CHICAGO — Chicago officials are scrambling to salvage short-term credit lines and liquidity arrangements after Moody's Investors Service downgraded its bonds, which triggered events in the city's credit contracts allowing banks to demand as much as $2.2 billion.

City officials are reaching out to investors to settle nerves over the severity of the city's fiscal distress, seeking to reassure them Chicago has sufficient liquidity to cover any near-term financial repercussions on debt-related banks agreements from the downgrade.

"We are talking about the general solvency and economic viability of the city," a city financial source said.

Moody's downgraded $8.9 billion of general obligation, sales-tax backed, and motor fuel revenue bonds two notches to Ba1 from Baa2 after the municipal market close Tuesday. Another $3.8 billion of water and wastewater bonds were lowered two notches and now range from Baa3 to Baa1.

The action triggers termination or defaults on bank credit support, short-term borrowing lines, and swaps that expose the city to the potential demand of debts totaling $2.2 billion. Half of that figure, however, is tied to floating-rate GOs and swaps the city expects to shed over the coming weeks by remarketing debt as fixed-rate and terminating the associated swaps.

Moody's analysts cited the Illinois Supreme Court's voiding on Friday of a 2013 state pension overhaul and its potential to derail the city's efforts to tackle its nearly $20 billion of unfunded liabilities, putting further pressure on the city's budget and the solvency of several pension funds.

The downgrade accelerates near-term budget pressures due to the termination events, dramatically raises the prospect of higher city taxes, and further tarnishes the city's standing in the municipal market. It will also resurrect chatter that Chicago could be the next Detroit, which filed for bankruptcy in 2013 and emerged from Chapter 9 with a plan that hit bondholders hard.

A Moody's downgrade of the Chicago Board of Education's $6 billion of GOs, now rated at Baa3, is expected to follow the city action.

Chicago's audience of buyers has further narrowed, market participants said, and the city is facing higher yield penalties as it embarks on the remarketing of $800 million in GOs in the coming weeks as part of its plan move away from swaps and bank liquidity.

Its GOs had already been trading in junk territory before the downgrade.

Bank Headache

The downgrade "poses a whole series of challenges" and "the timing is not good since we've been working toward insulating ourselves" from bank credit risks in the event of further ratings deterioration, the city financial source said.

The city could be forced to repay $600 million currently outstanding under its short-term borrowing program that includes commercial paper and credit lines, because the drop to a speculative grade rating constitutes an event of default.

Four swap terminations tied to the city's floating-rate GOs had already been triggered by Moody's February downgrade to Baa2; this week's drop to speculative grade hits all remaining GO swap termination triggers, plus one tied to its 2002 sales tax issue, with a combined negative valuation of $200 million. The new downgrade also now triggers a default event on 12 letters of credit, liquidity and direct purchase facilities on $800 million of GOs and the $112 million of sales tax bonds.

An event of a default on the GO and sales tax bond liquidity agreements allows the banks to declare all outstanding obligations immediately due and payable.

The city has begun to ease some of that pressure. On May 5 and 6, it terminated four interest-rate swaps tied a 2003 issue soon to be remarketed as fixed, paying $31 million in termination fees. The city tapped its short-term borrowing program to cover the payment.

Chicago has been planning to cover a total of $200 million in estimated termination payments tied to its plans to shift its variable-rate GOs and sales tax paper to a fixed rate by tapping its short-term paper program before rolling the cost into long-term debt.

The downgrade complicates that plan because termination events have now occurred on Chicago's short-term credit lines. The finance official said the city could tap other liquidity if its short-term program is no longer available.

"We are proceeding as planned" on the initiative to shift the floating-rate debt, the official said.

New termination events have also been triggered on bank arrangements tied to its water and wastewater bonds.

Banks could demand $123 million in termination payments on swaps tied to its second-lien wastewater and water bonds.

A termination event was triggered on two of three swaps with a negative valuation of $23 million that are tied to a $332 million issue of wastewater bonds from 2008. A third would be triggered if the bonds fell one more notch. It's negatively valued at $49 million.

A termination event was also triggered on the three direct purchase agreements supporting those 2008 bonds, which allows the banks to terminate the agreement.

Additional terminations were triggered on three interest-rate swaps tied to second-lien water bonds, including a swap on a 2000 series and two on a 2004 issue that combined are negatively valued at $100 million.

All combined, the downgrade poses a $2.2 billion liquidity risk, according to Moody's.

"We are in the process of talking to the banks about what they are willing to do, whether they will give a forbearance or some other change" in the terms of their arrangements such as a lowering of the rating threshold that triggers a default event, said the city financial source.

The city is stressing to investors it has the liquidity if called upon to immediately repay its bank lines or other obligations.

"If we should lose some or all of the lines we think we have a very good liquidity and reserve position that is sufficient to manage the city's short-term financial needs," the official said, adding that with respect to any obligations on the water or wastewater debt the city could tap revenues on hand from those enterprise systems. Both systems are in a more solid financial position than the city's corporate fund due to rising user rates charged by the city.

Moody's said the city reported in 2013 liquidity in its fund balances of $1 billion, or a healthy 25% of revenue.

The city warned of the potential impact of further downgrades in its new offering statement tied to the upcoming conversion of its 2002 and 2003 floating rate bonds under the heading of "investment considerations."

