Chicago "Junking" Triggers $2.2 Billion Payment, Deepening Financial Crisis

In early March, we discussed the rather deplorable state of Illinois’ public pension plans which, we noted, are underfunded by some 60%. On a statewide basis, making up the deficit would cost around $22,000 per household, which gives you an idea of the cost to taxpayers of the grossly underfunded pension liabilities.

A month later, we pointed out the fact that spreads between Chicago’s muni bonds and USTs had blown out to the tune of 60bps as mayor Rahm Emanuel's re-election became more assured. We also highlighted a WSJ graphic showing that when it comes to unfunded public worker pension liabilities per person, nobody does it like Chicago.

The situation worsened materially last Friday when the Illinois Supreme Court struck down a pension reform law that aimed at closing the state’s $105 billion hole. 

Via The Chicago Tribune:

The Illinois Supreme Court on Friday unanimously ruled unconstitutional a landmark state pension law that aimed to scale back government worker benefits to erase a massive $105 billion retirement system debt, sending lawmakers and the new governor back to the negotiating table to try to solve the pressing financial issue.

 

The ruling also reverberated at City Hall, imperiling a similar law Mayor Rahm Emanuel pushed through to shore up two of the four city worker retirement funds and making it more difficult for him to find fixes for police, fire and teacher pension funds that are short billions of dollars.

That ruling, it turns out, would be the death knell for Chicago’s credit rating, at least as far as Moody’s is concerned. Citing “expected growth in the city’s highly elevated unfunded pension liabilities,” the rating agency cut the city to junk at Ba1. This is bad news for Chicago for a number of reasons, not the least of which is the fact that 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 — clearly this will now be far more difficult. The ratings agency’s actions also given creditors accelerated payment rights, meaning the city could be on the hook for some $2.2 billion in principal and interest on its outstanding liabilities. 

Needless to say, Rahm Emanuel is not happy. Here’s the Tribune again:

Emanuel attacked Moody's decision to downgrade the city's credit, but his remarks illustrate the grave financial situation the city faces.

 

"This action by Moody's is not only premature, but it is irresponsible to play politics with Chicago's financial future by pushing the city to increase taxes on residents without reform," said Emanuel in a statement, just hours after appearing on the South Side to bask in the formal announcement that President Barack Obama's presidential library would be built in Chicago.

One analyst was sympathetic to the mayor's argument that Moody's acted too quickly, but noted the message being sent about Emanuel's leadership as he enters a second term.

 

"A cut below investment grade is a major statement, implying that there is material risk to the city not paying its bondholders on time or in full," said Matt Fabian, a managing partner at Municipal Market Analytics. "To have gone there without waiting to see the city's approach to the current budget gap, or whether or not they will raise revenues is clear demonstration of a lack of confidence in city management. In other words, they see little reason to wait because they expect little in the way of a management response."

Chicago now has the dubious distinction of being the only city “in recent history” to carry such a low rating other than Detroit:

Ciccarone noted that his firm's data showed Chicago's junk status rating is a level only reached in recent history by one other major city: Detroit, before it filed for bankruptcy in July 2013.

So we’re sorry taxpayers, but it looks like Chicago is going to need you to step up to the plate on this one:

Earlier market analyses have indicated that Chicago, unlike Detroit, has a varied economy and options for raising the needed revenue for righting its financial ship, but it won't be painless. "Raising taxes is going to have to be part of the solution," Ciccarone said.

 

Emanuel and city financial officials tried to downplay the action by Moody's, noting other major debt rating agencies had not downgraded city creditworthiness to such troublesome low levels. Budget Director Alex Holt called Moody's rating "an outlier."

 

For years, Moody's has warned the city about not addressing its pension problems, maintaining an intense focus not shared by other rating agencies, and also warned about city debt practices that Emanuel recently vowed to change.

 

Even so, Emanuel and the City Council last year put off making a decision on whether to enact a significant property tax increase to help cover the city's ballooning pension costs. That deferral came as Emanuel and aldermen prepared to run for re-election this spring.

In the end, this serves to underscore not only the pitiable plight of the country's pension plans (which, by the way, are likely to be far worse off on the whole than meets the eye due to the fact that managers cling to optimistic assumptions about investment returns in order to avoid having to revise the present value of their liabilities sharply higher) but also a worrying trend that we discussed earlier this week — namely, that state and city governments across America are going broke. 

