Back in May, the Illinois Supreme Court set a de facto precedent for lawmakers across the country when a bid to cut pension benefits was struck down in a unanimous ruling. Anyone who might have been confused as to the significance of the decision got a wake up call from Moody’s when the ratings agency, citing the read-through for Chicago’s fiscal situation, downgraded the city to junk.
As we noted at the time, Moody’s decision was bad news for a number of reasons, not the least of which was the fact that mayor Rahm Emanuel was looking to refi nearly a billion dollars in floating rate debt into fixed rate notes and borrow another $200 million to pay off the related swaps. The ratings agency’s actions also gave creditors accelerated payment rights, meaning the city could have been on the hook for some $2.2 billion in principal and interest on its outstanding liabilities.
But the larger story revolves around the implications for other fiscally challenged state and local governments, and as we noted in "States Turn To Pension Ponzi To Plug Funding Gaps [13]," one "solution" is to issue pension-obligation bonds, in what amounts to a nightmarish delay-and-pray scheme that’s virtually assured to end in still larger deficits. Meanwhile, Moody’s has found that using realistic return assumptions to calculate pension liabilities - as opposed to the absurd practice of accepting the assumptions of the pension funds themselves - makes lawmakers angry which is why some officials are now "omitting [14]" Moody’s from deals. "We wanted a fresh set of eyes," one financial officer told WSJ last month referring to the decision to not hire Moody’s. "Yes, a 'fresh set of eyes,' and preferably a set that will not take a realistic look at pension fund return assumptions," we quipped at the time.
Make no mistake, this is no trivial debate. Almost half of US states face [15] funding gaps for the upcoming fiscal year and the total pension shortfall [16] across states and cities is anywhere between $1.5 trillion and $2.4 trillion depending on who you ask. Against this backdrop, a judge is set to rule on Friday on Chicago’s 2014 pension reform law.
From the Illinois Policy Institute [17]:
A Cook County judge is expected to rule Friday on the legality of a 2014 pension law aimed at reforming two of Chicago’s underfunded city retirement systems. While the pension law included some much-needed reforms, such as an increase in the retirement age, if upheld the law ultimately would put Chicago residents on the hook for millions of dollars of tax increases.
Here are some facts about the 2014 Chicago pension law at issue in Friday’s ruling:
- The 2014 Chicago pension law only affects two of the city’s retirement funds: the municipal workers’ and laborers’ pension systems.
- The pension funds for police, firefighters, teachers, parks and transit workers are untouched by this law.
- The municipal workers’ pension fund has just 41 cents in the bank for every $1 that has been promised in retirement benefits.
- The laborers’ pension fund has just 64 cents in the bank for every $1 that has been promised in retirement benefits.
- The pension debt from the two pension systems affected by the 2014 law represents just $8.3 billion in pension debt.
- In total, Chicago residents are on the hook for more than $34 billion in pension debt, or roughly $33,000 per household.
And while the outlook is most assuredly not good, some say the 8% Chicago recently paid on a taxable bond offering is more than enough to compensate for the risk. Here’s Bloomberg with more [18] on who’s backing up the truck for Chicago’s "junk":
As Chicago wrestles with rising pension costs, cash-strapped schools and a swelling budget deficit, investors from Pacific Investment Management Co. to Wells Capital Management say they aren’t counting the Windy City out.
Wells Capital is increasing its exposure to the junk-rated metropolis, while Pimco said this week it sees long-term value in the city’s debt. A longer-term perspective may come in handy, with a judge to rule Friday on the legality of an overhaul of two of four city employee-pension programs.
The nation’s third-most populous city had to pay yields approaching 8 percent as part of a $743 million taxable-bond offering last week, putting it in the league of junk issuers such as telephone company CenturyLink Inc. A $346 million tax-exempt portion of the sale yielded as much as 5.7 percent.
Already the worst-rated major city except Detroit, Chicago risks being downgraded again if the pension changes are overturned. Yields on Chicago debt are close to the highs reached after Moody’s Investors Service cut the city’s credit rating to below investment grade in May.
"Despite the fact that we all know that they have their problems, and Chicago politics and Illinois politics are really, really difficult, it’s hard to ignore that kind of embedded yields," said Jim Colby, chief municipal strategist at Van Eck Global, which bought some of Chicago’s tax-exempt deal last week. "I know the risks."
Yes, Jim "knows the risks", so stop asking him about it. Of course that’s probably what quite a few folks who went yield chasing in HY energy said earlier this year and we’ve seen how that’s worked out.
But even if Jim knows, others might not, so Bloomberg, just what are the risks?
The pension system in Chicago is $20 billion short, and the state of Illinois’s retirement fund has a $111 billion shortfall. Chicago’s retirement system is only 36 percent funded as of December 2014, compared to 61 percent in 2005.
A partial solution was found last year when state lawmakers approved a plan, touted by Mayor Rahm Emanuel’s administration, that restructured the pensions of the laborers and municipal workers. That affects about 60,000 workers. The fix forces employees to pay more with lower benefits while also boosting the city’s contribution. Some unions sued to block the law that went into effect Jan. 1.
Friday’s ruling will decide whether that law is constitutional.
Got it. Ok, so let’s just say, for argument’s sake, that the ruling goes against Chicago, what kind of chance do they have on appeal?
The decision is expected to be appealed to the state Supreme Court, which in May unanimously ruled that Illinois couldn’t cut retiree benefits. "Seeing how the state supreme court ruled earlier in the spring, I don’t expect the decision to go favorably for Chicago," said Joseph Gankiewicz, an analyst at Blackrock Inc. in Princeton, New Jersey.
Ok, but let’s ask Chicago’s lawyers - maybe they can tell us why there’s still hope even in the event things don’t go well in the courts.
If the law is overturned, Chicago’s pensions will be broke in about 10 years, the city’s lawyers have argued.
Obviously the city's legal team has an incentive to make the situation seem especially dire in order to raise the stakes of a negative ruling, but that said, Chicago's fiscal problems aren't set to go away any time soon even under an optimistic scenario. "The city is projecting a budget shortfall of $430 million next year, up from $297 million this year," Bloomberg notes. Indeed, potential investors may want to think long and hard before throwing good money after bad here and on that note, we'll close with the following graph from May which gives you an idea of where things are headed in the windy city.
[19]