It says defaults on its bank credit agreements "could result in the city having to immediately repay outstanding borrowings under these credit agreements. In such event, the city's liquidity position could be adversely affected as the city would likely be required to seek alternative funding arrangements from a smaller pool of credit providers willing to lend to the city."

The Downgrade

The driving force behind Moody's downgrade to junk is the state Supreme Court's justices voiding of a 2013 overhaul of the state's pension system. The court found that it violated the state constitution's pension clause.

The opinion landed firmly in favor of protecting from cuts pension benefits promised to workers, while justices rejected the state's arguments that its fiscal crisis warranted the use of its sovereign police powers to violate its contract with workers.

The decision raises questions over whether reforms that took effect in January to stabilize Chicago's laborers and municipal funds can withstand a similar legal challenge and over whether any path is available to reform Chicago's police and firefighters' funds. The city faces a $550 million annual spike in contributions to the latter two to bring funding to an actuarial basis and is hoping for state relief to allow it to slowly phase in the increased contributions.

"We believe that the city's options for curbing growth in its own unfunded pension liabilities have narrowed considerably," Moody's wrote.

"Whether or not the current statutes that govern Chicago's pension plans stand, we expect the costs of servicing Chicago's unfunded liabilities will grow, placing significant strain on the city's financial operations absent commensurate growth in revenue and/or reductions in other expenditures," analysts added.

Significant cuts would be needed and the city shares a highly leveraged tax base when the debt and unfunded pension obligations of overlapping governments are counted.

"Balanced against the city's many credit challenges are several attributes, the greatest of which is the city's broad legal authority to tap into its large and diverse tax base for increased revenue," Moody's said.

Chicago Mayor Rahm Emanuel issued a stinging rebuke of Moody's, accusing the rating agency of political motivations.

"While Chicago's financial crisis is very real and at our doorsteps, today's irresponsible decision by Moody's to downgrade the city's credit by two steps goes far beyond that reality," Emanuel said in a statement.

"This action by Moody's is not only premature, but it is irresponsible to play politics with Chicago's financial future by pushing the city to increase taxes on residents without reform," Emanuel said. "Moody's is out of step with other rating agencies —by as many as six steps."

The city's current Moody's rating marks a long fall from where it stood when Emanuel first took office four years ago this month. Moody's then rated the city Aa3.

As the city's unfunded liabilities grew and after Moody's revised its methodology for analyzing pension burdens, the agency stung the city with a rare three-notch downgrade in July 2013. It dropped the rating out of the A category, lowering it one level to Baa1 in March 2014 and hit it again in February when it lowered it to Baa2.

The city's $8 billion of GOs are rated A-minus by Fitch Ratings and Kroll Bond Rating Agency and A-plus by Standard & Poor's. Fitch and Standard & Poor's assign a negative outlook. Kroll assigns a stable outlook.

With the exception of Detroit, Chicago is alone among major cities in carrying a junk bond rating from Moody's. In recent memory, Pittsburgh was Ba1 in 2004. Other cities have fallen into speculative grade after defaults, including Cleveland in 1978 and New York City in 1975, Moody's said.

The scheduled increase in public safety pension contributions poses a near-term reckoning for Chicago while the pending legal challenge the 2014 reforms of the two other funds creates long-term pressure. The city is arguing that the overhaul doesn't impair its funds, but saves them from insolvency, and adds that were struck through collective bargaining, in contrast to the state's unilateral pension actions.

Moody's offers a grim assessment of the future if the unions prevail because the city's pension contributions would revert to a formula that has long fell short of actuarial requirements and the funds will exhaust their assets in the next decade.

"As the plans move toward insolvency, the city's credit standing will continue to deteriorate, given our view that the state may eventually implement legislation forcing Chicago to pay annuitants directly. Annuitant payments would materially exceed current employer contribution levels. In our view, Chicago's ability and willingness to fund annuitant payments, should they be required of the city, is uncertain," analysts wrote.

Moody's calculates Chicago's adjusted net pension liability at $29.6 billion, an outlier among local governments, and highly elevated at 15.8% of current full valuation and 7.2 times of fiscal 2013 operating revenue.

The city's liquidity, bank facility and letter of credits impacted by the downgrade are with RBC Bank, Bank of New York, Barclays, Northern Trust, Bank of Montreal and JPMorgan.

They include one with RBC and two with BNY on $200 million of bonds from a 2002 issue; two with Barclays on $120 million of bonds from a 2007 issue; one with JPMorgan on a $112 million sales tax issue from 2002; three with JPMorgan on $180 million from a 2003 issue; one with JPMorgan on $80 million from a 2007 issue; and one with Bank of Montreal and one with Northern Trust $160 million from 2005 issue. They further include three agreements with PNC Bank, US Bank, and Wells Fargo on $332 million of second lien wastewater bonds from a 2008 issue.

The city's short-term borrowing program credit and commercial paper lines are provided by Bank of America, Barclays, BMO Harris Bank, Wells Fargo, Morgan Stanley, JPMorgan, PNC Bank.

The city's counterparties on interest-rate swaps affected by the downgrade are with Deutsche Bank, Wells Fargo, Morgan Stanley, Goldman Sachs, BMO, BNY Mellon, PNC, JPMorgan, Bank of America, UBS and RBC.

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