Three days after being forced into a runoff in his re-election bid, Chicago Mayor Rahm Emanuel faced a Moody's Investors Service downgrade of Chicago to Baa2.

CHICAGO — Chicago's latest rating downgrade paints the city further into a financial corner.

Moody's Investors Service dropped the Windy City one notch to Baa2 from Baa1 Friday, leaving it on the second-lowest investment grade rung.

Market participants said the action will further damage the city's reputation and could increase its borrowing costs, while prompting some investors to shed Chicago holdings.

The downgrade also triggered termination events on four swaps attached to floating-rate GO paper.

"This is wakeup call for anyone still asleep as to the precarious financial condition of the state of Illinois and many local units of government especially Chicago," said Laurence Msall, president of the Civic Federation of Chicago, which tracks local and state government finances. "The downgrade has immediate financial costs to the taxpayers and puts enormous additional financial pressure on the city's budget which is dependent on access to the credit markets."

Moody's retained a negative outlook after the downgrade, citing the city's daunting $20 billion unfunded pension tab.

The latest downgrade comes almost a year after Moody's March 4, 2014 one-notch downgrade to Baa1, which came after a three-notch downgrade in July 2013.

"The main thing is that another year has passed and gone by without a solution to the pension issues, both with respect to curbing the growth in the unfunded liabilities and dealing with the police and fire pension spike that is getting closer and closer," said Moody's analyst Rachel Cortez in an interview that included fellow analyst Matthew Butler.

The fresh blow gives new urgency to the city's fiscal challenges, potentially elevating the role city finances could play in the April 7 runoff between Mayor Rahm Emanuel and challenger Jesus "Chuy" Garcia, a Cook County board commissioner.

The downgrade leaves the city's rating lower than all other major cities with the exception of Detroit, which recently emerged from bankruptcy. Providence and Newark are now rated higher.

Shawn O'Leary, senior research analyst at Nuveen Investments, warned that as the city's rating moves closer to speculative grade "there's a transition" in its investor type.

"They are getting to a pretty critical point" on that front, he warned. Nuveen views Chicago as a pre-distressed credit.

The rating "incorporates expected growth in Chicago's already highly elevated unfunded pension liabilities and continued growth in costs to service those liabilities, even if recent pension reforms proceed and are not overturned in legal appeal," Moody's wrote in the action it posted after midnight Friday.

The city's tax base is significantly leveraged by the direct debt and pension obligations of the city, as well as indirect debt and pension obligations of overlapping governments, Moody's added. Chicago's strengths included strides in structurally balancing its budget and strong economic base.

"We strongly disagree with Moody's decision to reduce the city's credit rating and would note that Moody's has been consistently and substantially out of step with the other rating agencies, ignoring the progress that has been achieved," the Emanuel administration said in a statement.

Moody's downgrade widens its split from the other two rating agencies.

Fitch Ratings Tuesday affirmed its A-minus rating and negative outlook. Standard & Poor's affirmed its A-plus rating and negative outlook Friday.

The Moody's downgrade impacts $8.38 billion of general obligation debt, $542 million of sales taxbonds, and $268 million of motor fuel bonds. Moody's lowered the short-term rating on Chicago's 2002 sales tax revenue refunding bonds to speculative-grade VMIG-3.

Moody's affirmed the city's senior lien water revenue bond credit of A2 and its junior lien A2 rating but downgraded its sewer revenue bond ratings to A3 and Baa1. A negative outlook was retained on the credits.

The downgrade shouldn't dent the city's market access but it will fuel the perception that its credit is far from stable, said Matt Fabian, a partner at Municipal Market Analytics.

"As a potential Chicago investor you have to assume that more bad news is ahead," he said.

The city's is carrying $20 billion of unfunded pension obligations in its four funds. It won state legislative approval for changes last year that trimmed benefits and raised contributions to stabilize its laborers' and municipal employees' funds.

The rating agencies have cautioned that it will take years for those reforms to result in significant progress, assuming they even withstand legal challenges from unions and retirees.

The city has for years faced a reckoning on its public safety pensions in 2016 when a longstanding state mandate to stabilize public safety systems through actuarially based funding kicks in, driving the city's annual contribution up by $550 million.

Emanuel's 2015 budget ignored the looming spike with no effort to begin tackling it with more revenue or spending cuts.

The administration is banking on state help through reforms and permission to phase in the higher contributions but Moody's warned that simply delaying the payment spike without reforms would further burden the funds' mounting liabilities.

Moody's analysts Cortez and Butler acknowledged it was no easy task for the city to win reforms to two of its funds last year; the city's pension contributions have long been based on a statutory formula that falls short of an actuarially based level to stabilize the funds.

