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 The downgrade to Baa2, just two steps above junk, and a warning
the rating could fall further still, means the third-biggest U.S.
city could face even higher costs in the future if banks choose to
terminate other interest-rate hedges against fluctuations in
interest rates. All told, Chicago holds swaps contracts covering
$2.67 billion in debt, according to a disclosure late last year.
"This is an unfortunate wake-up call for anyone still asleep over
the fiscal cliff facing the city of Chicago," said Laurence Msall,
president of the Chicago-based government finance watchdog, The
Civic Federation.
Chicago's finances are already sagging under an unfunded pension
liability Moody's has pegged at $32 billion and that is equal to
eight times the city's operating revenue. The city has a $300
million structural deficit in its $3.53 billion operating budget and
is required by an Illinois law to boost the 2016 contribution to its
police and fire pension funds by $550 million.
Cost-saving reforms for the city's other two pension funds, which
face insolvency in a matter of years, are being challenged in court
by labor unions and retirees.
 State funding due Chicago would drop by $210 million between July 1
and the end of 2016 under a plan proposed by Illinois Governor Bruce
Rauner.
Given all the financial pressures, both Moody's and Standard &
Poor's, which affirmed the city's A-plus rating, warned on Friday
that Chicago's credit ratings have room to sink.
Moody's said Chicago's rating could be cut if Illinois courts find
pension reform laws enacted to shore up the state's financially
ailing pension system and for two of Chicago's retirement systems
are unconstitutional. A ruling by the Illinois Supreme Court on one
of the laws could come as early as this spring.
S&P warned of a multi-notch downgrade if the city fails to come up
with a sustainable plan this year to pay its escalating pension
contributions.
In a report, Moody's noted that the downgrade to Baa2 moves the city
closer to termination of 11 more swaps deals. Termination on those
contracts would potentially cost Chicago an additional $133 million,
Moody's noted.
Chicago has the financial resources at hand to cover the initial $58
million termination payments on the four swaps if the city is unable
to renegotiate terms, Moody's said.
"The city's available liquidity is more than sufficient to cover
these termination costs," Moody's stated.
If the rating falls below Baa3, Chicago could be forced to pay about
$1.2 billion if banks that provide liquidity facilities like letters
of credit for city debt demand immediate collateral, Moody's said.
In an affidavit late last year, the city's chief financial officer,
Lois Scott, acknowledged that a single-step downgrade by either
Moody's or S&P could trigger about $50 million in immediate payments
and expose the city to variations in interest rates.
A spokeswoman for Chicago Mayor Rahm Emanuel did not immediately
respond to a request for comment.
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The downgrade and violation of terms on the swaps agreement likely
will become an issue in Emanuel's re-election campaign. The
first-term mayor, a former chief of staff to President Barack Obama,
failed on Tuesday to win a majority of votes in a primary election,
and faces a runoff vote April 7 against a Cook County commissioner,
Jesus "Chuy" Garcia.
Moody's based its one-notch downgrade affecting $8.3 billion of
general obligation bonds to Baa2 with a negative outlook on the
city's growing costs related to its big unfunded pension liability.
Chicago is defending a 2014 Illinois law that boosted pension
contributions by the city and its workers to two of its retirement
funds and reduced benefits. In the affidavit and in testimony
earlier this month in Cook County Circuit Court, Chicago CFO Scott
quantified the city's exposure to a variety of credit instruments as
a result of further rating downgrades.
Under a three-notch downgrade, Chicago would default on about $2.8
billion of credit facilities, including letters of credit, that the
city would likely not be able to replace, according to Scott.
Moody's analysts said most of Chicago's $806 million of
variable-rate GO bonds are tied to swaps.
The city, under Mayor Rahm Emanuel, has eliminated hundreds of
millions of dollars in risk by terminating or renegotiating 18
interest rate swap or swaption contracts and those efforts are
continuing, spokeswoman Libby Langsdorf said last month.
Shawn O'Leary, a senior research analyst at Nuveen Investments, said
banks tend to renegotiate terms on swap agreements.
"I would be surprised if the parties demand termination payments,"
he said.
Some Chicago debt is trading at worse levels than bonds sold by
Illinois, which is paying the biggest yield penalty among states in
the U.S. municipal bond market due to its own fiscal woes.
The spread on Friday for Chicago bonds due in 2019 over the market's
benchmark triple-A scale hit 125 basis points, which is 25 basis
points over Illinois' so-called credit spread, according to
Municipal Market Data.
(Reporting by Karen Pierog; editing by Phil Berlowitz, David
Greising and Bernard Orr)
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