[November 14, 2012]

Fitch Affirms Chicago Board of Ed (IL) ULTGOs at 'A'; Outlook Negative

Fitch Ratings rates the Chicago Board of Education, IL's (the board's) approximately $106 million unlimited tax general obligation refunding bonds (dedicated revenues), series 2012B at 'A'.

The bonds are expected to be sold through negotiation the first week in December. Proceeds will provide budget relief in fiscal 2013 and fiscal 2014.

Fitch affirms its 'A' rating on the board's approximately $6.1 billion in outstanding unlimited tax general obligation (ULTGO) bonds at 'A'. The Rating Outlook is Negative.

SECURITY

The bonds are general obligations, payable from unlimited ad valorem taxes levied against all taxable property in the City of Chicago. The bonds are additionally secured by state aid revenue.

KEY RATING DRIVERS

REDUCED FINANCIAL FLEXIBILITY: The labor agreement following the recent Chicago Teachers' Union (CTU) strike results in increased costs to the Chicago Public Schools (CPS) of about $103 million annually, or 2% of fiscal 2013 general fund spending. The increases come at a time of highly stressed operations, when Fitch believes spending reductions are imperative to maintaining fiscal stability.

BUDGETARY GAP LOOMS LARGE: Prior to the settlement CPS had already planned to nearly deplete reserves in fiscal 2013. The schools now face a budget gap of about $1 billion in fiscal 2014. The gap arises largely from the combination of the new labor contract, use of reserves to balance the current fiscal year's budget, and a dramatic jump in pension costs in fiscal 2014.

OUTLOOK REMAINS NEGATIVE: Fitch believes dramatic changes are necessary over the next several months to support operating and fixed cost spending in fiscal 2014. Options within the board's control appear unlikely to be sufficient. The coming challenges appear considerably greater than they have been historically.

PENSION WEAKNESS: Weak pension funded ratios were exacerbated by payment deferrals for the teachers' plan in fiscal years 2011-2013. The city's plan in which non-teachers participate is even more poorly funded. Proposed pension reform, if approved by the state, could reduce the pressure notably. However, approval is uncertain and outside the district's control.

UNFAVORABLE DEBT POSITION: The district's debt levels are above average with very slow amortization. The current debt restructuring will further slow overall amortization.

CAPITAL PLAN REDUCED: Expectations for future capital spending are down significantly from prior plans. However, Fitch believes maintenance-related needs may exceed planned spending.

ECONOMY RECOVERING SLOWLY: Chicago ('AA-', Stable Outlook) benefits from a large and diverse economic core whose employment base and housing market are nonetheless under substantial stress.

WHAT COULD TRIGGER A RATING ACTION

PERSISTENT FISCAL 2014 GAP: A further rating downgrade might result if CPS is unable to address the large upcoming budget gap without implementing measures that reduce future financial flexibility, such as further deferral of fixed cost payments or use of more than a moderate level of one-time solutions to close the gap.

MOUNTING FIXED COSTS: Fitch believes management's ability to address mounting fixed costs, including full funding of annual pension contributions and increased debt service, will be tested. Inability to contain growth in these costs would additionally pressure the rating.

CREDIT PROFILE:

CPS served 404,151 students in school year 2011/2012 in a district with 675 schools that is coterminous with the city. Enrollment trends are slowly declining and management reports its demographer projects continued declines of about 1% annually.

STRIKE SETTLEMENT INCREASES COSTS, REDUCES FLEXIBILITY

The settlement of the recent CTU strike results in cost increases of about $103 million annually over the four-year term through fiscal 2016. The fourth year of the contract will be implemented at CPS's option, with CTU approval. The contract includes COLAs, step and lane increases, and the addition of 512 positions to accommodate a longer school day. CTU represents about 74% of board employees.

Prior to the tentative agreement Fitch cited the need for CPS to address a large budgetary imbalance of at least $770 million in fiscal 2014 (14.9% of fiscal 2013 budgeted spending). The district now estimates that imbalance to be about $1 billion. Fitch believes the settlement narrows the options for achieving balance as salary and wage increases are already built in. Fitch also believes long-term savings included in the agreement primarily avoid, rather than redue, future costs. These include eliminating a pension enhancement program, reducing sick day accumulation, and changing the step increase structure. However, the changes should have a positive impact on pension ARC payments.

RESERVES HISTORICALLY MODERATE BUT VOLATILE

Fiscal 2011 ended with a large operating surplus after transfers of $316 million and a sound unrestricted general fund balance (the sum of committed, assigned, and unassigned under GASB 54) of $521 million or 10.6% of spending. Both the surplus and the balance were much improved from fiscal 2010, which ended with a general fund operating deficit of $102 million and an unreserved balance of 4.1% of spending.

