Matt Fabian

CHICAGO - Moody's Investors Service's decision to drop Chicago out of the A rating category over its pension woes strikes at both its credit and reputation, market participants said Wednesday.

The hit comes as the city prepares to face investors late next week with a $400 million general obligation sale. The deal, with Wells Fargo Securities running the books, is tentatively set to price on March 13.

Moody's downgraded Chicago's GO and sales tax ratings one notch to Baa1 from A3 and also hit the city's water and sewer bonds with downgrades to A2 and A3, depending on their lien status.

Moody's analysts Matthew Butler and Rachel Cortez warned that the sheer size of the city's pension obligations is the driving force behind the downgrade because it threatens Chicago's "fiscal solvency" absent action on reforms and a long term infusion of funding.

"The total unfunded liability is the central issue here," Cortez said in an interview Tuesday. "It's the sheer size the unfunded liability and the rapid growth in that liability."

Moody's warned the credit deterioration could continue by assigning a negative outlook to the ratings of Chicago's $7.8 billion of GO debt, $556 million of sales tax bonds, $1.9 billion of water bonds, and $1.3 billion of sewer bonds. The revenue bonds were downgraded due to links to city general operations.

Moody's action followed its three-notch downgrade of Chicago GOs to A3 in July.

The fresh downgrade sets the stage for investors to demand steeper interest rate penalties, despite affirmations at higher ratings by Standard & Poor's and Fitch Ratings. It could also negate some of the boost Chicago enjoyed in secondary market trades after lawmakers passed state-level pension reforms in December and pledged to tackle local governments next.

"That's a tough blow," Alan Schankel, of Janney Capital Markets' municipal bond strategy and research group, said of the four-notch drop since July. "The triple notch downgrade was the big one and that certainly changed how people looked at Chicago … This is a further negative and a Baa1 rating evokes a whole different credit spectrum from what Chicago is used to residing in."

Chicago GOs are now three notches above junk and even with Providence, R.I. among major cities rated by Moody's, though Providence has a stable outlook.

Although the latest downgrade does not trigger a default or termination event on the city's swaps or letters of credit, any further credit deterioration could spark an event on some although the city has sufficient liquidity, Moody's noted.

"There is risk in buying a city of Chicago bond that the value could drop," said Matt Fabian, a managing director at Municipal Market Advisors.

"There's good reason to believe that there could be further negative headlines and the price of Chicago bonds could be less predictable unless it's more proactive on its pensions," Fabian said. Buyers next week could be more cautious and that could result in a 10 to 25 basis point swing especially given a softening market and competition from growing supply.

Fitch affirmed the city's A-minus rating and negative outlook last week. It downgraded Chicago three notches in November.

Standard & Poor's affirmed its A-plus rating and negative outlook. It shifted its outlook in September.

"As noted by other rating agencies as recently as last week - and by Moody's in a previous report - Chicago's economy is strong and growing, and the investments in our city since Mayor [Rahm] Emanuel took office point toward a bright future for Chicago. But make no mistake, meaningful pension reform is critical to securing that future," chief financial officer Lois Scott said in a statement.

The city sought to highlight that little has changed with its credit profile and that the downgrade stemmed from Moody's revised GO criteria adopted in January that gives greater weight to the health of a government's pensions.

"This raises questions about the 'Why Now?' aspect of the rating change and makes the triple-downgrade of last summer appear more like a quadruple downgrade in hindsight," said one municipal analyst.

Several market participants said they were not surprised with the latest downgrade given Moody's altered criteria, because Chicago has the highest adjusted net pension liability among local governments rated by Moody's. The ANPL is compiled by Moody's based on a formula that enables analysts to more consistently assess the impact of pension liabilities on governments' balance sheets.

The city's last actuarial assessment put the collective unfunded liabilities of its four funds at $19.5 billion for a funded ratio of 35%. Its laborers and municipal funds are headed toward insolvency in the next decade while the city faces a $600 million spike in its contributions next year to shore up its police and firefighters funds under a state funding mandate. The city operates on a $7 billion annual budget with a $3.2 billion general fund.

Moody's said its calculation of the city's fiscal 2012 adjusted net pension liability of $32 billion is 8 times its operating revenue, making it an "extreme outlier among its rated credits."

The city's obligations have grown so burdensome that Moody's warned even with benefit reforms, a large infusion of funding is needed. Moody's also warned it expects the city's payments will continue to lag an actuarial level. Payments tied to a state formula have underfunded the actuarially required contribution level by more than $7 billion between 2003 and 2014.

Emanuel has blamed state inaction for its pension woes as its contribution levels and benefits are set by state law; he is lobbying for a pension overhaul that trims benefits and phases in the $600 million spike. Emanuel has said it can't afford the deep cuts or a doubling of property taxes the spike would demand.

"The options are not good in any direction," Moody's Cortez said. "The liability has grown so large there's no easy solution."

Butler said contributing negative factors are "the growth in the city's debt burden and slow amortization rate, and the extensive nature of the leverage on the tax base" when factoring in other local governments.

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