Fitch Affirms Chicago, IL's ULTGOs at 'A-'; Outlook Negative
--\$8.3 billion unlimited tax general obligation (ULTGO) bonds at 'A-';
--\$546.5 million (accreted value) sales tax bonds at 'A-';
--\$200 million commercial paper notes, 2002 program series A (tax exempt) and B (taxable) bank bond ratings at 'BBB+'.
The Rating Outlook is Negative.
Fitch also withdraws the following rating as the series was not sold:
--sales tax revenue series 2011C.
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.
The bank bond rating for the commercial paper (CP) notes is based upon the city's general obligation pledge payable from any legally available funds without an ability or obligation to levy additional taxes. The CP notes also carry a letter of credit.
KEY RATING DRIVERS
PENSION SOLUTION REMAINS ELUSIVE: The 'A-' rating and Negative Outlook reflect the lack of decisive solutions to both the near- and long-term burdens associated with the city's severely underfunded pension plans. Pension reform for two of the city's four pension plans that was passed by the state legislature in 2014 has been challenged in court, underscoring the difficulty the city faces in its efforts to put the pension plans on firmer footing.
PENSIONS OUTWEIGH BUDGETARY IMPROVEMENT: Pension concerns overshadow recent improvement in other aspects of the city's credit profile. Recent budgets have been narrowly balanced with lesser reliance upon one-time items. Maintenance of significant long-term reserves is an important element of financial flexibility.
WEAK DEBT PROFILE
Pension stress exacerbates the already weak debt profile, which features an above-average debt burden and moderate payout. Several overlapping area governments also have underfunded pension systems, which likely will require some measure of increased funding, presenting a stacked burden on residents and taxpayers.
ECONOMIC HUB; SLUGGISH RECOVERY: Chicago serves as an economic hub for the Midwest region and maintains good prospects for long-term stability if not expansion. Growth in cyclical revenues and improvement in employment measures reflects a measure of economic recovery; however, property tax base recovery is not yet evident. The next triennial reassessment will take place in 2015.
STRONG SALES TAX COVERAGE: The sales tax bonds benefit from high 15x historical coverage of maximum annual debt service (MADS) and a very conservative 5x additional bonds test (ABT) which protects against excessive leverage. The sales tax bond rating is capped by the ULTGO rating.
PROGRESS TOWARDS PENSION REFORM IMPLEMENTATION: Fitch believes implementation of pension solutions that move all of the city pension plans towards a clear path towards adequate funding while preserving sustainable budgetary balance is necessary to stabilize the credit. Absent that, the rating is likely to be downgraded.
STRUCTURAL BALANCE: The 'A-' rating assumes the city will continue to make progress toward the goal of structural balance, which Fitch defines as matching recurring revenues with recurring expenditures including sound, actuarially-based funding of long-term obligations. Lack of material progress toward this goal could result in a downgrade.
RATING CAPS: The ULTGO rating serves as a ceiling to the sales tax rating. The CP (bank bond) rating is capped one notch below the ULTGO rating. A downgrade of the ULTGO rating, therefore, would result in a downgrade to both the sales tax and CP (bank bond) ratings.
PENSION RISKS OVERSHADOW RECENT FISCAL IMPROVEMENT
Financial and budgetary management has improved notably, moving the city closer to structural balance, following the prior administration's reliance upon asset sales and other non-recurring items to fund operations. However, the impact of this improvement on credit quality is muted by the severe underfunding of the pension ARC. Fitch considers full actuarially-based funding a necessary component of structural balance.
The city maintains four single-employer defined benefit pension plans, all of which are poorly funded due to declines in investment performance coupled with a statutory funding formula which has fallen far short of actuarial requirements. The combined unfunded liability for all four plans is reported at \$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.
MUNI/LABORER PENSION REFORM FACES LEGAL CHALLENGE
The state legislature passed pension reform legislation for the municipal and laborers plans in April 2014. The changes went into effect on Jan. 1, 2015. The payment will rise by approximately \$50-75 million per year for five years. The city passed a mid-year phone tax surcharge to fund 911 operations in 2014 that frees up approximately \$50 million annually to fund the first year's increase, due in 2016. The changes eliminate the threat of pension insolvency within the next 14 years previously facing the two plans, but are being challenged in court.
The legislation improves the two pension systems by trimming future growth of the liability with changes to the cost of living adjustments (COLA), while providing increased contributions from both employer and employees. The plan redefines the city's annual required contribution (ARC) to an amount that would be sufficient to produce 90% funding in 40 years, similar to the weak funding standard used by the state's plans prior to its recent pension reform.
Even if the legislation is upheld, Fitch believes long-term pension fund sustainability is many years away. If the litigation succeeds and changes to the COLAs and employee contributions are struck down (and no replacement legislation is passed), the city would likely revert to the lower, statutorily based payments, as annual payments on an actuarially sound basis would likely be unaffordable. Under this scenario, the funded ratio could be expected to continue declining and the rating would likely be downgraded.
POLICE AND FIRE PLANS REQUIRE INCREASED PAYMENTS
The municipal and laborers plan contribution increases will occur the same year as a statutorily required \$538 million increase in contributions for the city's police and fire pension systems in 2016. The new formula requires a contribution that would be sufficient to bring both systems to 90% funding level by 2040 - a 25 year amortization schedule that is more aggressive than the city's other plans. The city would like to moderate the burden of that payment increase through passage of pension reform legislation that would address the amortization period and other reforms, but has not been successful thus far.
