Rating Update: Moody's downgrades to A3 from Aa3 the rating on the City of Chicago's (IL) motor fuel tax

debt; outlook is revised to negative

Global Credit Research - 13 Mar 2013
A3 rating with negative outlook applies to $181 million of outstanding rated motor fuel tax debt

CHICAGO (CITY OF) IL MOTOR FUEL TAX Cities (including Towns, Villages and Townships) IL
Opinion

NEW YORK, March 13, 2013 --Moody's Investors Service has downgraded to A3 from Aa3 the rating on the City of Chicago's (IL) $181 million of outstanding rated motor fuel tax debt. The outlook has been revised to negative. SUMMARY RATING RATIONALE The downgrade of the rating to A3 and the revision of the outlook to negative is based on the credit quality of the State of Illinois (general obligation rated A2/negative outlook) and the state's ability to reappropriate or otherwise limit pledged revenues. Debt service on the motor fuel tax bonds of the City of Chicago (general obligation rated Aa3/negative outlook) is secured by a senior lien pledge of a portion of the city's allocation of state motor fuel tax revenues. With legislative approval, the state has the authority to reduce pledged revenues by reducing motor fuel tax rates, increasing appropriations for various state purposes from gross motor fuel tax revenues, or reducing the allocation of remaining motor fuel tax revenues to municipalities. The state's ability to alter pledged revenues presents the risk of non-appropriation, and the rating is therefore notched from the state's general obligation rating. Illinois's general obligation credit profile is most recently discussed in our rating report dated January 25, 2013. The A3 rating also reflects the state's large and diverse economic base from which the pledged revenues are generated; still sound debt service coverage despite recent declines; an additional bonds test (ABT) that should preclude overleveraging of pledged revenues; a flow of funds that provides for the monthly set aside of pledged revenues with the trustee (Amalgamated Bank); and the conservative structure of the city's motor fuel tax debt, which carries no exposure to the risks associated with variable rate debt or interest rate swaps. These positive credit attributes are balanced against significant pressures, namely steady declines in gross motor fuel tax revenues, which reflect the broader economic downturn, increased fuel prices, and increased use of fuel efficient vehicles, all of which have contributed to a decline in fuel consumption. Another credit challenge stems from Chicago's declining population relative to that of other incorporated Illinois municipalities; this trend factors unfavorably into the statutory formula used to allocate motor fuel tax revenues to Chicago. STRENGTHS - Despite recent declines, debt service coverage remains adequate: 2011 and 2012 pledged revenues provided 3.4 times and 3.2 times maximum annual debt service (MADS) coverage, respectively. - The general ordinance that governs the city's motor fuel tax debt establishes a monthly set aside of pledged revenues with the trustee, who receives funds directly from the state before passing on any excess to the city. - Legal provisions include an ABT of 2.0 times, which should preclude overleveraging of pledged revenues. - All outstanding motor fuel tax bonds are fixed rate and have no exposure to the risks associated with variable rate debt or interest rate swap agreements. CHALLENGES - The State of Illinois controls pledged revenues by establishing motor fuel tax rates, appropriating for various state purposes prior to allocating funds to other units of government, and controlling the formula by which these remaining monies are allocated to Chicago and other municipalities. The state's ongoing budget pressures enhance the risk that motor fuel tax revenues could be diverted for other state purposes.

