CHICAGO – Concerns are rising that holders of local debt in Illinois will take a backseat to public safety pension obligations.

Those doubts were highlighted in two special rating reports released this week that examined how revenue intercepts allowed under an Illinois law designed to bolster local pension funds could impact local governments.

Illinois Comptroller Susana Mendoza recently began enforcing a 2011 law requiring her office to intercept state-collected revenues to cover overdue public safety pension contributions after a certification process.

The police fund for the fiscally distressed Chicago suburb of Harvey was the first out of the gate seeking collection on a $7 million court judgment, followed by the city’s firefighters’ fund with an $11 million judgment. The comptroller has so far withheld about $1.8 million to meet the police fund’s request.

The diversion prompted a back-and-forth in the courts as the city sought a preliminary injunction to free up the money. The lower court refused. An appellate court overturned the judge’s decision but the Illinois Supreme Court on April 26 vacated the appellate ruling and sent the matter back to the circuit court for a hearing.

“The court’s decision is credit negative for Harvey, whose financial distress thus far demonstrates that municipal pensions are “must-pay” obligations under Illinois law and have greater protection against default than a city’s general obligation bonds,” Moody’s wrote in a Thursday report.

The high court issued its ruling without any comment on its reasoning. Arguments over whether Harvey’s funds can be withheld under the law are expected to play out in the coming weeks and months.

Harvey’s suit argues that the city’s property can’t be garnished to satisfy a judgment under state law; that the funds are needed for critical services; that a portion is pledged to bondholders with greater rights than the pension fund; and that future levies have been appropriated to meet the judgment.

Harvey is not rated by any agency but Moody’s weighed in because the situation underscores the tensions between bondholders and pension funds vying for the same pot of funds. The state law also stands to have more widespread repercussions as other police and fire funds seek redress.

“Harvey’s financial dilemma demonstrates the risk to bondholders from sustained pension underfunding,” said the report by Moody’s analyst Thomas Aaron. “The city is now unable to afford state-mandated pension contributions to improve funding levels while also maintaining spending on other service priorities, calling into question the ultimate affordability of its debt. As municipalities’ financial capacity to provide core services declines, the risk of bond default and/or restructuring rises.”

Harvey responded last month to the original court ruling by making deep cuts in its public safety staff.

“Continued service cuts are unlikely a politically palatable option for increasing pension affordability, heightening bondholder risk,” the report said.

Harvey defaulted on two debt service payments in fiscal 2016 and six in 2017, Moody’s said.

It has made good on some payments but remains behind on November 2017 and May payments, one investment manager said Friday.

“Harvey’s pension stress is now developing into a budget and liquidity crisis. In particular, its firefighter pension fund risks running out of assets if the city cannot maintain higher annual contributions,” Moody’s said.

The city has long been beset by corruption that in one case led federal regulators to block a bond sale.

The city settled fraud charges accusing it of misleading bondholders over the use of funds from a sale that was have funded a hotel project that was later abandoned.

The state comptroller continues to hold the intercepted funds pending a 90-day review period of Harvey’s appeal of the certification. The city has been in negotiations with the pension funds but a deal with the police fund fell apart.

The comptroller’s review period ends May 21, but it’s unclear whether the office would release the revenue to the police fund on that date.

“We are looking for direction from the court” since this is the first enforcement of the law, comptroller spokesman Abdon Pallasch said Friday. He added that the best solution is a global settlement between the city and both funds.

It’s unclear, too, what priority would be given on future withholdings to the police or firefighters fund as the law lacks a provision on competing claims, Pallasch said.

The 2011 law requires local governments outside of Chicago to fund their public safety pension plans at a level that will bring them to a 90% funded ratio by 2040. Beginning in fiscal 2016, pension funds became empowered to intercept state-collected revenues to municipalities in a gradually increasing amount reaching 100% this year.

If a municipality falls 90 days in arrears on that actuarially based payment schedule, the fund may certify the delinquency with the comptroller and the office must deduct the certified amounts or a portion from various state funds that flow to the municipality.

In addition to the Harvey funds, the comptroller has received a certified request from North Chicago’s firefighters' fund.

Local government public safety pensions outside Chicago are carrying about $9.9 billion of unfunded liabilities with a collective funded ratio of 57.58% and several reports have warned that hundreds of funds have not received their full actuarial contributions from sponsoring governments.

Fitch Ratings weighed in Thursday with a report about recent Illinois securitization transactions that said revenues “sold through securitizations are not subject to diversion in the event the transferring unit underfunds public safety pension contributions.”

Chicago has leveraged its state-collected sales taxes in $1.4 billion of debt sales through its Sales Tax Securitization Corporation to refund outstanding debt since last December and the suburb of Bridgeview leveraged $47 million. A 2017 law established the program.

The two special entities “have no pension obligations and therefore there is no legal basis by which their revenues would be diverted by the state comptroller,” Fitch wrote. The state pledges not to limit or alter the rights and powers vested in the state comptroller, treasurer or department of revenue that would impair any contract made by the transferring unit with the issuing entity, including contracts executed in connection with the issuance of debt.

Chicago, furthermore, is not subject to the 2011 pension intercept law. Under the city’s more recent state-approved pension legislation, all four of its retirement funds can only seek to divert state grant funds in the event the city falls short of making the payments required under its statutes.

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