Expect more downgrades for Chicago after Moody’s Investors Service dropped the city to junk, Nuveen Asset Management warns in a report co-authored by analyst Molly Shellhorn.

CHICAGO - Expect more downgrades for Chicago after Moody's Investors Service dropped the city to junk, warns Nuveen Asset Management LLC.

The downgrade to Ba1 gives banks the right to demand $2.2 billion in debt repayments from the city.

"We expect this significant risk to the city's liquidity will force Standard and Poor's, Fitch Ratings and Kroll Bond Rating Agency to downgrade the city - most likely by multiple notches," analysts Molly Shellhorn and Kristen DeJong wrote.

The assessment comes in a report this week that looks at the impact of the recent Illinois Supreme Court opinion that threw out out the state's 2013 overhaul of four of its five employee pension funds.

The decision "means the state and many local governments face immediate, tough financial decisions," Nuveen's report said.

"Illinois faces near-term budget challenges that may also negatively impact underlying local governments and school districts. Investors should be concerned about headline risk, pricing volatility and credit rating downgrades at the state and local level," it said.

The first credit fallout to come from the ruling was Moody's downgrade Tuesday of Chicago, citing concerns that the ruling throws up multiple roadblocks to the city's efforts to stabilize its funds through reforms.

Moody's followed that action by dropping the Chicago Board of Education and Chicago Park District to junk Wednesday. All carry a negative outlook. Nuveen had raised the specter in a report last month that Chicago could fall below investment grade if it didn't quickly made headway in tackling its fiscal pressures led by its nearly $20 billion pension mess.

By moving Chicago to speculative grade, Moody's action pulled triggers that allow banks that provide credit or serve as interest-rate swap counterparties to the city to demand repayment of $600 million in short-term credit lines, $1.1 billion in floating-rate debt and swaps, and $500 million in sewer or water related floating-rate paper and swaps.

No banks have demanded payment and the city is in negotiations seeking to achieve forbearance agreements or rework terms. City officials say they have the liquidity and reserves to cover the costs if needed. The city plans in the coming month to eliminate $1.1 billion of the exposure by remarketing variable-rate debt as fixed to eliminate associated interest-rate swaps and the need for bank support.

The other rating agencies have not yet weighed in on the impact of the Moody's downgrade.

Nuveen warned that the prospect for negotiated changes to public safety pensions now "seems remote, at best" and the school system is also now unlikely to see the Chicago Teachers Union yield ground.

Nuveen warns it would not be surprised "if Chicago and Board of Ed officials pursued state approval for a pension funding holiday for next year" even though it would only serve to increase future liabilities and "would certainly be viewed as a credit negative by the rating agencies."

At the state level, Nuveen said the ruling puts downward pressure on Illinois' rating but expects rating agencies to allow a little breathing room. The ruling does build pressure to raise income taxes, expand the sales tax or find some other form of new revenues.

"Another round of rating downgrades should be expected if a reasonable budget solution is not reached for fiscal year 2016," Nuveen said.

A new pension solution to deal with the state's $111 billion of unfunded obligations was also made all the more difficult because the high court said benefits in place when an employee starts are protected.

Rauner has proposed reforms that would protect accrued benefits while cutting future benefits.

"The limitation placed upon the state's ability to adjust future pension benefits is surprising," the Nuveen analysts wrote. As a result, the report said, state leaders will likely have to pursue negotiated concessions from unions or make drastic cuts to other programs to accommodate pension funding.

The state could transfer some of funding woes to local governments through cuts or by shifting its funding burden for teachers and university pensions to universities and school districts.

"As the state seeks to fix its fiscal house, financial pressures could be transferred down to local governments, prompting rating downgrades at the local level as well," Nuveen wrote. Rauner has proposed cutting in half of the $1.2 billion in income taxes that now go to local governments.

The ruling also stands to influence other initiatives before the General Assembly.

The Republican governor wants the state to adopt a Chapter 9 provision, with supporters saying it would give local units of government more flexibility in winning union concessions to ease fiscal challenges. A pending bill has not found much traction among the Democratic majority.

"We could see support for Chapter 9 grow if local units of government in Illinois determine that pension benefit cuts are critical to achieving budgetary balance and there is little hope of achieving cuts through negotiation," Nuveen says. "We would not rule out the state approving Chapter 9 on a one-off basis for specific entities in dire need of budget relief."

Nuveen said despite the bleak assessment, it's not currently concerned about any state payment default given the strong structural and legal mechanisms in place to ensure timely repayment. That's not the case at the local level where fundamental credit research will be key.

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