What Chicago’s Fiscal Emergency says about the Quality of Credit Analysis in the Municipal Bond Market

Because it demands large-scale paradigm destruction and major shifts in the problems and techniques of normal science, the emergence of new theories is generally preceded by a period of pronounced professional insecurity. As one might expect, that insecurity is generated by the persistent failure of the puzzles of normal science to come out as they should. Failure of existing rules is the prelude to a search for new ones.

— Thomas Kuhn, The Structure of Scientific Revolutions

On May 12th, Moody’s Investors Service fired the shot heard around the world. The credit rating agency downgraded the City of Chicago and bonds issued by related tax districts to speculative (“junk”) status.

In a sense, Moody’s was only validating the bond market’s opinion of the city’s creditworthiness — the bonds had already been trading at junk levels for several months. This should have been a straightforward event for the chattering class to process intellectually. Rating actions tend to lag the market rather than lead it.

Oddly, however, Moody’s downgrade sparked a debate over whether Moody’s was being “fair” to Chicago. And with Chicago attempting to convert a portion of its variable rate debt to a fixed rate tomorrow, this debate has received considerable amounts of publicity. How could Moody’s cut the city to junk when the other rating agencies rate the city so much higher? (That has obviously never happened before in an era of ratings shopping and superdowngrades.) Wouldn't having a diverse economy and large tax base cancel out the costs associated with machine politics? (It’s not like this is Chicago’s third fiscal crisis in the past century.)

This was probably the first instance in the history of the capital markets that a rating agency was accused of having too radical an attitude toward risk. How did we get here, folks?

A period of pronounced professional insecurity

Since the financial crisis, municipal bond market participants have been particularly defensive about the level of credit risk in the market as a whole. Commentary on any financially challenged issuer is reliably qualified with “the municipal market defies generalizations,” “these issuers are outliers,” or “remember that, historically, municipal defaults are small relative to corporate bonds.” But the parade of apologies for an issuer with Chicago’s level of financial dysfunction should signal that things have gone too far.

These observations began as a legitimate response to Meredith Whitney’s extremism. Whitney was never going to be correct — the amount of local defaults she predicted exceeded the amount of local government debt outstanding. It was mathematically impossible. It is still mathematically impossible. The financial media that turned her claims into clickbait have moved on to sensationalizing other sectors.

Five years later, however, many municipal market participants remain locked in an unproductive dialogue with an irrelevant personality. Consequently, they are now blind to the fact that what they are saying is no longer true. The market has more financially challenged issuers than can be counted on one hand. These governments are not outliers. They are a class, with similar characteristics and a universe of risks that differentiate them from other borrowers. And they are not small borrowers. It is a more meaningful trend that bondholders are receiving pennies on the dollar in court than it is that defaults remain rare.

There is a conversation to be had about how politics influences the perception of financial commitments and whether bond structures can further evolve to protect bondholders. If the general obligation pledge — absent a statutory lien, which few states have — lacks teeth in court, why isn’t it obsolete? Why is this bond structure still the foundation for credit analysis? Does the general obligation pledge allow governments to over-commit themselves financially in certain political contexts? I would submit to you that this is absolutely the case with Chicago.

None of these issues will be substantively explored so long as market participants remain in “move along, nothing to see here” mode. These are the first fiscal crises where pensions have been a factor at all. In previous fiscal crises, capital markets creditors had the luxury of control. That is no longer a given.

So municipal credit analysis has a lot of growing up to do. Essentially half the market was insured several years ago. As Kuhn noted regarding paradigm shifts in science, there will probably be “a period of pronounced professional insecurity” in the municipal market until new approaches emerge. Until then, there will be a lot of failures.

I will explain my own philosophy regarding financially challenged issuers at the end of this essay.

Rating divergence is actually the status quo — that’s not the story here

Shawn O’Leary at Nuveen Asset Management points out that this divergence is nothing new in Chicago’s Rating Split: Is Moody’s Out of Step?:

Before looking at rating divergence specific to Chicago, it’s helpful to look at the long-term trend of rating divergence between Moody’s Investors Service and Standard and Poor’s. In our opinion, the ratings of the two rating companies have been largely incongruous for several years …
While S&P upgraded 1.01 municipal ratings for each Moody’s upgrade from 2002 through 2007, that ratio ballooned to a whopping 6.66 S&P upgrades for each Moody’s upgrade from 2008 to 2014. And, as noted by the unemployment rate at the time, S&P’s drastic spike in the pace of upgrades occurred at the height of the Great Recession and continued through 2014. This was long after the recession’s effect on municipal finances became apparent to most market participants. While Moody’s pace of upgrades slowed in response to the recession, S&P behaved as though the recession never happened.
We believe this broader context is important to understanding how S&P could rate Chicago’s general obligation pledge at A+ (now A-) while Moody’s rates the same pledge at Ba1. Specific to Chicago, however, we find that not only has the market long treated Chicago’s debt as being at a speculative credit quality — but that it is also well-founded given the credit fundamentals.

