We’ve spent quite a bit of time recently discussing the fiscal crises facing many state and local governments across the US. There are quite a few explanations for the deteriorating financial situation ranging from falling oil prices to outright fiscal mismanagement.
One persistent theme is grossly underfunded pension liabilities. The most dramatic example of this problem is Chicago, whose debt was cut to junk by Moody’s after an Illinois State Supreme Court decision struck down a pension reform bid, complicating Mayor Rahm Emanuel’s efforts to push through similar legislation in Chicago where, as we’ve shown, the budget gap is set to triple over three years thanks to rising pension liabilities.
The Moody’s downgrade triggered some $2 billion in accelerated payment rights for creditors and also complicated Emanuel’s efforts to refinance $900 million in floating rate notes and pay down $200 million in related swaps. This underscores how a ratings agency downgrade can quickly cause a chain reaction that is self-feeding and can further imperil already beleaguered city finances. Citi has more on the “ratings agency feedback loop”:
How does a downgrade create a feedback loop?
Payment induced liquidity shock
For many issuers’ credit contracts, a drop to a speculative grade rating acts as a payments trigger. For instance, the issuer may have commercial paper programs and line of credit agreements as a part of its short term borrowing program and a rating downgrade could qualify as an event of default for these borrowing arrangements. This enables the banks to declare all outstanding obligations as immediately due and payable.
A rating downgrade could also force accelerated repayment schedules and penalty bank bond rates on swap contracts and variable-rate debt agreements.
Thus, as a result of the rating action, an issuer could face increased liquidity risk at an unfortunate time when it is working to navigate its way out of a fiscal crisis.
Knock-on rating downgrade risk
In some instances, rating agencies may disagree on an issuer’s creditworthiness which could result in a split level rating for a prolonged period. But a drastic rating action by one main rating agency (either Moody’s or S&P) which knocks the issuer’s debt to below investment grade could force the other rating agencies to follow with a similar downgrade. While the other rating agencies might feel that underlying credit fundamentals of the issuer do not merit a sub-investment grade rating, their rating action could be dictated by negative implications due to the liquidity pressures posed by the first downgrade to junk status. Recently, S&P downgraded a credit as a result of Moody’s rating action that stated that its rating action reflected its view that the issuer’s efforts “are challenged by short-term interference” that prevents a solid and credible approach to resolving their fiscal problems.
Shrinking buyer base
Many investors have mandates to buy investment grade debt only and a fall to speculative grade status could cause existing investors to liquidate the holdings of the fallen credit and shrink the universe of buyers.
Rising issuance costs
In many cases the issuer may have been working diligently to reduce its exposure to bank credit risks in the event of a ratings deterioration (for e.g. shifting its variable-rate GOs and sales tax paper to a fixed rate by tapping its short-term paper program then converting it into long-term debt) but the unfortunate timing of the downgrade will make this task much more challenging as a shrunken buyer base for an entity’s debt, quite naturally, translates into a higher cost of debt.
A higher cost of debt exacerbates liquidity problems and thus the feedback loop could continue to gain traction.
To demonstrate just how pervasive the underfunded pension problem truly is, consider the following map:
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