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Pension-Cost Surge Puts Chicago In Bind

As Chicago's public pension costs mount, the municipal bond market is starting to penalize the city for its inability to grapple with the problem. Yields on city debt have moved significantly above those of Illinois, which has the worst debt rating of any state.

Fitch Ratings on Friday announced a three-notch cut of Chicago's credit rating, following Moody's similar "super-downgrade" in July. Fitch cited the low funding ratios of the four public pension systems, which average about 32%, as well as the total unfunded liability of about $19 billion at the end of 2012. Fitch also cited the city's inability to negotiate a solution with unions or to lobby the state for relief.

Mayor Rahm Emanuel wants the state legislature to ease a 2010 law it passed mandating sharp funding increases starting in 2015 to help the pension systems catch up. Without relief, Emanuel says, annual pension costs will more than double, an event he calls the "pension cliff.

State reform could help the mayor bring Chicago's powerful public-sector unions to the table.

"There's a lot of thought that at this point, for the mayor to be successful he needs some leadership in Springfield, not just in respect to the cliff but also for a state deal," said Chris Mier, managing director at Loop Capital.

State Of Refusal

But Illinois has been even more stymied by pension reform than its largest city. Lawmakers failed to agree on a fix this year, even during a special session called by Gov. Pat Quinn. After that session, Standard & Poor's said that Illinois "is approaching a precipice from a credit standpoint.

The state not only has $95 billion in pension liabilities, it also routinely lets accounts payable accrue unpaid, to the tune of $4.2 billion by the end of 2013, according to S&P.

Ralph Martire, executive director of the Chicago-based Center for Tax and Budget Accountability, said Emanuel is "asking for relief in the wrong way." The mayor "just wants the burden to be cut so he can get through the budget cycle.

That kind of planning is what's led Chicago to where it is today. Ratings agencies and analysts point to decades of barely balanced budgets relying on one-time revenues, an antiquated tax system and a failure to cut spending or demand union concessions. The only way to address the city's accrued pension debt, Martire said, is a decades-long, mandatory amortization plan.

"The unfunded liabilities have been built up over longer than 30 years, and getting them repaid in less is not feasible," he said.

In fact, Chicago's failure to make adequate annual pension payments is codified in statute. If the city were to pay the full $1.4 billion recommended by actuaries, that would equal nearly half the city's entire general fund revenues of $3.1 billion.

No Detroit

While Detroit's bankruptcy has loomed large over municipal bonds, there are key differences with Chicago. Motown was dependent on a single, shrinking industry. Chicago remains the Midwest's economic powerhouse, whatever its budget woes. Detroit was hobbled by years of ineffective, even corrupt, leadership. Detroit, unlike Chicago, issued bonds to pay down pension liabilities. Such pension obligation bonds are often seen as a clear sign of municipal distress.

Still, the city must borrow to fund ordinary spending, and is counting on the issuance of $1.5 billion in 2014, some of which will go to refinance the $8.2 billion it has outstanding.

Now Chicago will pay more. Moody's July ratings cut will hike annual borrowing costs by $500,000 to $1 million for every $100 million in debt issued, Chicago's CFO Lois Scott has said.

In a strange twist, the bond market now views Chicago as a shakier investment than Illinois, Mier said. Whatever its woes, the state's debt has airtight bondholder protections, as well as a much broader taxing base.

"Most investors I've talked to continue to believe they're going to work it out and the city's going to improve," Mier said. "But it's been an act of patience from the investor standpoint and their expectations haven't been fulfilled."