* Moody’s just put out a “FAQ” which explains its Chicago downgrade to junk status. First up, “Future Rating Drivers for Chicago”…

Question: What could cause Moody’s to change its GO rating on Chicago, in either a positive or a negative direction?

Answer: Our future rating actions on Chicago will largely reflect city officials’ actions on pension contributions and, ultimately, the growth of debt and pension leverage on the city’s balance sheet. Chicago’s pension funding requirements are governed by PA 98-0641 (the statute that applies to the Municipal and Laborer plans) and PA 96-1495 (the statute that applies to the Police and Fire plans). Whether or not either statute ultimately stands, we believe that Chicago’s administration will eventually have to increase pension contributions through some combination of operating revenue growth and operating expenditure reduction. The magnitude of those expected budget adjustments will be significant and will force city officials to make difficult decisions for years to come.

If both PA 98-0641 and PA 96-1495 stand, Chicago’s annual pension contributions are projected to increase by 135% in 2016; by an average annual rate of 8% in 2017-21; and by an average annual rate of 3% in 2022-26. To comply with these requirements, Chicago’s administration will need to grow revenue or cut spending by an average annual rate of 12% year-over-year (YOY) for the next decade in order to bring net pension contributions back to historical norms of 10% of annual operating revenue by 2026. (Given the scheduled contribution increases, actual annual revenue increases or spending cuts would likely be greater in 2016 than in 2017-26.) If PA 98-0641 is ultimately overturned, however, future pension funding will depend on how the city responds.

» Chicago officials could respond to an adverse ruling on PA 98-0641 by pursuing new state legislation that authorizes the city to increase contributions to the plans. If Chicago’s administration increases pension contributions in the context of balanced operating budgets that do not rely on non-recurring revenue sources, we could move the rating up or revise our rating outlook to stable.

» Chicago officials could also respond to an adverse ruling on PA 98-0641 by declining to pursue new state legislation that would allow the city to increase contributions to the plans. Chicago’s funding commitments would presumably revert to those which existed prior to the passage of PA 98-0641. Under the prior funding framework, the city’s contributions were well below those called for by plan actuaries, who projected that the Municipal and Laborer funds would deplete assets in the next decade. If the plans reach insolvency, the state could potentially implement legislation forcing Chicago to pay benefits to annuitants, either directly or through the plans. Benefits paid from the city’ four pension plans (Municipal, Laborer, Police and Fire), net of employee contributions, would significantly exceed the city’s employer contributions to those plans, as required under current laws (see Exhibit 2). If Chicago is forced to pay benefits from city operating revenue, we believe the city’s finances and GO credit profile would weaken. Therefore, if PA 98-0641 is overturned, and the city’s response raises the risk of plan insolvency, we could move the rating down.

* And here’s something for all you “We’re the next Detroit!” fanatics…

Meaning of Chicago’s Ba1 Rating in Terms of Default and Loss Potential Upon Default

Question: Does Moody’s Ba1 rating signal an expectation that Chicago will declare bankruptcy or default on its debt?

Answer: No. Moody’s ratings speak to both probability of default and expected loss upon default. The Ba rating range implies speculative elements in the risk profile but only a relatively small risk of default. Historically, approximately 1% of credits rated in the Baa range have defaulted over a three-year horizon. For credits in the Ba rating range, the share is 5%, and for B-rated credits, 15%.

We do believe, however, that the city’s pension-related challenges are significant and introduce speculative elements into the credit profile. Chicago’s pension plans will fund annuitant payments as long as assets remain in the funds. If plan insolvency occurs under the conditions described above, new questions would arise. Illinois law (40 ILCS 5/22-403) defines pension benefit payments as obligations of the pension funds, but if the pension funds are unable to fulfill these obligations, it is unclear which party will be responsible for paying annuitants.

If Chicago is forced to pay net benefit payments directly to annuitants or to the plans, elevated pension costs would compete with essential public services for city resources, creating particularly tough challenges for Chicago’s administration. We expect that this scenario would present city officials with several difficult options.

» One option would be to pursue massive revenue raising and expense cutting initiatives. Given the sheer size of the pension benefit payments that would be required, we believe that the magnitude of such budget adjustments would be extreme and would therefore be difficult to execute.

» A second option could be to pursue bankruptcy. Currently, Illinois local governments cannot file for bankruptcy, but in March 2015, proposed legislation (House Bill 298) was introduced in the Illinois General Assembly that would grant local governments authority to file for protection under Chapter 9 of the federal bankruptcy code.

» A third option would be bondholder impairment. In fact, we note that for cities in distress, pensioners have fared better than bondholders. For example, the City of San Bernardino, CA recently put forth a plan of adjustment that proposes no impairment to pensioners but a 99% loss to holders of the city’s pension obligation bonds (POBs).

Chicago’s decisions on future pension contributions – whether or not current laws stand – will be critical to our placement of the GO rating going forward. [Emphasis added.]

* OK, on to Illinois…

The State of Illinois General Obligation Rating

Question: Why hasn’t Moody’s taken rating action on the State of Illinois when the Illinois Supreme Court ruling concerned the state’s pensions?

Answer: The Illinois Supreme Court’s May 8 ruling has clear implications for the state because it appears to close the door on efforts to reduce accrued liabilities through benefits cuts. However, our credit view and rating was not dependent on the implementation of the state’s 2013 reforms, which had been stayed during the litigation. Our A3 rating on the State of Illinois reflects the state’s broad legal powers and fiscal tools to address its budget challenges, including pensions. Among the state’s options are reversing its recent income tax cuts and reducing revenue sharing with local governments. We note that the state itself also retains the option of shifting pension costs to lower levels of government, notably public universities and school districts (other than CPS), the pension liabilities of which are currently funded by the state. State shifting of pension costs to public universities and school districts would be credit positive for the state but credit negative for affected entities.

The state’s outlook remains negative, which reflects cuts in state income taxes and rising fixed costs, including those associated with pensions that have contributed to a budget gap of approximately 21% in the fiscal year starting July 1. Reliance on one-time or questionable fixes to address this gap – such as deficit financing, reduction in pension contributions or increased payment delays – would put downward pressure on the state’s ratings. [Emphasis added.]

Go read it all.