CHICAGO— Moody’s Investors Service socked $11.5 billion of Chicago general obligation, sales tax-backed, and water and sewer revenue bonds with multi-notch downgrades citing mounting pension woes and warning of a potential further hit because a dramatic contribution spike looms.
Moody’s cut $7.7 billion of GO debt and $566 million of sales-tax backed debt three notches to A3 from Aa3.
It also hit the city’s $2 billion of water revenue and $1.3 billion of sewer revenue bonds with multi-level downgrades. The senior lien bonds were lowered to A1 from Aa2 and second lien bond to A2 from Aa3.
“The downgrade of the GO rating reflects Chicago’s very large and growing pension liabilities and accelerating budget pressures associated with those liabilities,” Moody’s wrote. “The city’s budgetary flexibility is already burdened by high fixed costs, including unrelenting public safety demands and significant debt service payments,” Moody’s said.
The city’s unfunded liabilities for its four pension funds grew on an actuarial basis to $19 billion at the close of 2012 from $16.9 billion a year earlier as city contributions are based on a state-set statutory formula, not tied to the health of the funds.
A combination of the city’s mounting pension strains and Moody’s recent adjustment in its analysis of state and local government pension liabilities drove the three-notch downgrade, said Rachel Cortez, Moody’s lead analyst on Chicago.
Mayor Rahm Emanuel has offered up a framework for reform that requires state approval, but has no city directed strategy to shore up the system. He is banking on state lawmakers to enact pension reforms that cover local governments. Those hopes so far have been dashed by the political impasse in the state capitol that drove recent downgrades of the state’s GO rating.
“Without comprehensive pension relief from Springfield, municipalities such as Chicago will continue to receive negative reviews from rating agencies. Since I became mayor, I have used every tool available to tackle and reform government, strengthen our financial position, and invest in our city’s future. But the pension crisis that is nearing our doorstep puts all of those investments at risk,” Emanuel said in a statement Thursday.
The action on the water and sewer bonds is due to the link between those enterprise systems to city operations, and the sales tax bonds are capped at the city’s GO rating due to the lack of a legal separation between pledged revenues and the city’s general operations, Moody’s said.
The outlook on all $11.5 billion of debt is negative, a position attributed to the looming spike in annual pension payments “which will place material strain on the city’s operating budget,” Moody’s said. The city estimates its payments will rise to $1.2 billion in 2015 from $467 million in 2014. The steep increase is due to a state mandate to bring the fire and police funds to a 90% funded ratio by 2040 by shifting payments to the actuarially required contribution, or ARC.
The outlook also reflects the view that unfunded liabilities will continue to grow and the strong protections afforded benefits by the state constitution. Any reforms enacted by the General Assembly are expected to be challenged by unions or retirees.
Moody’s in April placed Chicago’s GO rating on review for a possible downgrade along with 28 other local governments and school districts following a methodology change to incorporate its view that pension obligations posed a significant source of credit pressure for those governments.
“We are now giving more weight” to pensions in the rating methodology and “the city’s audited financial statements for 2012 show a more stressed picture than we had otherwise seen…the pension underfunding with each passing year grows larger and larger,” Cortez said in an interview. Applying Moody’s more conservative adjusted net pension liabilities formula that takes into account the strain on a government’s overall fiscal foundation, Moody’s calculated the city’s net liability at $36 billion.
Moody’s has recently lowered several Midwestern cities, including Evanston and Cincinnati, after applying the new pension methodology, but by only one step.
The lower rating dings the city’s reputation while the multi-level nature of the downgrade illustrates the scope of the city’s pension mess, market participants said. It comes as the city is preparing to host an investors’ conference on Aug. 25 in downtown Chicago.
The city’s GOs have been trading at the single-A level, but Nuveen Investments’ senior investment officer, Thomas Spalding, said the downgrades could result in a further 10 basis point penalty.
Moody’s rates some other major cities in the same category including New Orleans and Newark but Chicago has never been rated lower by the agency. It had been rated at the A2 level in the 1990s. After that, Chicago’s rating benefitted from the first-time establishment of reserves following the lease of the Chicago Skyway in 2005 and then from Moody’s 2010 recalibration which pushed it up to Aa2. Moody’s downgraded the city to Aa3 in August 2010.
Chicago’s pension obligations are among the highest of major cities when looking at the obligation as a percentage of full property tax valuation, on a per capita basis, and as a percentage of its operating budget.
Cortez noted that an additional $1 billion would have been needed in 2012 to meet the ARC for all four funds. The state formula sets city contributions at a percentage of employee contributions which is based on salary.
City officials have long said they can’t change their contribution without state action, although some market participants have questioned that position.
For Emanuel, the steep downgrade and focus on the pension quagmire steers attention away from other fiscal accomplishments achieved since he took office in May 2011.
“The financial challenges they are facing are at odds with the tremendous economic advantages in Chicago and headway they’ve made,” said Richard Ciccarone, chief research officer at McDonnell Investment Management. “The pension issue is going to be their albatross they’ve got to overcome.”
Moody’s highlighted the city’s recent strides while noting the pension issue overshadows those gains. The city has cut spending in its $6.5 billion budget, halted the drain on reserves used by the previous mayor, Richard Daley, to shore up his last few budgets, and reduced other one-shots to improve the city’s structural balance.
The credit also benefits from Chicago’s long-standing role as the center of one of the most diverse economies in the country, broad legal authority to raise revenues from a large tax base. The city closed 2012 with $231 million in general fund reserves and $625 million in reserves established with proceeds of its asset leases. It will also shed much of its retiree healthcare costs in the coming years by shifting the burden over to the state’s healthcare exchange under federal reform.
Other fiscal challenges include a high debt burden, slow amortization, ongoing infrastructure needs, and demands for services especially on public safety as Chicago crime has received national attention. While the city enjoys broad taxing flexibility as a home rule community, raising taxes especially property taxes faces political repercussions.
Emanuel earlier this year laid out a framework for city reforms in a proposed agreement with leaders of the Chicago Police Sergeants Association, but its members recently rejected the plan underscoring the need for state action on any benefit changes. The city has warned the looming pension payment increase would drive a massive property-tax hike and/or deep cuts.
Fitch Ratings last month put the city’s AA-minus GO and sales tax ratings on negative watch over the pension crisis. Standard & Poor’s rates the city’s GOs A-plus with a stable outlook.