While the build-up of reserves provided a sound cushion for the financial pressures to come, it was garnered primarily through non-recurring sources. These included the release of city tax increment funds ($127 million), a debt restructuring ($110 million), pension relief ($400 million per year through fiscal 2013), and federal stimulus funds through the EduJobs program ($50 million per year through fiscal 2012).

The fiscal 2012 CAFR is not yet available, but Fitch anticipates it will show a modest drawdown in general fund balance and a still-solid ending unrestricted general fund balance of about 8% of spending. Results reflect continued pension relief, EduJobs funding, and the suspension of a contractual 4% salary increase based on projected financial strain. Favorably, state aid payment delays had lessened by the end of fiscal 2012 to one month from three. At present the delays are back up to five months but budgeted to recede to three months by fiscal year-end.

FISCAL 2013 BUDGET DEPLETES RESERVES, SETS UP GAP FOR 2014

The amended fiscal 2013 budget, reflecting the labor settlement, includes use of all but $63 million in unrestricted reserves to support spending. The additional spending related to the CTU contract will be accommodated mainly with non-recurring actions, including the upcoming debt restructuring that defers debt service spending of $50 million in each of fiscal years 2013 and 2014.

Fitch views the fiscal 2013 budget situation with particular concern given a required $338 million increase in pension spending in fiscal 2014 to $534 million (10.3% of budgeted fiscal 2013 spending).

Fitch believes significant actions will be necessary in fiscal 2014 to avoid a deficit position. Fitch's concern that near-term non-recurring solutions will come at the expense of longer-term flexibility is heightened given the increased size of the gap and reduced ability to achieve productivity gains from labor. Recent examples of such solutions include the deferred pension payments and debt restructuring that deferred principal payments.

Recent financial management turnover is an additional challenge for the district. Both the CEO and CFO were just replaced, and senior management vacancies include the controller and treasurer positions.

PENSION LIABILITIES CONSISTENT WITH WEAK REGIONAL NORMS

Pension funded ratios have 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, 2011 the plan was 59.9% funded, or 51.4% using a 7% return rate, compared to 79.7% and 68.4%, respectively, in fiscal 2008. District non-teachers participate in even more poorly funded city plans.

The increased pension payment beginning in fiscal 2014 is needed to bring payments up to the level 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 and expects the district will be challenged to meet it.

Pension reform being discussed at the state level could have a meaningful impact on the board's liability but so far there are no solid indications of when, if, or how it would be implemented. Other post-employment benefits (OPEB) are similarly underfunded but annual payments are capped at $65 million, leaving an increasing burden for employees and retirees. Fitch is concerned about not only these plans but other city, Cook County, and State of Illinois plans which are all poorly funded.

DEBT CONSTRAINTS MAY HINDER ABILITY TO ADDRESS CAPITAL NEEDS

The district's overall debt levels are above average at 6.7% of market value, with very slow amortization of 31% in 10 years, the result of long-dated debt and restructurings. The upcoming restructuring will further decrease amortization slightly. However, Fitch views positively a reduction in variable rate debt to 23% from 49% in the last five years. Management has worked to stagger liquidity facility expiration dates to reduce rollover risk, and reports favorable bids for recent liquidity agreements.

Planned capital spending has been reduced to $100-200 million annually through fiscal 2017, compared to $500-700 million spent in each fiscal year between fiscal 2009 and fiscal 2012. Fitch views positively management's attempts to reduce its debt burden but is concerned that slated amounts will be insufficient to keep up with essential capital maintenance needs on the district's vast and aging facilities.

ECONOMY SHOWING SOME IMPROVEMENT:

Chicago serves as the economic and cultural hub for the Midwest region and maintains good prospects for long-term stability if not growth. The city gained over 30,000 jobs in 2011 primarily in professional and business services despite reductions in both manufacturing and public service. Chicago's population totaled 2.7 million in 2011, down 7% from the 2000 census, but still accounts for 21% of the state's entire population.

Socioeconomic indicators are mixed with elevated unemployment and individual poverty rates, slightly below average per capita income levels, but strong educational attainment levels. As of July 2012, the city's unemployment rate at 10.5% was still well above the state and national averages. A 2.7% boost to employment drove a notable improvement in the rate from the 12.3% recorded in July 2011.

Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.

In addition to the sources of information identified in the Tax-Supported Rating Criteria, this action was additionally informed by information from Creditscope, University Financial Associates, S&P/Case-Shiller Home Price Index, IHS (News - Alert) Global Insight, Zillow.com, National Association of Realtors.

Applicable Criteria and Related Research:

--'Tax-Supported Rating Criteria', dated Aug. 14, 2012;

--'U.S. Local Government Tax-Supported Rating Criteria', dated Aug. 14, 2012.

Applicable Criteria and Related Research:

Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=686015

U.S. Local Government Tax-Supported Rating Criteria

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm rpt_id=685314

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