Chicago's downgrade to a junk-bond rating is sobering, said Lawrence Msall of the Civic Federation of Chicago.

CHICAGO — Moody's Investors Service's defense of its May 12 Chicago downgrade took center stage at a long-planned discussion of city finances hosted by the City Club of Chicago this week.

The agency's decision to drop Chicago to junk-bond-level Ba1 from Baa2 was based on the implications of the Illinois Supreme Court's May 8 decision voiding state pension reforms on Chicago's own reform efforts "as we view it," said Moody's vice president and senior analyst Rachel Cortez.

Cortez participated in the panel discussion with Matt Fabian, partner at Municipal Market Analytics, and Laurence Msall, president of the Civic Federation of Chicago, which tracks local government and the state's finances.

Fabian warned that Chicago is at a critical juncture with the buyside, which wants to see action on a fiscal fix, while Msall stressed the need for state lawmakers to step up.

Cortez said the court's overturning of benefit cuts might have been expected given justices' ruling last year protecting retiree healthcare subsidies, but it was not until the ruling was in hand that it became clear how much it limited policymakers' future options.

After the downgrade, Chicago Mayor Rahm Emanuel delivered a stinging rebuke of the action accusing the rating agency of trying to force the city's hand and raise property taxes.

"To us it was pretty clear that benefit reductions under any circumstances are impermissible and in violation of the Illinois constitution," Cortez told the crowd. Chicago's 2014 overhaul of two of its four funds faces its own legal challenge although the city contends the changes are permissible based on legal arguments not addressed by the court.

Cortez also addressed another question Moody's has fielded frequently: why was the city downgraded but not Illinois? Moody's rates the state A3 with a negative outlook. The rating agency in a special commentary called the opinion a credit negative for Illinois but did not take any action.

"Chicago is in a much more precarious place than Illinois," Cortez said. Insolvency is decades off for the state pension funds - though they are burdened with $111 billion of unfunded obligations - while the city's $20 billion of unfunded liabilities include those to two funds on track to exhaust assets in the next decade.

Cortez said Illinois also is in a stronger position with "a lot more tools in its tool chest than Chicago" to address its pension and budget ills through tax hikes, spending cuts, or by pushing obligations such as pension contributions off to local governments.

Former city comptroller Phoebe Selden, who opened Moody's Chicago office and is now a financial advisor, asked Cortez why the agency would act on speculation rather than actual facts and events, because the high court's action does not directly impact the city reforms.

"The court spoke pretty clearly," Cortez said.

Cortez also sought to tamp down concerns that a speculative grade means it expects a default to occur, noting that Ba level credits show just a 5% likelihood of default in the coming years. She also laid out the metrics reviewed by the agency that put the city's overall debt burden and net pension liabilities at a $26,000 per capita ratio, compared to $18,000 for New York and $13,000 for Detroit, which emerged late last year from Chapter 9 bankruptcy.

Fabian, who had previously said he disagreed with Moody's decision to drop the city to junk, said all can agree there's an urgent need for a long-term solution.

"There's a broad understanding that action needs to be taken" so Chicago doesn't find itself in a cash flow crisis like New York City in 1975, which prompted state intervention and business and union help, he said.

Msall, whose organization has long taken the city to task for its use of debt to prop up operations and called for actuarially based pension contributions, called the downgrade to junk sobering.

"It was inconceivable for me….or my colleagues….that we would be looking at a city that was rated junk," he told the crowd.

Msall stressed the need for state help - a difficult task given Illinois faces its own pension mess - on a solution for both the city's and Chicago's Board of Education's underfunded pension systems.

"The sense of urgency, the awareness of the crisis ….is not as clear as you would have expected," he said.

Moody's dropped the school board even further into speculative grade territory over its $1.1 billion deficit, driven by a $700 million pension contribution to service $9.5 billion of unfunded liabilities.

How do we get the Chicago public schools open in the fall, Msall asked. One suggestion has been for the state to take over teachers' pensions, or to cover contributions as it does now for other school districts.

"We are nearing a crucial pivot point in the markets continued tolerance" of Chicago policy decisions, Fabian said. In part, the city is paying for investor distrust caused by Detroit.

Chicago has the power to act; for Chicago and Illinois "it's about the revenue side," Fabian said.

"The state and city have not taxed to the extent that others have," he said.

"The market is ready to participate and to go along" with giving the city time to tackle its woes, "because there is still a broad tolerance and broad interest in lending," Fabian said. "But there has "to be something proactive that comes out of the fiscal '16 budget and out of the current crisis."

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