- Pledged revenues have steadily declined in each of the past seven years due to decreased fuel consumption and declines in the City of Chicago's population, a trend which factors unfavorably into the allocation formula used to determine the amount of pledged revenues. - Legal provisions do not require a debt service reserve (DSR) for the rated motor fuel tax bonds. - The city's outstanding motor fuel tax debt is slowly amortized: just 29% of the outstanding principal is scheduled to be repaid in ten years. DETAILED CREDIT DISCUSSION LEGAL SECURITY Debt service on the City of Chicago's motor fuel tax bonds is secured by a senior lien pledge on 75% of the receipts from the city's share of revenues derived from the state's motor fuel taxes. Per state statute, the remaining 25% must support pay-go capital projects and cannot be used for debt service. AMOUNT AND RECEIPT OF PLEDGED REVENUES ULTIMATELY SUBJECT TO STATE CONTROL Pledged revenues that support debt service on the City of Chicago's motor fuel tax bonds are ultimately controlled by the State of Illinois. The Illinois General Assembly has the authority to amend and supplement the Motor Fuel Tax Law and the Use of Motor Fuel Tax Funds Act, and the distribution of motor fuel tax revenues are subject to annual appropriation by the Illinois General Assembly. Despite the state's credit pressures, city management reports that revenues for debt service continue to be received on time and in full. We believe that the state is unlikely to take any action that would materially reduce or delay revenues available for debt service, in part because the state approves each municipal issuance of debt secured by the state's motor fuel taxes and is therefore aware of the municipal obligations. While remote, the risk of state impairment of pledged revenues exists and is a key component in the current rating assignment. Illinois's Motor Fuel Tax Law imposes a 19 cent per gallon tax on gasoline and an additional 2.5 cent per gallon tax on diesel fuel. The state last changed these tax rates in 1990. Tax receipts are deposited each month into the state's Motor Fuel Tax Fund, from which the state first makes "priority allocations" for various purposes defined in state statute. The amounts of several such allocations are pre-defined. For example, $420,000 per month is to be transferred to the State Boating Act Fund. Other allocations, such as support for administrative costs of the Illinois Department of Revenue and supervisory costs of the Illinois Department of Transportation, are established by the Illinois General Assembly as needed and without limitation. The state can change the amounts of the priority allocations at any time. For example, in 2008, the Motor Fuel Tax Law stated that $2.25 million was to be transferred from the Motor Fuel Tax Fund to the Grade Crossing Protection Fund each month. By 2012, this amount increased to $3.5 million. We note that total annual amounts of the state's priority allocations (the net effect of changes in the amounts of the individual priority allocations) have been relatively contained, ranging between $178,000 and $226,000 during the past decade. Still, the state's ability to increase the amount of priority allocations - thereby reducing pledged revenues - is a key credit weakness that has become more pronounced as the state's budget pressures have intensified in recent years. After the state's priority allocations are made, the funds remaining in the state's Motor Fuel Tax Fund are allocated to various units of state and local government according to formulas defined in state law. The state last altered this formula in 2000. Currently, 45.6% of the remaining monies are allocated to various state purposes related to road construction and 54.4% is allocated to local units of government. This local allocation is further divided so that 49.1% is distributed to municipalities (including Chicago), 35% is distributed to counties, and 15.9% is distributed to road districts. Finally, the state apportions the 49.1% municipal allocation to cities based on the city's population relative to all incorporated Illinois municipalities. Per state law, 25% of each city's final allocation cannot be used for debt service and instead must be used for pay-go financing for non-arterial residential street improvements. Pledged revenues for debt service on Chicago's motor fuel tax debt consist of the remaining 75% of Chicago's allocation. The City of Chicago's general bond ordinance establishes a flow of funds that provides for a monthly set aside of revenues for debt service with the trustee who maintains the Debt Service Account. The state distributes motor fuel tax revenues directly to the trustee each month. The trustee sets aside an amount equal to 1/5th of the upcoming interest payment and 1/11th of the upcoming principal payment, so that funds for each debt service payment are available in the Debt Service Account one month in advance. After the deducting the required monthly amount, the trustee sends any remainder to the city to be used for street improvements and other purposes permitted in state statute. City officials report that the state has remitted the monthly allocations to the trustee on

