OREANDA-NEWS. July 06, 2015. Fitch Ratings has assigned a 'BBB+' rating to the following Chicago, Illinois obligations:

--\\$389.6 million general obligation (GO) bonds series 2015A;
--\\$689.6 million GO bonds taxable series 2015B.

Fitch also affirms and removes from Rating Watch Negative the following ratings:

--\\$8.1 billion unlimited tax GO bonds at 'BBB+';
--\\$546.5 million (accreted value) sales tax bonds at 'BBB+'.

Fitch withdraws the following rating as the notes are no longer outstanding and therefore, the bank bond rating is no longer considered to be relevant to the agency's coverage:

--\\$200 million (pre-refunding) commercial paper notes, 2002 program series A (tax exempt) and B (taxable) bank bond ratings at 'BBB'.

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

REDUCED NEAR-TERM RISKS: The removal of the Negative Watch reflects the significant reduction in near-term liquidity risks. The city recently refunded its variable rate GO and sales tax bonds with fixed rate debt and terminated all associated liquidity support agreements and swaps which were in defaulted status and subject to immediate repayment, due to credit downgrades. The series 2015 bonds will fix out most of the city's short-term borrowing program, the only remaining variable-rate general government debt.

PENSION FUNDING RISKS REMAIN: The Negative Outlook reflects the uncertainty regarding the prospects for sustainable and affordable funding of pensions. The outcome of the legal challenge to the city's pension reform legislation is still unknown and an adverse decision could cause a further downgrade.

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.

STRONG SALES TAX COVERAGE: The sales tax bonds benefit from high historical coverage of maximum annual debt service (MADS) and a very conservative additional bonds test (ABT). The sales tax bond rating is capped by the ULTGO rating as Fitch believes these revenues are not insulated from the city's general credit.

RATING SENSITIVITIES

MODE CHANGE PLAN COMPLETION: The current issue represents the final piece of the city's strategy to reduce general government vulnerability to current variable rate debt instruments. The current rating and Outlook assume the city will complete the plan without materially damaging its financial profile, but failure to do so could cause a significant downgrade.

ADEQUATE RESERVE MAINTENANCE: The city's reserves, including those in the general fund as well as the long-term reserve funds, are an important aspect of the city's overall credit quality. Drawing upon those reserves could trigger a downgrade.

PENSION FUNDING RISKS: Implementation of pension solutions that move all of the city's pension plans on 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.

CREDIT PROFILE

ELIMINATION OF NEAR-TERM LIQUIDITY RISKS

The city successfully remarketed all of its general government variable rate debt and terminated all related swaps, thereby eliminating the threat posed by the events of default triggered on these instruments by recent credit downgrades. The city had good market access for the conversion transactions, albeit at higher interest rates. The offerings were reported to be five times oversubscribed including some new investor participation. The city no longer faces the prospect of immediate repayments and/or penalty rates under these agreements. The city appears to have sufficient market access as long as it is willing to pay elevated rates.

The rating downgrade also qualified as an event of default under the city's commercial paper and line of credit agreements that comprise its short-term borrowing program, exposing them to immediate payment in accordance with their terms. The city was able to achieve forbearance agreements with most of the banks that avoided immediate repayment and restored access to the lines. Other lines were terminated and replaced by current and new banks.

The current issue will provide long-term, fixed-rate funding for most of these short-term facilities, although a yet to be determined amount of lines will remain in place for working capital purposes and approximately \\$100 million-\\$200 million will remain outstanding. The lines in place after this transaction will be eventually governed by new terms which will not place them in defaulted status due to the city's below investment grade rating from another rating agency. The current issue includes some weakening elements to debt structure, including scoop and toss and two and a half years of capitalized interest, but importantly, reduces the city's vulnerability to accelerations of variable rate debt instruments.

LONGER-TERM CREDIT CONCERNS REMAIN

The city continues to face credit challenges related to critically-underfunded pension obligations and next year's large required payment increases, for much of which the city has not yet identified funding. The Outlook for the city's credit quality cannot be considered stable until such challenges are met in a sustainable fashion.

