The Chicago skyline is seen above a partially frozen Lake Michigan in Chicago, Illinois, January 5, 2015. REUTERS/Jim Young (UNITED STATES - Tags: ENVIRONMENT SOCIETY CITYSCAPE)

By Karen Pierog

CHICAGO (Reuters) - Chicago drew closer to a fiscal free fall on Friday with a rating downgrade from Moody's Investors Service that could trigger the immediate termination of four interest-rate swap agreements, costing the city about $58 million and raising the prospect of more broken swaps contracts.

The downgrade to Baa2, just two steps above junk, and a warning the rating could fall further still, means the third-biggest U.S. city could face even higher costs in the future if banks choose to terminate other interest-rate hedges against fluctuations in interest rates. All told, Chicago holds swaps contracts covering $2.67 billion in debt, according to a disclosure late last year.

"This is an unfortunate wake-up call for anyone still asleep over the fiscal cliff facing the city of Chicago," said Laurence Msall, president of the Chicago-based government finance watchdog, The Civic Federation.

Chicago's finances are already sagging under an unfunded pension liability Moody's has pegged at $32 billion and that is equal to eight times the city's operating revenue. The city has a $300 million structural deficit in its $3.53 billion operating budget and is required by an Illinois law to boost the 2016 contribution to its police and fire pension funds by $550 million.

Cost-saving reforms for the city's other two pension funds, which face insolvency in a matter of years, are being challenged in court by labor unions and retirees.

State funding due Chicago would drop by $210 million between July 1 and the end of 2016 under a plan proposed by Illinois Governor Bruce Rauner.

Given all the financial pressures, both Moody's and Standard & Poor's, which affirmed the city's A-plus rating, warned on Friday that Chicago's credit ratings have room to sink.

Moody's said Chicago's rating could be cut if Illinois courts find pension reform laws enacted to shore up the state's financially ailing pension system and for two of Chicago's retirement systems are unconstitutional. A ruling by the Illinois Supreme Court on one of the laws could come as early as this spring.

S&P warned of a multi-notch downgrade if the city fails to come up with a sustainable plan this year to pay its escalating pension contributions.

In a report, Moody's noted that the downgrade to Baa2 moves the city closer to termination of 11 more swaps deals. Termination on those contracts would potentially cost Chicago an additional $133 million, Moody's noted.

Chicago has the financial resources at hand to cover the initial $58 million termination payments on the four swaps if the city is unable to renegotiate terms, Moody's said.

"The city's available liquidity is more than sufficient to cover these termination costs," Moody's stated.

If the rating falls below Baa3, Chicago could be forced to pay about $1.2 billion if banks that provide liquidity facilities like letters of credit for city debt demand immediate collateral, Moody's said.

In an affidavit late last year, the city's chief financial officer, Lois Scott, acknowledged that a single-step downgrade by either Moody's or S&P could trigger about $50 million in immediate payments and expose the city to variations in interest rates.

A spokeswoman for Chicago Mayor Rahm Emanuel did not immediately respond to a request for comment.

The downgrade and violation of terms on the swaps agreement likely will become an issue in Emanuel's re-election campaign. The first-term mayor, a former chief of staff to President Barack Obama, failed on Tuesday to win a majority of votes in a primary election, and faces a runoff vote April 7 against a Cook County commissioner, Jesus "Chuy" Garcia.

Moody's based its one-notch downgrade affecting $8.3 billion of general obligation bonds to Baa2 with a negative outlook on the city's growing costs related to its big unfunded pension liability.

Chicago is defending a 2014 Illinois law that boosted pension contributions by the city and its workers to two of its retirement funds and reduced benefits. In the affidavit and in testimony earlier this month in Cook County Circuit Court, Chicago CFO Scott quantified the city's exposure to a variety of credit instruments as a result of further rating downgrades.

Under a three-notch downgrade, Chicago would default on about $2.8 billion of credit facilities, including letters of credit, that the city would likely not be able to replace, according to Scott. Moody's analysts said most of Chicago's $806 million of variable-rate GO bonds are tied to swaps.

Story continues