permitted in state statute. City officials report that the state has remitted the monthly allocations to the trustee on time and in full. However, the state's budgetary challenges have led to delays in other forms of local government revenues, including state shared income taxes, which Chicago officials report are typically delayed by one to two months. The city has pledged to remedy any deficiency in the Debt Service Account with funds on hand in the city's Motor Fuel Tax Fund. However, the city is not required to maintain a minimum balance in this fund. The ordinance for the rated bonds allows the city the option of establishing a DSR but does not require one. STEADY DECLINE IN PLEDGED REVENUES REFLECTS REDUCED MOTOR FUEL CONSUMPTION AND CHICAGO'S POPULATION LOSS RELATIVE TO OTHER ILLINOIS MUNICIPALITIES Pledged motor fuel tax revenues have declined in recent years due to reductions in motor fuel consumption, which has reduced total state motor fuel tax revenues, and Chicago's population loss, which has reduced Chicago's share of total state motor fuel tax revenues. During the past decade, revenues from the state's motor fuel tax have steadily declined. According to data provided by the Illinois Department of Transportation, the state's motor fuel taxes generated a total of $1.216 billion in revenues in 2012, which represented an 8% decline from 2002 revenues. Annual statewide motor fuel tax collections have declined in each of the past five years at an average annual rate of 2.5%. The tax is based on gallons consumed, rather than price, so declines in revenue reflect declines in consumption. Factors that account for decreased consumption include an increase in the use of fuel efficient vehicles, an increase in gas prices, and the overall economic downturn. Continued declines in fuel consumption would likely weaken total motor fuel tax revenues available for debt service on Chicago's motor fuel tax bonds and other statewide purposes. While fuel consumption trends are affecting gross motor fuel tax revenues, Chicago's population trends are affecting net motor fuel tax revenues. Between the 2000 and 2010 census counts, the city's population fell from 2.9 million residents to 2.7 million residents. Concurrently, the overall population of other incorporated Illinois municipalities has grown, particularly as people have moved from Chicago to the surrounding suburbs. Consequently, Chicago's population relative to that of other incorporated municipalities in the state has slowly but steadily dropped over the past decade. In 2001, this percentage was 27.2%, but by 2012, the percentage was 24.2%. This ratio is a key determinant of the state's allocation of motor fuel tax revenues to municipalities, so the rate of decline in pledged revenues has exceeded the rate of decline in gross revenues. In 2012, pledged revenues equaled $49.4 million, which represented a 20% decline from 2002 revenues. Annual pledged revenues have declined in each of the past seven years at an average annual rate of 3.7%. As pledged revenues have declined over the past decade, debt service coverage has dropped somewhat but remains adequate. Based on unaudited results, 2012 pledged revenues provided 3.2 times MADS coverage, compared with 2002 pledged revenues, which provided 3.9 times MADS coverage. (MADS is $15.6 million.) Debt service coverage is not expected to significantly weaken in the future, in part because annual debt service is scheduled to slightly but steadily decline. However, should fuel consumption, population trends, and/or future state actions materially weaken pledged revenues and debt service coverage, Chicago's motor fuel tax debt rating will likely weaken. DEBT IS CONSERVATIVELY STRUCTURED BUT SLOWLY AMORTIZED Chicago's motor fuel tax debt is conservatively structured but slowly amortized. All outstanding motor fuel tax debt is fixed rate, and the security is not exposed to any derivatives or interest rate swap agreements. The security is therefore not subject to interest rate or liquidity risks that are associated with variable rate structures. The ordinance governing the rated bonds permits the issuance of variable rate debt and the execution of interest rate swaps, but city management reports no plans to enter into these structures. Going forward, overall debt service is scheduled to slightly decline each year, although principal payments significantly ascend in later years. Payout is therefore quite slow, with just 29% of the principal to be retired in ten years and 71% to be retired in 20 years. The final maturity is scheduled for 2038. A sound ABT requires that pledged revenues in the most recently completed 12 month period provide at least 2.0 times coverage of MADS on all existing and new debt. We believe this provision should prevent significant overleveraging of pledged revenues. City management reports potential plans to issue additional debt through a possible federal Transportation Infrastructure Finance and Innovation Act (TIFIA) loan. The loan application is pending. If the loan is awarded, the city will issue an additional $96.5 million in debt to complete the final phase of the Wacker Drive reconstruction project in downtown Chicago. The new debt would enjoy a parity claim with the outstanding motor fuel tax revenue debt. Additional revenues would also be pledged to the current and existing debt. City management projects MADS coverage of 2.7 times on all existing and potential debt.

OUTLOOK Assignment of the negative outlook is in keeping with the negative outlook assigned to the state's general obligation debt. What could change the rating or outlook - UP - Upward movement in the state's general obligation rating or outlook - Changes in the provisions governing the city's motor fuel tax debt to effect a legal separation between the pledged revenues and the state's general operations What could change the rating or outlook - DOWN - Downward movement of the city's or state's general obligation rating or outlook - Any delay, reduction, or other impairment in the transfer of pledged revenues from the state to the trustee - Further declines in pledged revenues (caused by increases in the state's competing priority allocations, reductions in fuel consumption, and/or reductions in Chicago's population) that further weaken debt service coverage - Changes in the legal provisions governing the city's motor fuel tax debt that would weaken covenants such as the ABT or the monthly set aside of funds in advance of debt service due dates KEY STATISTICS 2011 pledged revenues (audited): $52.9 million (3.4% average annual decline since 2007) 2012 pledged revenues (estimated): $49.4 million (4.8% average annual decline since 2008) MADS (2014) coverage from 2011 pledged revenues: 3.4 times MADS (2014) coverage from 2012 pledged revenues: 3.2 times Additional bonds test (ABT): 2.0 times MADS Debt service reserve (DSR) requirement: none on rated debt Ten year principal amortization rate: 29% Total motor fuel tax debt outstanding: $187 million (Series 1993, 2003, 2008A, and 2008B) Rated motor fuel tax debt outstanding: $181 million (Series 2003, 2008A, and 2008B) The principal methodology used in this rating was US Public Finance Special Tax Methodology published in March 2012. Please see the Credit Policy page on www.moodys.com for a copy of this methodology. REGULATORY DISCLOSURES For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com. Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

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