Moody's offered no advice as to how the city should fix the problem — whether through higher revenue and or spending cuts — but noted that last year it took the position that Chicago as a home rule city has flexibility to act.

"Another year has gone by," Cortez said.

O'Leary called Emanuel's budget "irresponsible" for failing to acknowledge the safety pension spike.

"They asked for this downgrade," he said, adding that with local and state pension reforms being challenged "there doesn't seem to be any credible path to reform, so they need to start fully funding their obligations."

Moody's analysts said the April mayoral runoff, after Emanuel fell short of a majority in his re-election bid Tuesday, did not contribute to the downgrade. Emanuel was the top vote-getter.

They also said Gov. Bruce Rauner's proposal to cut $125 million from Chicago's annual income tax aid was not a factor as analysts consider it an "opening gambit" in the budget process.

The city warned investors of the potential impact of further downgrades in a section added last year to its bond offering statements.

The city warns in its offering statements that "further reductions …could affect its relationships with creditors and financial counterparties" and "could have significant adverse effects on the city's financial condition, including its ability to borrow and service its debt obligations."

Friday's downgrade triggers termination events on four interest-rate swaps, but Chicago retains breathing room on its bank support contracts. If the counterparties were to act, the city would face about $58 million in payments based on recent mark-to-market valuations, according to Moody's.

"The city's available liquidity is more than sufficient to cover these termination costs," Moody's report said. Chicago is party to 14 interest rate swap agreements tied to its floating rate GO paper and one on floating rate sales tax bonds.

Market participants said they expect that the counterparties and city would come to some agreement on a forbearance that prevents a collateral posting because the city is a frequent borrower that enjoys good banking relationships.

Another Moody's downgrade would trigger termination events on two GO swaps and a sales tax swap. Recent combined mark-to-market valuation of the three swaps total a negative $39 million. Eight of the city's GO swaps include a downgrade of the rated security below Baa3 as termination events for a negative valuation of $94 million.

The city has more breathing room on its bank support. Default events are not triggered on all of the city's bank support, letter of credit and other credit agreements until a downgrade by any one rating agency below the Baa3 or BBB-minus level to speculative grade, two notches below the Moody's rating.

"An event of default on the CP debt and line of credit would provide the lending banks the option to declare all outstanding obligations immediately due and payable," Moody's said. "This could necessitate payments from the city approximating $1.2 billion, per current agreements, if the city's rating falls below Baa3 and the banks demanded immediate collateral."

The city has worked over the last year to negotiate more favorable terms in its counterparty and bank credit support contracts. Just last fall, a Moody's downgrade would have triggered termination events on 10 swaps.

The Emanuel administration did not respond to requests for a comment on the status of the swaps or any special market outreach being made Friday after the downgrade.

Chicago's downgrade and swap termination events spurred comparisons to Detroit, sparked by prior concerns raised over the impact of further downgrades on swaps. In Detroit, which lost its investment-grade status five years ahead of its historic bankruptcy filing, the steady stream of downgrades worsened the city's operations, particularly by triggering termination events on its eight interest-rate swaps.

Stung by repeated downgrades into junk territory starting early 2009, Detroit increasingly struggled to access the market, was forced to pay higher borrowing costs when it did, and forced into years-long negotiations with its swaps counterparties to avoid termination payments.

Ratings analysts starting in 2009 warned that the risk of termination had become another major credit concern for Detroit. The downgrades came faster in 2012, with analysts pushing the city further into junk territory. Those downgrades triggered another termination event on the swaps that the city had renegotiated with counterparties in 2009. Illinois law does not allow for Chapter 9 filings although the governor has proposed creating such a law.

Chicago already pays steep penalties to borrow.

The spreads on its 10-year tax-exempt maturity in a sale last year widened to 145 basis points over the Municipal Market Data benchmark from 84 basis points on a 2012 sale. Recently, the city's bonds have traded at a spread of 135 basis points to the top-rated MMA triple-A benchmark scale and the firm early Friday said it was not seeing much trading or any elevated bids, according to Municipal Market Analytics managing director Matt Posner.

Markit said Chicago bonds were cheapening as Friday advanced. It saw trades on a taxable city bond trading 12 basis points cheaper while a Chicago Board of Education bond traded 15 basis points cheaper than a day earlier.

Under Moody's adjusted net pension liability calculation, the city's unfunded liabilities averaged in recent years $29.6 billion, or a highly elevated 15.9% of current full valuation and 7.2 times fiscal 2013 operating revenue. The difference between the city's actual 2013 payment and one at an ARC level was $1.1 billion. The city operates on a $7 billion budget.

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