Fiscal 2013 carrying costs for pension, OPEB and debt service would have amounted to a very high 35.9% of governmental fund spending if the ARC were fully funded, well above the 16.1% burden under the statutorily-based payment structure. As a home rule entity, the city has a variety of revenue-raising options available to it, but typically, such plans are funded in large part from the property tax levy. The city has not yet said how the increased pension costs will be accommodated, but Fitch believes that rising carrying costs threaten to crowd out other governmental priorities and remain a formidable challenge to the city's financial equilibrium.
PRESSURE HEIGHTENED BY OVERLAPPING STRESS
The city's weak long-term liability profile is compounded by factors related to overlapping units of government. The majority of the high overall debt burden of 9.7% of market value is due to substantial borrowing by overlapping entities as well as the decline in the city's taxable value over the past several years. The city's principal payout is moderate-to-slow at 41.1% in ten years.
The widespread use of statutorily-based pension contributions for single employer plans in Illinois results in multiple underfunded Chicago area pension plans, placing stress on the city's residents and taxpayers.
Fitch estimates that if each area government including the city raised its property tax rate to cover the ARC with no corresponding reduction in the liability, the average bill would rise by roughly a third. Fitch believes such an increase is absorbable but could present some stress to the local economy, which has been slow to recover from the recession. The city's property tax comprises 20% of a typical resident's overall property tax bill.
ECONOMIC HUB; RECOVERY PICKING UP
Chicago's population of 2.7 million in 2013 is down 7% from the 2000 census. The city accounts for 22% of the state's population. The highly educated work force supports its status as a major financial and business services center. Educational attainment levels are strong, with 34% achieving a bachelor's degree and 14% an advanced degree, compared with the U.S. averages of 29% and 11%, respectively.
The employment picture has improved notably, after several years of stubbornly high unemployment. Employment expanded by 1.9% in 2014 reflecting a gain of over 21,000 jobs for the year. The labor force contracted marginally by 0.8% in 2014, after expanding 0.6% in each of the prior two years. The seasonally adjusted unemployment rate dropped markedly in 2014 to 8.0% from 10.5% in 2013. The rate continues to trend lower; the seasonally unadjusted rate for December 2014 was 6.2% versus 9.5% a year prior, as the city recorded robust employment growth and a slight decline in labor force over the time period. The 6.2% rate is now much closer to, but still above, the state and national rates of 5.7% and 5.4%, respectively.
Within the larger metro area, gains in construction, professional and business services, leisure and hospitality, and wholesale trade offset reductions in retail trade, information and durable goods sectors. Manufacturing remained a moderate share of the overall economy, consistent with the national average.
Overall income and wealth indices are mixed. Per capita income is at 96% of the state and 101% of the U.S. levels; however, as is typical for an urban area, the poverty rate remains elevated at 22.6%, much higher than the U.S. average of 15.4%.
Market value, down 39% over the past five years, has not yet shown signs of recovery, due in part to the lagging assessment cycle. Preliminary information for 2014 points to an increase in in assessed valuation; after application of the Cook County multiplier, equalized assessed valuation (EAV) is projected to be roughly flat. All taxable property within the city of Chicago will be subject to a triennial reassessment in 2015. Economically sensitive tax revenues have recovered to pre-recession levels.
IMPROVED FINANCIAL PERFORMANCE
Management has made significant progress toward matching ongoing revenues with non-pension annual expenditures, but has not yet achieved structural balance. Fitch views positively the city's stated commitment to ending the practice of using the corpus of its long-term reserves to balance the operating budget. Other recurring improvements over the past three years include a hiring freeze for non-essential positions, the elimination of 2,000 vacant positions and a marked reduction in retiree health care costs, although the latter is subject to litigation.
REVENUE FLEXIBILITY A STRENGTH
Fitch views the city's home rule status as a credit positive, 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 city's home rule status also exempts it from the state's Property Tax Extension Limitation Act. A self-imposed limit matches that of the state, limiting increases in the levy to the lesser of 5% or the CPI. In recent years, the city has kept its levy flat, without accessing the allowable growth. Fitch believes the self-imposed levy limit is relatively flexible and that increased property taxes may provide an important source of funding for potential future increases in pension payments.
Governor Rauner supports a state-wide property tax freeze, which, if implemented and applicable to home rule entities such as Chicago, would place a considerable constraint on the city's revenue-raising options. The governor's recommended budget, if passed, would also result in the loss of \$135 million of state shared income tax revenue in the general fund (approximately 4% of budgeted revenue in 2015).
NARROWING FINANCIAL GAPS
Fitch views favorably management's trend of decreasing reliance upon one-shots, but this has not produced a GAAP-based general fund net operating surplus in fiscals 2012 or 2013. The general fund recorded a \$68 million operating deficit after transfers, equal to -2.2% of spending in fiscal 2013. This compares favorably to the budgeted appropriation of \$177 million of general fund balance.
Fiscal 2013 unrestricted general fund balance dropped to 4.6% from 6.8% of spending a year prior. Fitch views the approximately \$590 million, equivalent to 19% of fiscal 2013 general fund spending, in the service concession and reserve fund as an important element of financial flexibility. The sum includes the remaining amount of the Skyway lease proceeds.
Results for fiscal 2014 are not yet available, but management expects results to generally track to budget.
Fiscal 2015 BUDGET
The \$3.5 billion fiscal 2015 general fund budget closed the previously identified budget gap of \$297.3 million through a variety of recurring and one-time measures and no appropriation of general fund balance. Fitch believes that balance 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.