resulting in a one-notch cut to the original AA STSC rating.

The securitization bonds benefit from a lien on the state-collected portion of the city's home rule sales and use taxes and the local share of the state-wide sales and use taxes. Its high-grade ratings are due to rating agencies consideration of the STSC as a bankruptcy-remote special entity that’s insulated from city fiscal strains through a true sale of sales taxes.

Fitch began reconsidering its criteria on tax-supported debt after rulings in Puerto Rico’s bankruptcy case shook market beliefs that repayment of special revenue debt would continue to be repaid during bankruptcy proceedings. The U.S. Supreme Court declined earlier this week to hear an appeal.

“The downgrade … reflects a change in Fitch's 'U.S. Public Finance Tax Supported Rating Criteria' (January 2020) which limits the rating for true sale structures to a maximum of six notches above the associated government's issuer default rating,” Fitch wrote in the report published late Tuesday.

The city’s general obligation bonds carry a BBB-minus rating and stable outlook.

Security features kept the downgrade to just two notches as the new criteria imposes a two-to-six-notch cap depending on the credit security features.

“Solid revenue growth prospects and very strong resilience of the dedicated tax security contribute to the AA-minus rating for the second lien subordinate bonds,” Fitch said. “The bankruptcy-remote, statutorily defined nature of the issuer and a bond structure including a true sale of the sales tax revenues are key credit strengths that allow a rating of up to six notches above the city of Chicago issuer default rating.”

The rating remains sensitive to both the city’s GO credit and a material decline in coverage ratios.

If the revenue stream was leveraged to the maximum, revenues could withstand a 34% decline before they were insufficient to fully cover combined maximum allowable debt service. Pledged revenues grew by 3.1% in 2018 and preliminary estimates for 2019 indicate 2.1% growth.

Chicago planned to include a Fitch rating on the new deal only if Fitch had finalized the draft criteria released over the summer. The revised criteria was published Friday.

"We embarked on this criteria revision after the First Circuit ruling upended the long-established belief in the municipal market that the payment of special revenue debt would continue during an automatic stay period," Amy Laskey, a managing director, said in the revised criteria report. "Fitch thinks the decision, having stood through two courts, substantially erodes the ability to confidently say that any legal protection can provide full insulation from the operating risk of the related municipality.”

"As a result of this erosion of confidence, the criteria now limits the relationship between security ratings and the related government's issuer default rating,” Laskey said.

The revised criteria also clarifies the relationship between the issuing entity and related local government and limits the rating on revenue bonds with strong independent credit characteristics that are issued by enterprises of a local government with weaker general credit quality.

Fitch expects the new criteria to impact about 20 ratings in sectors including utilities, school districts and other special districts. Fitch will put affected ratings on either Rating Watch Negative, indicating a preliminary assessment that the distance between the ratings is greater than the cap allows, or Under Criteria Observation, which indicates a potential credit impact, but the impact is more uncertain. Fitch is expected to release the list of affected credits by Friday.

Kroll is holding steady in its position that the STSC is insulated from the city’s credit. The rating agency affirmed the senior lien’s AAA Monday and gave the second lien a one-notch penalty that’s typical of junior lien status.

Kroll said it “believes that the recent U.S. First Circuit ruling related to Puerto Rico Highway and Transportation Authority bonds did not address situations where a municipality has assigned its rights to revenue streams pursuant to a true sale and to protections provided by specific state statutes.”

“Other than subordination to the senior lien debt service, the second lien bonds enjoy all the same exceptionally strong legal and structural protections that separate the pledged sales tax revenues from ongoing operating and financial risk of the city and KBRA believes these protections apply even in the unlikely event of an insolvency or bankruptcy of the city," Kroll said.

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