The weight of the city's extremely large unfunded pension liability is compounded by the very high (over 10%) 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. 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.

SB1 DECISION NOT NECESSARILY APPLICABLE TO CITY'S REFORM

The May 2015 state Supreme Court's decision striking down the state's pension reform package (SB1) represents a marginal impediment to the city's efforts to reform its own pensions as Fitch believes the state and city legal arguments differ.

The SB1 decision specifically struck down the state's argument that there is a 'police powers' exception to the state constitution's pension protection clause, which prohibits diminishing or impairing benefits.

Last year, the state legislature passed pension reform legislation (SB 1922), covering two of the city's four pension plans (Municipal and Laborers), which was subsequently challenged in court. The city acknowledges that the pension reform package for its Municipal and Laborers' pension funds is not reliant on a 'police powers' argument.

The city contends its reform should pass constitutional muster because the reform preserves and protects benefits, rather than diminishing or impairing them. The basis for this contention is 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. Without reform, those two funds faced depletion in 10 - 13 years.

Under SB 1922, the city assumed that legal burden only as part of the overall pension reform package legislation, and, it contends, thereby is preserving the benefits rather than impairing them. Given the nature of this argument, Fitch does not believe the SB1 Supreme Court decision provides clear direction on whether the court will find that the city's reform is constitutional.

If the legal challenge is litigated expeditiously, there could be a final ruling from the state Supreme Court as soon as the end of the year. If the pension reform changes to the COLAs and employee contributions are struck down, the city would likely revert to the lower, statutorily based payments. Under this scenario, the related liability could be expected to continue to rise and the rating would likely be downgraded.

POLICE AND FIRE PLANS REQUIRE INCREASED PAYMENTS

The SB1 decision has had some effect on the city's strategy to renegotiate the sharp increase in Police and Fire pension plan payments in 2016. Under Illinois statute, the city is legally responsible for the unfunded liability of those plans, and following the decision, has no option to invoke the 'police powers' argument to change benefits to lower the actuarial liability. Consequently, the city's focus is now on easing the transition to the statutorily-imposed, much higher, actuarially based payments.

The existing formula requires a contribution that would be sufficient to bring both systems to a 90% funding level by 2040 - a 25-year amortization schedule that is more aggressive than the city's other plans. 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 change the increase in the first year's payment from \\$530 million to \\$330 million. The legislature has not sent the bill to the governor for his signature. If it is not sent to the governor or if he vetoes it, it will not become law, but if it is sent, and he does not sign, it would become law 60 days after receipt. In September, the city plans to introduce its fiscal 2016 budget which should include its plan for funding the increased pension payments.

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.'

Preliminary, unaudited results show the general fund recorded a \\$25 million net operating deficit after transfers, equivalent to -0.8% of spending in fiscal 2014. This compares favorably to the budgeted appropriation of \\$53.4 million of general fund balance.

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.

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 unaudited fiscal 2014 unrestricted general fund balance dropped to 3.6% from 4.6% of spending a year prior. Fitch views the approximately \\$619 million, equivalent to 19% of fiscal 2014 general fund spending, in the service concession and reserve fund as an important element of financial flexibility. A draw on reserves could trigger a rating downgrade.

SALES TAX RATING CAP RATIONALE
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). The city's dependence upon the residual revenues for operations provides additional practical protection against excessive leverage. These features alone are quite strong; however, Fitch believes the sales tax revenues are exposed to the city's credit quality and therefore caps the rating at the ULTGO level of 'BBB+'.

Fitch's opinion is that the city's sales tax is a general revenue for general governmental purposes and as such, does not fall within the definition of 'special revenues' in section 902 of the U.S. Bankruptcy Code. Fitch expects the tax would be subject to the automatic stay and default would be likely in the extreme case of a city bankruptcy. Therefore, an accurate judgment of the likelihood of in-full and on-time payment of the sales tax bonds must incorporate the city's ULTGO credit quality.