Moreover, it is worth noting that the credit rating agencies have published rating methodologies. S&P’s US Local Government General Obligation Ratings Methodology and Assumptions (September 12, 2013 — stashed behind their paywall) includes overriding factors for liquidity and structural imbalance that the rating agency has long decided to ignore for Chicago. Those factors would have put a junk-level ceiling on Chicago’s ratings. In other words, S&P is arbitrarily holding Chicago to different standards than the other local governments the agency rates. And it is obvious why.

What financial risks does Chicago pose to investors?

Let’s examine Chicago’s credit profile and you can decide whether or not the city’s bonds are speculative investments.

Unfunded pension liabilities

The magnitude of Chicago’s unfunded pension liabilities receives considerable attention, and rightfully so. From Nuveen:

Chicago’s combined annual debt and pension costs are substantially higher than any [of the ten largest US cities] when these obligations are indexed to total governmental revenue. Chicago’s fiscal 2015 debt service and annual pension costs account for 44.8% of fiscal 2013 governmental revenue. San Jose is the next closest city at 27.8%. The nine cities other than Chicago averaged 22.4% of revenue.

Last Thursday’s Bloomberg Municipal Market Brief also provided some good comparisons (refer to the StoryChart):

The next 10 years will be the most difficult for Chicago, as current statutes require the city to increase contributions to its four pension plans by 135 percent in 2016, and 8 percent annually through 2021, according to Moody’s. Pension payments will rise 3 percent, on average, through 2026 and around 2 percent through 2032 …

The median per capita aggregate unfunded actuarial accrued pension liability for the largest US cities and Puerto Rico is $3,350. The City of Chicago’s is $7,149.

Most municipal market analysts assume that the city will address its unfunded pension liabilities and relatively high debt burden by increasing residents’ property taxes by nearly 50%.

Chicago officials have been unwilling to raise property taxes for at least a decade. Offering documents indicate that this attitude continues. The city is currently in negotiations with its police and fire unions to postpone transitioning from a system of arbitrary contributions to actuarial contributions (i.e., contributions that reflect the true cost of benefits).

If officials lack the political will to raise taxes when their bonds are trading at 300 basis points (3%) over the AAA benchmark, will there ever be a resolution short of insolvency? This is a material risk that should not be shrugged off.

Borrowing money in order to borrow money

Bloomberg also notes that Chicago has the second-highest general obligation debt per capita among US cities at $3,047, following New York City at $5,500.

According to offering documents (available here), the city won’t be able to afford to make debt service payments on its outstanding bonds from available funds until 2019. The city has been borrowing money on a long-term basis to make debt service payments since before the financial crisis:

Since 2007, proceeds from general obligation bonds in the range of $90 million to $170 million per year have been used to make the city’s general obligation debt service. The city expects to use approximately $220 million of proceeds of long-term general obligation bonds to fund general obligation debt service in levy year 2015 for debt service paid in 2016. The city currently plans to eliminate the use of general obligation bonds to pay general obligation debt service by 2019.

As I described at length in my earlier essay, How Chicago Has Used Financial Engineering to Paper Over its Massive Budget Gap, the city has also been using long-term debt to: (1) finance everyday expenses and maintenance; (2) finance judgments and settlements, including police brutality cases and retroactive wage increases and pension contributions for unionized employees; (3) restructure the city’s existing debt to extend the the maturities on its bonds far out into the future, in order to avoid having to pay the debt as it was coming due; and (4) provide slush funds for the city’s 50 aldermen to undertake projects in their respective areas (i.e., pork).

State and local governments typically only issue bonds to finance the construction of capital projects — buildings and infrastructure with long useful lives that will benefit residents for generations. Chicago has incurred literally billions of dollars of debt where residents have nothing to show for it.

Excessive reliance on short-term debt

Besides a sharp loss in population (as what happened in Detroit), excessive reliance on short-term debt is a solid indicator of financial stress. Chicago has essentially used its credit lines as permanent source of funding in the sense that they are usually carrying a large balance and have frequently been utilized for non-capital expenditures. The city recently expanded its short-term borrowing program to $1 billion. For the sake of comparison, the city’s general fund operating budget is in the neighborhood of $3.3 billion.

