Fitch Downgrades Chicago After "Worst Possible Outcome" In State Supreme Court Pension Reform Bid

Last week, Rahm Emanuel got some bad news. The Illinois Supreme Court agreed with Cook County judge Rita Novak’s ruling that the Chicago mayor’s scheme to put worker pension plans on a sustainable path was unconstitutional.

"These modifications to pension benefits unquestionably diminish the value of the retirement annuities the members of (the city workers and laborers funds) were promised when they joined the pension system,” the high court wrote in its opinion. “Accordingly, based on the plain language of the act, these annuity reducing provisions contravene the pension protection clause's absolute prohibition against diminishment of pension benefits, and exceed the General Assembly's authority.”

To be sure, the ruling didn’t come as a surprise. Indeed, it would have been next to impossible for the court to decide otherwise, given that the justices had effectively ruled on the exact same set of issues last May. As judge Novak put it in her opinion (delivered last summer), “the principle [that public pensions shall not be diminished or impaired] is particularly compelling where the Supreme Court’s decision is so recent, deals with such closely parallel issues and provides crystal-clear direction on the proper interpretation of the law.”

That “crystal-clear direction” makes it all but impossible for officials to implement reform measures that will help ensure the city’s pension system doesn’t go belly up in the short span of 10 years. As we noted last week, the good news for taxpayers is that they'll be off the hook in the short-term as money earmarked to sweeten the deal for pensions that went along with the reform plan will no longer be needed. "The city faces a short-term benefit of about $89 million that’s currently in escrow that can be used to help other areas of the budget,” Civic Federation President Laurence Msall said, before warning that “it will be a very hollow victory for the beneficiaries.” That’s because over the long haul, this is a disaster. “The ruling eases some immediate demands as the overturned law had stepped up the city's required contributions,” Bloomberg wrote on Monday afternoon. “Without the restructuring, the unfunded liabilities of the municipal and laborers funds will climb by $900 million a year, making them insolvent by 2026 and 2029.”

Right. Which means that unless city officials can come up with alternative ways to fill the holes, pensions will be more than “diminished and impaired” - they’ll disappear altogether like a Chinese short seller after a market rout.

But the inviolable nature of pension benefits means that no matter how certain insolvency is, the court will never sanction a plan that seeks to alter the “implicit contract” between public sector employees and state and local governments.

Needless to say, none of the above bodes well for the city’s credit rating.

Moody’s decided to get out ahead of things last year when, on the heels of the Illinois Supreme Court’s ruling regarding a reform bid for state pensions, the ratings agency cut Chicago to junk. On Monday, Fitch cut the city by two notches to BBB- the lowest investment grade rating. “Last week’s Illinois Supreme Court ruling striking down pension reform legislation for two of the city of Chicago’s four pension plans was among the worst of the possible outcomes for the city’s credit quality,” Fitch said. “Not only did it strike down the pension reform legislation in its entirety, but it made clear that the city bears responsibility to fund the promised pension benefits, even if the pension funds become insolvent.” And make no mistake, they will become insolvent.

Fitch's decision affects nearly $10 billion in GO debt and nearly a half billion in sales tax revenue obligations.

For their part, Moody’s calls the ruling “a credit negative setback.”

“The ruling significantly limits the city’s ability to curb its $20 billion pension shortfall by restructuring benefits,” Moody’s said on Tuesday, before noting that it “expects Chicago to find an alternate plan to address unfunded liabilities” and any delay in doing so will “likely weaken” the city’s credit profile.

In other words, Emanuel needs to figure out a way to address the underfunded liabilities and he needs to do it fast.

The problem: there are no good options. Emanuel just raised property taxes (by a record amount no less) and the city has already borrowed $220 million this year. 

It may be about time to get on the phone with Detroit and ask for pointers on how to efficiently navigate the bankruptcy process.

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From Fitch

Fitch Ratings has downgraded to 'BBB-' from 'BBB+' the ratings on the following Chicago, Illinois obligations:

--$9.8 billion unlimited tax general obligation (ULTGO) bonds;

--$486 million sales tax revenue bonds.

The Rating Outlook is Negative.

SECURITY

The ULTGO bonds are payable from the city's full faith and credit and its ad valorem tax, without limitation as to rate or amount.

The sales tax bonds have a first lien on the city's 1.25% home rule sales and use tax and the city's local share of state-distributed 6.25% sales and use tax. Additionally, there is a springing debt service reserve, funded over a 12-month period that would be triggered if coverage fell below 2.5x.

KEY RATING DRIVERS

PENSION RULING HEIGHTENS PRESSURE: Fitch believes last week's Illinois Supreme Court ruling striking down pension reform legislation for two of the city of Chicago's four pension plans was among the worst of the possible outcomes for the city's credit quality. Not only did it strike down the pension reform legislation in its entirety, but it made clear that the city bears responsibility to fund the promised pension benefits, even if the pension funds become insolvent.

CITY STRATEGY ANTICIPATED: The city expects to present a strategy to address the increased burden resulting from the ruling in the next several weeks. Given the lack of flexibility to alter the liability, Fitch believes the plan must rely on meaningful use of revenue and expenditure controls to meet much higher annual payments.

