Moody's drops Chicago's credit rating to 'junk'

CHICAGO (Reuters) - Moody's Investors Service on Tuesday pushed Chicago's credit rating into the "junk" category, potentially triggering $2.2 billion in accelerated debt payment and increasing the fiscal challenges facing the nation's third-largest city.

The downgrade of Chicago's $8.1 billion in general obligation debt to "Ba1" could limit Mayor Rahm Emanuel's options as he seeks to address a state-mandated $550 million increase in city pension payments in 2016.

The only big U.S. city with a lower Moody's rating is Detroit, which exited bankruptcy in December.

Emanuel lashed out at the rating agency, which said its records do not show Chicago ever having junk rating before.

"This action by Moody's is not only premature, but it is irresponsible to play politics with Chicago's financial future," said Emanuel, a Democrat.

Moody's said Chicago's options for curbing its $20 billion unfunded pension liability "have narrowed considerably" after last week's Illinois Supreme Court ruling invalidated a state pension reform law.

The ruling signals that a separate law aimed at boosting funding for Chicago's municipal and laborers' pension systems could meet the same fate.

Clint Krislov, the attorney representing retired city workers in one of two lawsuits against the Chicago pension reform law, said he will ask a judge on Wednesday for a summary judgment invalidating the law.

Moody's said spending cuts and tax increases may be needed, regardless of how the court rules. The state could force the city to pay retirees directly, possibly leading to another rating cut, Moody's warned.

"Chicago's unfunded liabilities will grow, placing significant strain on the city's financial operations," Moody's said.

The city's GO rating with Moody's has been in a free fall, dropping eight notches since 2010. The other two major rating agencies, Fitch Ratings and Standard & Poor's, still rate Chicago in the single-A investment-grade category.

Moody's on Tuesday also cut ratings on Chicago's sales tax, motor fuel tax, and water and sewer revenue bonds.

Illinois Governor Bruce Rauner, a Republican, has ruled out a state bailout for Chicago. Rauner recently said Illinois' largest city could be headed to bankruptcy, although Illinois law does not allow cities to file for bankruptcy.

Chicago already is struggling with a $300 million structural budget deficit and the looming $550 million increase for payments to police and fire retirement funds. Emanuel has said he expects to seek state legislation to restructure that payment, and the Moody's action could increase pressure on Illinois lawmakers to reform pensions statewide.

Emanuel late last month announced steps to clean up sometimes controversial debt practices. Emanuel plans to spend about $200 million to eliminate swaps contracts used to hedge interest-rate risk on variable-rate bonds.

The latest Moody's downgrade gives banks that provide credit support and interest-rate swaps the right to demand a total of $2.2 billion in accelerated principal, interest and termination payments from Chicago, according to Moody's.

Chicago debt has been trading at huge spreads over the municipal market's triple-A benchmark yield scale. Chicago's descent into junk status could obligate managers of some high-quality muni funds to dump the city's bonds, warned Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management.

“We would continue to urge investors to have an extreme level of caution here,” Heckman said.

Bond investors seemed to take Chicago's decline into junk-bond status in stride.

"They are still pretty far from … being in a default situation," said Dan Solender, a municipal portfolio manager at Lord Abbett, which has minimal exposure to Chicago debt.

(Additional reporting by Megan Davies and Hilary Russ in New York; Editing by David Greising and Lisa Shumaker)