Forbearance agreements

Apparently the irony of assigning an investment grade rating to an issuer that is already in forbearance — i.e., its lenders and counterparties have conditionally agreed to delay declaring events of default and exercising their rights and remedies —has been lost on the rating agencies, let alone an issuer that has $2.2 billion worth of forbearance agreements for variable rate debt, short-term credit facilities, and interest rate swap agreements. Chicago’s offering documents contain six pages of triggered events of default. It would be understandable if the city simply needed to replace a deal participant, but having to take it all out at (presumably) much higher interest cost in short order?

Absent these forbearance agreements, that $2.2 billion would become due immediately. The city usually has less than $1 billion of liquidity. The municipal bond market has not seen a liquidity problem of this magnitude for a local government borrower since the financial crisis. And S&P calls this situation “short-term interference.”

Although a portion of these products will be addressed by the city’s offering this week, Chicago’s lenders and counterparties have imposed some strict conditions on the remaining amount. The agreements are for a short period of time and if the city’s credit continues to deteriorate, the standstill agreements will end and the remaining amount will come due.

A large and diverse tax base, but…

Many of the analysts arguing that Chicago should still be considered investment grade cite the city’s large and diverse tax base. Chicago is a transportation hub and home to a number of major corporations.

The city’s population has been declining in recent years and only grew by 82 residents last year. That is not a typo. According to the Chicago Tribune:

Chicago’s population grew by only 82 residents last year, giving it the dubious distinction of being the slowest-growing city among the top 10 US cities with one million or more residents.
With a population of 2,722,389 residents as of July 1, 2014, Chicago still easily holds its place as the nation’s third-largest city … But cities on both sides of it are gaining.
New York maintained its ranking as the nation’s largest city, gaining 52,700 residents last year, for a gain of 0.6 percent that pushed its population to 8,491,079. Los Angeles added 30,924 residents, up 0.8 percent and bringing its population to 3,928,864.
Sun Belt cities with more than 1 million residents — places like Houston, San Antonio, Dallas and Phoenix — all continued to see dramatic gains in new residents …
“The boom of Chicago in the 1990s was due to immigration,” said Rob Paral, a Chicago-based demographer who advises nonprofits and community groups. “You take away the catalyst of immigration, and you see what we have. They’re going to different parts of the country, and there much less immigration to the US than there was decades ago.
“Texas, as an example, has been a magnet for a lot of lower-paying jobs and has the benefit of lower housing costs. If you’re making $15 an hour, the difference between making it where a house costs $100,000 and $300,000 is great.”

This last point brings us to property taxes. Some have also pointed out that Chicago has the lowest effective tax rate in Cook County, which means the city can withstand a large tax increase. This is true. According to Bloomberg, Chicago’s effective tax rate on residential property is 1.8% versus Harvey’s 8.9%. On commercial property, Chicago is not the lowest, but its 4.9% effective tax rate is much lower than Harvey’s 15.1%.

Discussing the level of property taxes in absolute terms fails to capture residents’ calculus in deciding on where to live, however. Just because Chicago has a lower tax rate does not mean residents will stay in the city if or when tax rates are increased significantly. In other areas, higher taxes will translate into more government services, better schools, and so on. In Chicago, they will be used to offset the costs associated with meaningless debt and unfunded pensions from a decade of fiscal mismanagement. That’s a huge difference and something to take into account.

The city has few assets left to sell

Chicago has already blown through the reserves it established from the Skyway and lease of its parking meters. It could try to hawk Midway Airport, but that has already failed three times.

The city’s other tax districts have their own problems

The Chicago Board of Education is also heavily indebted and its recent downgrade likewise triggered events of default. These will force the school system to pay penalty interest rates ranging from 9% to 13.5% and make swap termination payments. The board has significant unfunded pension liabilities and a $1 billion deficit.

Bonds are legally and likely politically subordinated to pension benefits

Perhaps the greatest irony of the debate over Moody’s downgrade is the other municipal bond market news it obscured. Last week, with a 6-t0–1 vote, the San Bernardino city council approved a plan of adjustment that would keep pension beneficiaries whole and basically wipe out bondholders. San Bernardino would be the third in a series of bankrupt municipalities to do so.

Some rulings in federal bankruptcy cases suggest that Chapter 9 could potentially be used to adjust pension liabilities. For that to happen, however, the municipality would have to want to adjust its pension liabilities. So far, when capital markets creditors have gone toe-to-toe with pension beneficiaries in court, they have walked away with massive haircuts.