UNDERLYING FUNDAMENTALS REMAIN SOUND: The 'BBB-' rating recognizes the city's role as an economic hub for the Midwestern region of the United States with a highly educated workforce and improving employment trends. Aside from its pension funding issues, Chicago's financial profile has markedly improved in recent years, although full structural balance remains a challenge. The city's independent legal authority to raise revenues remains a key credit strength.

RATING SENSITIVITIES

PATH TO PLAN SOLVENCY: The rating could stabilize at 'BBB-' if the city presents a realistic plan that puts the pension funds on an affordable path toward solvency. The lack of such a plan would likely result in a downgrade as it would raise the risk that plan assets will be depleted and pension benefit payments would be made on a paygo basis, severely impairing financial flexibility.

RATING CAPS: The ULTGO rating serves as a ceiling to the sales tax rating. A change of the ULTGO rating, therefore, would result in a change to the sales tax rating.

CREDIT PROFILE

LONGER-TERM LIABILITIES A CHIEF CONCERN

The city continues to face credit challenges related to critically-underfunded pension obligations and rising associated costs. The Outlook for the city's credit quality cannot be considered stable until such challenges are met in a sustainable fashion. Since last week's ruling appears to eliminate the option of reducing the liability, the city will need to rely on its ability to increase revenues and control spending. Fitch will evaluate the direction of the rating and Outlook as their level of ability to do so becomes more apparent.

The weight of the city's extremely large unfunded pension liability is compounded by the high (8.7% of market value) debt burden, which is the product of substantial borrowing by the city as well as overlapping jurisdictions. Many of these overlapping governments also maintain underfunded pensions, and Fitch remains concerned that the funding requirements for all of these long-term liabilities will pressure the resource base in the coming years.

The city maintains four single-employer defined benefit pension plans, all of which are poorly funded due to a statutory funding formula which has fallen far short of actuarial requirements. In fiscal 2014, the combined actual pension contribution amounted to just a quarter of the actuarially determined requirement. The combined unfunded liability for all four plans is reported at approximately $20 billion, yielding a very low funded ratio of 34% or an even lower estimated 32% when adjusted by Fitch to reflect a 7% rate of return assumption.

PENSION REFORM CHALLENGE DECISION

Last week's court ruling struck down pension reform legislation covering two of the city's four pension plans (Municipal and Laborers). The legislation included some changes to the benefit structure that reduce the liability, as well as a multi-year ramp up in contributions.

The city contended its reform would preserve and protect benefits, rather than diminishing or impairing them. The basis for this contention was that prior to the pension reform legislation, under Illinois statute the city was not legally responsible for the unfunded liability of the Municipal and Laborers' pension funds.

The ruling struck down the benefit changes and confirmed the city's responsibility for providing promised benefits. If the city does not implement a plan to increase funding, those funds face depletion in 10-13 years. The Municipal plan is the largest of the city's four pension plans.

POLICE AND FIRE PLANS REQUIRE INCREASED PAYMENTS

The Police and Fire pension plans also faced increased funding requirements. The existing formula requires a contribution that would be sufficient to bring both systems to a 90% funding level by 2040. The state legislature passed a bill that would change the amortization period to 40 years and allow for a ramp up period to the 90% actuarially based funding level in 2020.

Those two changes are estimated to lessen the increase in the first year's (2016) payment from $550 million to $330 million. The legislature has not sent the bill to the governor for his signature. Once the legislature sends the bill to the governor, if not signed, it would become law 60 days. The city has arranged to fund the full, higher contribution for 2016, using short-term borrowing proceeds to fund the difference.

PENSION CHALLENGES OVERSHADOW IMPROVED FINANCIAL PERFORMANCE

Management has made significant progress toward matching ongoing revenues with non-pension annual expenditures. Fitch will not consider the city's financial operations to be structurally balanced in the absence of a sustainable, actuarially-based pension funding structure. Successful execution of the city's plan toward financially sustainable practices would be considered a positive rating factor. Remaining plan elements include the elimination of scoop-and-toss refundings by 2019, the use of current funds to pay legal settlements or judgments, and growth of the 'rainy day fund.'

The city ended the practice of appropriating reserves beginning with fiscal 2015. The $3.5 billion fiscal 2015 general fund budget was balanced with a reduced but still significant amount of one-time measures, including scoop-and-toss refunding. The city expects to end fiscal 2015 on budget, with no use of fund balance anticipated.

The $3.6 billion fiscal 2016 general fund budget closed the previously identified budget gap of $232.6 million through a variety of recurring and one-time measures and no appropriation of general fund balance. Fitch believes the budget target is achievable given the city's recent history of budgetary adherence. Despite the progress made, the city's budget still requires some non-recurring measures for balance, which is concerning several years into an economic recovery.

REVENUE CONTROL AND RESERVES KEY

Fitch views the city's home rule status as a credit strength, fostering revenue independence and flexibility. The general fund derives support from utility taxes, state sales taxes, transaction taxes, and recreation taxes among others. The general fund does not rely upon property taxes for operations, as they are earmarked for pensions, library expenses and debt service.

The audited fiscal 2014 unrestricted general fund balance dropped to 3.6% from 4.6% of spending a year prior. Fitch views the approximately $626 million, equivalent to 19.4% of fiscal 2014 general fund spending, in the service concession and reserve fund as an important element of financial flexibility. A draw on reserves would signal an increasing reliance on non-recurring measures and could trigger a rating downgrade.