Here's a look at just how underfunded Illinois' pension system truly is:

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Moody's statement:

Rating Action: Moody's downgrades Chicago, IL to Ba1, affecting $8.9B of GO, sales, and motor fuel tax debt; outlook negative

Also downgrades senior and second lien water bonds to Baa1 and Baa2 and downgrades senior and second lien sewer bonds to Baa2 and Baa3, affecting $3.8B; outlook negative

New York, May 12, 2015 -- Moody's Investors Service has downgraded to Ba1 from Baa2 the rating on the City of Chicago, IL's $8.1 billion of outstanding general obligation (GO) debt; $542 million of outstanding sales tax revenue debt; and $268 million of outstanding and authorized motor fuel tax revenue debt.

We have also downgraded the following ratings on debt secured by net revenues of Chicago's water and sewer enterprises: to Baa1 from A2 on $38 million of outstanding senior lien water revenue bonds; to Baa2 from A3 on $2.3 billion of outstanding second lien water revenue bonds; to Baa2 from A3 on $35 million of outstanding senior lien sewer revenue bonds; and to Baa3 from Baa1 on $1.5 billion of outstanding second lien sewer revenue bonds.

We have also downgraded to Ba2 from Baa3 the rating on $6 million of outstanding MetraMarket Certificates of Participation (COPs), Series 2010A, and to Ba3 from Ba1 the rating on $3 million of outstanding Fullerton/Milwaukee COPs, Series 2011A.

Finally, we have affirmed the Speculative Grade (SG) short term rating on $112 million of Chicago's outstanding Sales Tax Revenue Refunding Bonds, Series 2002.

The outlook on all long term ratings remains negative.

SUMMARY RATING RATIONALE

The Ba1 rating on Chicago's GO debt incorporates expected growth in the city's highly elevated unfunded pension liabilities. Based on the Illinois Supreme Court's May 8 overturning of the statute that governs the State of Illinois' (A3 negative) pensions, we believe that the city's options for curbing growth in its own unfunded pension liabilities have narrowed considerably. Whether or not the current statutes that govern Chicago's pension plans stand, we expect the costs of servicing Chicago's unfunded liabilities will grow, placing significant strain on the city's financial operations absent commensurate growth in revenue and/or reductions in other expenditures. The magnitude of the budget adjustments that will be required of the city are significant. Furthermore, Chicago's tax base is highly leveraged by the debt and unfunded pension obligations of the city, as well as those of overlapping governments. Balanced against the city's many credit challenges are several attributes, the greatest of which is the city's broad legal authority to tap into its large and diverse tax base for increased revenue.

OUTLOOK

Our negative outlook reflects our expectation that Chicago's credit challenges will continue, both in the near term and in the long term. Immediate credit challenges include potential draws on liquidity associated with rating triggers embedded in the city's letters of credit (LOCs), standby bond purchase agreement (SBPA), lines of credit, direct bank loans, and swaps. The current rating actions give the counterparties of these transactions the option to immediately demand up to $2.2 billion in accelerated principal and accrued interest and associated termination fees. Of this amount, the GO and sales tax revenue rating actions trigger $1.7 billion of potential payments; the second lien water revenue rating action triggers $99 million of potential payments; and the second lien sewer revenue rating action triggers $355 million of potential payments.

The negative outlook also reflects our expectation that Chicago's credit quality will weaken as unfunded liabilities of the Municipal, Laborer, Police, and Fire pension plans grow and exert increased pressure on the city's operating budget. In the near term, Chicago's administration must comply with a 179% contribution increase to its Police and Fire pension plans in 2016.

Developments involving the Municipal and Laborer plans present longer term risks to the city's credit profile. In our opinion, the Illinois Supreme Court's May 8 ruling raises the risk that the statute governing Chicago's Municipal and Laborer pension plans will eventually be overturned. If so, the city's obligation to fund the Municipal and Laborer plans would likely revert to that which existed before the statute took effect in January 2015. Under the prior funding requirements, the city's pension contributions were well below the plans' actuarial requirements. Therefore, if the Municipal and Laborer statute is overturned, and no other adjustments are made to plan revenues and/or expenditures, we believe the plans will continue to extinguish assets to pay annuitants. As the plans move toward insolvency, the city's credit standing will continue to deteriorate, given our view that the state may eventually implement legislation forcing Chicago to pay annuitants directly. Annuitant payments would materially exceed current employer contribution levels. In our view, Chicago's ability and willingness to fund annuitant payments, should they be required of the city, is uncertain.