Why is this happening? I see two (largely ignored) things driving outcomes in municipal bankruptcy cases where pensions are involved. The first is that courts neglect to situate claims in larger public policy contexts. Perhaps this is because some of the judges and law firms involved have mostly corporate restructuring experience and do not fully understand how public policy works. Perhaps it is just impossible the way Chapter 9 was drafted. Whatever the reason, the vocabulary of sacrifice in Chapter 9 cases has become quite mangled. The second is that Chapter 9 provides subtle opportunities for political rebalancing in regions where machine politics prevails. Let’s discuss these in turn.

The treatment of other post-employment benefits (i.e. health care) has been a land mine for capital markets creditors in Chapter 9 cases, whether they realize it or not. Bankruptcy judges have agreed with the municipalities that pension beneficiaries are “making sacrifices” when a plan of adjustment strips them of their health care benefits but leaves their income benefits intact.

It has become something of a farce that the courts fail to recognize and quantify the other forms of government assistance available to retirees in determining the scope of their sacrifices. In a post-Affordable Care Act world, a municipality shedding OPEBs is not an economic sacrifice — it is tantamount to transferring those commitments from local taxpayers to state and federal taxpayers. It does seem like a sacrifice from a contract perspective, however, which allows locals to say, “See what we gave up? Now it is your turn.”

This is sufficient logic for capital markets creditors to receive haircuts, which then provide the resources required for the city to honor its pension commitments. To the extent that there are future Chapter 9 cases, expect OPEBs to be the starting point for crafting a plan of adjustment going forward. It’s just too easy.

If one looks at these insolvencies from the standpoint of local politics, it is not difficult to see how capital markets creditors can end up in the crossfire between different interest groups. Market observers tend to talk about organized labor as if it were a unified whole. In reality, large city governments can have dozens of labor groups with different perspectives and connections. This can be a very big deal with respect to pension politics. Cities can have several different pension plans depending on employees’ affiliations with funded levels that vary according to influence. Pension contributions are appropriations and appropriations are political.

If a municipality can keep its income benefits whole by making a token sacrifice that “frees up” funds that would have otherwise gone to investors, then policymakers can realign the political interests of all of these groups. They are all finally back on equal footing with respect to what they are due from the government. This keeps the machine working like a machine. Considering that governments can wander down this path (and in Detroit’s case, with open contempt for its investors) and still have some borrowing options, it is not surprising that Chapter 9 cases remain tethered to local politics.

That’s a bit of a digression, but it is still instructive with respect to Chicago. Chicago bondholders could potentially be subjected to the same destructive politics, but they would be in a worse situation legally if the city’s credit continued to deteriorate. Chicago is not eligible to file for Chapter 9, which means bondholders would have seek remedies in state courts with resistance from all of the other stakeholders (who are local). The Illinois Supreme Court has elegantly subordinated their claims to pensions through its interpretation of the state constitution and has expressed indifference about the financial impact. Absent Chapter 9, there isn't even the possibility of sharing resources.

Regardless of what one thinks about ratings divergence, the divergence between the rating agencies and market participants with skin in the game makes perfect sense. Bondholders have been repeatedly hosed for giving municipalities the benefit of the doubt in these circumstances.

How I regard financially challenged governments

Chicago’s fiscal emergency is the confluence of two distinct, but related, problems: (1) the city has made extraordinarily bad decisions for over a decade about how to manage its resources; and (2) the city has made extraordinarily bad decisions for over a decade about which financial products to use in borrowing money. Both the city and its school system used excessive amounts of short-term debt, variable rate debt, and interest rate swaps. They have also waited until it is too late (expensive) to transition their debt portfolio to a more sustainable structure.

Ester Fuchs points out in Mayors and Money: Fiscal Policy in New York and Chicago, a classic text on fiscal crises, that municipalities can “afford” (i.e., financially survive) decades of mismanagement as long as the municipality can service its debt. While I agree with this observation (cynical as it is), I believe financial innovation has introduced some notable twists.

A municipality can “afford” either protracted fiscal mismanagement or an unconventional debt structure. Municipalities that are dealing with both, however, tend to be screwed. As its credit deteriorates, resources that would have cushioned the municipality against mismanagement are instead diverted to resolving broken debt structures (until they aren't).

In Chicago’s case, the city is going to have to learn how to function without most of the gimmicks that have helped it through the last decade. Many market observers underestimate how difficult that will be, even with steep tax increases. They also seem to believe city officials are capable of becoming intellectually honest overnight.

Chicago is hardly exploring new territory here. All of the recent insolvencies in the municipal bond market have combined protracted fiscal mismanagement with a reliance on innovative financial products (e.g., interest rate swaps and pension obligation bonds). This epiphany continues to elude many market participants, especially those who believe credit analysis is as simple as financial ratios.

Perhaps Chicago will successfully navigate through this storm, but it is insane to disregard the risk involved.