Fitch Downgrades Chicago Board of Ed (IL) ULTGOs to 'BB+'; Negative Watch
The rating has been placed on Negative Watch.
SECURITY
The bonds are general obligations, payable from unlimited ad valorem taxes levied against all taxable property in the city of Chicago. Most of the bonds are additionally secured by state aid revenue, though this does not provide any enhancement to the rating.
KEY RATING DRIVERS
CONTINUED FINANCIAL STRESS: The downgrade reflects the limited progress the Chicago Public Schools (CPS) has made in addressing a structural budget gap approximating 20% of spending for the current fiscal year. Following substantial drawdowns in fiscal years 2013-2015, reserves will likely be fully depleted by the end of fiscal 2016.
PLACED ON NEGATIVE WATCH: The district is highly dependent on borrowing in the upcoming months to finance on-going operations, so Fitch will be monitoring access to external financing. Substantial changes are necessary to support ongoing operating and fixed cost spending. Options within the board's sole control are limited and Fitch believes meaningful solutions with other parties over the next several months will be a determining factor in the rating.
CASH FLOW DRAIN: Liquidity levels have been greatly diminished, requiring increasing levels of short-term borrowing.
PENSION LIABILITY WEAKNESS: Large pension liabilities were exacerbated by a three-year payment deferral that caused a dramatic jump in annual contributions beginning in fiscal 2014. Most options for relief are dependent on actions by the state, which is plagued by political disagreements and its own challenged financial position.
POOR LABOR HISTORY: The last contract negotiation with the Chicago Teacher's Union (CTU) was highly acrimonious and involved a strike. Talks regarding a new agreement to replace the recently expired contract have so far yielded no resolution.
ECONOMY RECOVERING: Chicago benefits from a large and diverse economic core that has shown gradual signs of improvement. The city, county and state finances remain challenged, mainly due to a large long-term liability burden.
UNFAVORABLE DEBT POSITION: The district's debt levels are above average with very slow amortization. A large planned upcoming debt issuance will further exacerbate this challenge.
RATING SENSITIVITIES
MARKET ACCESS: Reliable market access is important to long-term stability. Fitch will monitor the district's ability to access external financing for planned short- and long-term borrowing during the Watch period.
REVERSING STRUCTURAL IMBALANCE: Fitch would downgrade the rating further if there is not clear and meaningful progress over the next several months in reducing the large structural imbalance.
MOUNTING FIXED COSTS: A notable increase in debt levels or unfunded post-employment liabilities would also likely result in a rating downgrade.
CREDIT PROFILE
CPS serves almost 400,000 students in 664 schools in school year 2014/2015 in a district that is coterminous with the city. Enrollment trends are slowly declining.
LIMITED OPTIONS TO ADDRESS LARGE BUDGETARY GAPS
Fitch believes the size of the operating shortfalls in fiscal 2014 and 2015, and the magnitude of the gap in fiscal 2016, underscore the difficulty of balancing fiscal operations. CPS projects a $862 million (15%) general fund gap for fiscal 2015 despite implementation of a far-reaching and controversial school closure plan in 2013, an increase in property tax revenues to the statutory cap, and sizable reductions in non-education spending. Projected gaps for fiscal years 2016 and 2017 are over $1 billion, or about 20% of spending.
The district currently estimates fiscal 2015 to end with reserves of about $159 million (roughly 3% of spending) in the general fund. This follows a drawdown in fiscal 2014 of $513 million (9.4% of spending). Property taxes make up about 44% of total revenue. Balance in recent prior years has relied largely on non-recurring measures.
Management's efforts to reduce costs have yielded some savings and included school closures as well as central office and other administrative spending. Management has attempted to avoid cuts to classroom spending. Additional savings in these areas appear to be limited. Management recently announced $200 million of cuts, eliminating 1,400 positions, 350 of which were vacant.
Fitch believes the 2012 CTU strike made apparent the poor working relationship between the board and CTU. The agreement reached in 2012 expired June 30, 2015. Absent improvement, upcoming labor negotiations are likely to be challenging.
GAP GROWS IN FISCAL 2016
The board recently released a preliminary fiscal 2016 budget with a $1.1 billion operating deficit. Per-student spending was kept flat, although enrollment declines led to a slight decrease in overall student-based funding. In addition to the cuts described above, management expects to bridge the remaining gap with a combination of tax increases, contributions from the state, and employee concessions.
The fiscal 2016 deficit arises largely from the pension payment, which is certified at $675 million. Of this amount, approximately $200 million is the normal cost and the remainder represents the amortization of the unfunded accrued actuarial liability (UAAL). Proposed avenues for pension relief include having the state pick up the normal cost as proposed by the governor, merging the primary pension plan into the state plan, and deferring some or all of the fiscal 2016 and possibly future UAAL payments, and increasing employee contributions. No action has been taken thus far on any of these items, and Fitch believes most face steep hurdles.
CPS currently pays on behalf of all employees 7% of their required 9% contribution to the pension plan. CPS is hoping that employees will agree to pay this 7% contribution, equal to approximately $175 million per year.
Tax increases may include a property tax pension levy, valued at $170 million annually, and a $50 million capital improvement property tax levy. The former requires state approval, while the latter can be adopted by the city council.
Management is also requesting a change in the state education funding formula to increase state aid. A blue ribbon commission has been proposed to examine this issue, so Fitch does not expect resolution in the current fiscal year. The agency would look unfavorably upon a solution that deferred current year obligations to future years.
The district has tried to avoid cuts that would impact the classroom, but such cuts are growing increasingly likely. The district estimates that an increase in class size of two students would yield $100 million, so that much larger classes would be needed to achieve meaningful savings relative to the $1 billion gap.
If structural solutions prove unattainable the district may undertake a scoop-and-toss restructure and/or finance its pension payment. Both would result in increased longer-term costs, thus would be considered a negative credit factor by Fitch.
LIQUIDITY CONCERNS
Even with significant spending cuts, the district will be highly dependent on short-term borrowing to maintain positive cash flow. Liquidity declined dramatically from $1.1 billion of cash at the close of fiscal 2013 to $109 million a year later. The decline was exaggerated by the use of cash to pay for capital projects that are being reimbursed by a planned bond issue and the acceleration of vendor payments that were partially reimbursed in fiscal 2015.
Liquidity continues to deteriorate with negative cash balances for much of fiscal 2016 absent outside support. The district was forced to tap $700 million of liquidity agreements to make its required fiscal 2015 pension payment, which must be repaid by October, and plans to use additional liquidity facilities for ongoing operations in fiscal 2016 and likely beyond. Fitch will monitor the district's ability to access external markets for both this short-term borrowing and planned long-term borrowing.
PENSION LIABILITIES CONSISTENT WITH WEAK REGIONAL NORMS
Pension funded ratios dropped significantly in the last several years due to a combination of lower-than-expected investment returns and payment deferrals for the CTU plan granted by the state for fiscal years 2011-2013. As of June 30, 2014 the plan was 52% funded, or approximately 48% using a 7% return rate, up slightly from the prior year but way down from 80% and 72%, respectively, in fiscal 2008. The unfunded actuarial liability totaled $9.5 billion in fiscal 2014, up over 200% since fiscal 2008. District non-teachers participate in even more poorly funded city plans, though recent reform to those plans, if successful, should gradually improve funding levels.
The increased pension payment beginning in fiscal 2014 of $613 million over $208 million in fiscal 2013 was needed to bring payments up to the level statutorily required to increase the CTU plan's funded ratio to 90% by fiscal 2059. Fitch does not believe this is an aggressive goal with respect to addressing the unfunded liability but still expects the district will be challenged to meet it. The contribution increased to $694 million in fiscal 2015 ($634 million paid by CPS) but will decline slightly in fiscal 2016 before increasing again in fiscal 2017. Fitch is concerned not only about these plans but other city, Cook County, and state of Illinois plans which are all poorly funded.
HIGH DEBT, SWAP TERMINATION TRIGGERED BY DOWNGRADE
The district's overall debt levels are high at 9.1% of market value, with slow amortization of 29% in 10 years, the result of long-dated debt and restructurings. Fitch views positively a reduction in variable rate debt to 17% from 49% in the last several years. CPS recently announced an upcoming bond issue for $1.2 billion to pay for capital costs, refundings and swap terminations. This new issue will further weaken the district's debt profile, though not all $1.2 billion is expected to be issued in the current fiscal year.
Downgrades earlier this year resulted in termination events for eight of the district's 10 swaps. CPS has been working on strategies to resolve these events, largely through negotiating revised termination events and the financing mentioned above.
Other post-employment benefits (OPEB) are similarly underfunded but annual payments are capped at $65 million. Carrying costs including the full payment of the actuarially required pension contribution (ARC) are currently estimated to be a moderate 19%. Costs will likely stay relatively controlled due to the slow amortization of the pension obligation, assuming the full ARC is paid each year.
NO RATING ENHANCEMENT FROM LIEN ON STATE AID
Fitch does not believe the pledge of state aid revenues reduces default risk. A statutory lien on pledged revenue might enhance recovery, but does not provide protection from an automatic stay in the event of district bankruptcy. The state aid revenues flow to the district before being transferred to the trustee for bond repayment. While actual debt service coverage from state aid revenue is strong, the additional bonds test requires only 1.1x coverage, and the state has not always remitted the full amount of formula-based aid to the district.
ECONOMY SHOWING SOME IMPROVEMENT
Chicago ('BBB+', Negative Outlook) serves as the economic and cultural hub for the Midwest region, and maintains good prospects for long-term stability if not growth. The city has gained almost 50,000 jobs since 2010 primarily in professional and business services despite reductions in both manufacturing and public service. Chicago's population totaled 2.7 million in 2014, down 6% from the 2000 census, but still accounts for 21% of the state's population.
Socioeconomic indicators are mixed with elevated unemployment and individual poverty rates, average per capita income levels, but strong educational attainment levels. As of March 2015, the city's unemployment rate was 6.9%, down from 8.5% a year earlier. Employment during this period was up 1%.
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