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Monday, April 20, 2015 4:38 AM

Credit Swap Event Triggers for Chicago Schools: Out of Cash in 30 Days, Cooking the Books to Oblivion:Rauner Ponders Bankruptcy; Emanuel Out to Destroy Middle Class

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Bad news on Chicago is deep and broad:

  • The Chicago Public School System has a $1.1 Billion Budget Hole in $5.9 Billion Budget
  • A $228 to $263 million derivative time bomb just triggered on the Chicago Board of Education
  • Chicago Public Schools may be out of cash in 30 days
  • Corruption investigations plague the school board
  • Chicago booted Moody's as a bond rater
  • Roadblocks impair pension reforms by the Illinois legislature
  • Rauner issued a statement he will not bail out Chicago on the backs of Illinois taxpayers
  • Chicago teachers threaten strikes demanding more money that isn't there

Let's investigate those ideas starting with the bond rating cuts that triggered the derivatives time bomb.

Bond Rating Cuts

On March 9, Moody's dropped Chicago School bonds two notches to Baa3, that last rank above Junk.

Chicago responded by dumping Moody's in favor of little-known rating agency Kroll, essentially shopping around for better results.

This is the way the system works. Ratings agencies lose business if they do not rate bonds high enough.  

On March 20, Fitch downgraded Chicago Board of Education Rating to BBB-, also one step above junk.

Synthetic Swaps

Chicago is involved in ill-advised synthetic fixed-rate interest swaps that have a negative value of $228 million according to Moody's and negative $263 million according to Fitch.

As part of the swap agreement, a forced termination event triggers when rating agencies lower the district's General Obligation bonds to below the mid-triple B level. That happened with Fitch's downgrade.

Swap Termination Triggers

The Bond Buyer reports Chicago Schools Face Swap Termination Events.
Under a termination event, the board would be required to pay any negative valuation on the swap, according to its offering statement. Fitch reported a more current negative valuation of $263 million and raised concerns over the district's ability to cover the payments, given its lean cash reserves on hand.

"Fitch believes the district will have to either renegotiate the terms of the swaps with the counterparties or bond for the funds, as cash balances appear inadequate to cover both termination payments and operations," the report said.
Chicago Public Schools Broke

The Chicago Sun Times commented on the CBOE's fiscal state in CPS’ $228 Million Time Bomb.
Even as it confronts a federal investigation that’s embroiled its chief executive, Chicago’s public school system is facing the prospect of having to make payments to four financial institutions that would largely wipe out its cash reserves.

And they could demand those payments with just 48 hours’ notice, records examined by the Chicago Sun-Times show.

That possibility was triggered by the school system being hit with a dramatic downgrade in its credit rating last month.

As a result, the financial institutions can end the deals and demand termination payments within “two business days following notice of the amount payable,” the Chicago Board of Education said in a regulatory filing Friday.

If the investment banks decide to terminate the deals, the district “currently has” enough money to pay the termination fees, but the payments would leave CPS virtually broke, records show. They would eat up more than the $227 million projected to be left in the school system’s main reserve fund after this school year.

CPS has another $174 million in a “debt-stabilization fund.” But without specifying how long that money would last, school officials warned they are on the verge of tapping out their reserves.

“No assurance can be given . . . regarding the board’s future liquidity position,” school officials said in the filing with regulators.
Chicago School Chief On Leave Amid Federal Probe

The Chicago Tribune reports CPS Chief Barbara Byrd-Bennett on Leave Amid Federal Probe
Chicago Public Schools chief Barbara Byrd-Bennett is taking a paid leave of absence in the face of a federal investigation that subpoenas show is taking a broad approach in its search for information about the district's decision to award a $20.5 million no-bid contract.

Among CPS employees called to appear before a grand jury is James Bebley, the school board's general counsel. Also receiving grand jury subpoenas were Byrd-Bennett's chief of staff, Sherry Ulery, and Rosemary Herpel, a district employee who worked with Byrd-Bennett during her earlier leadership stints in Cleveland and Detroit.
Chicago Public School $1.1 Billion Budget Hole

Tribune writer Eric Zorn discusses the CPS Budget Hole of $1.1 Billion
I ran into Ald. Bob Fioretti, 2nd, at the Hideout on Friday evening and asked him if — come on, honestly, now that his campaign for mayor is over — he had workable, realistic solutions to the financial problems the next mayor of Chicago will confront.

He said, he had no idea how to address the estimated $1.1 billion budget deficit facing the Chicago Public Schools. That problem, he said, kept him lying awake at night.

CPS is out of tricks. For years the system has been relying on a variety of, um, strategies to make it appear that its budget is balanced, as required by law. Pension holidays. Spending down cash reserves. The fiscal 2015 budget incorporated two months of property tax revenue from fiscal 2016, if you can top that.

A property tax increase isn't the answer. The maximum allowable hike under state-imposed caps will only boost the bottom line by $50 million, according to CPS.
Cooking the Books to Oblivion

Got that? Chicago is $1.1 billion in the hole, on a total budget of about $5.9 billion even though it kited two months of property taxes from the fiscal 2016 budget to help balance the budget!

What's next? Four months of kiting? Six?

This isn't legal, and here's another thing that isn't: floating tax-exempt municipal bonds to meet current operating expenses. Chicago did that as well.

And it's not like this is a one-time surprise either. On July 24, 2013, Crain's Chicago Business reported Chicago Schools to Burn reserves to Fill $1 Billion Budget Hole.

Summer 2015 Strike?

The school district faces a pension payment in 2016 of about $700 million. Where is that going to come from?

While pondering that question, please note the Chicago teachers unions want more money, and the contract will expire June 30, 2015.

In May of last year, and in reference to this year's mayoral election the Chicago Teachers Union Chief, Karen Lewis all but promised a strike.
Chicago Teachers Union President Karen Lewis today declared in unmistakable terms that the union will forgo the fourth, optional year of a pact negotiated to end the 2012 strike. That means the current contract will expire on June 30, 2015.

"I'm not looking to make anyone's election easy," Ms. Lewis added in a thinly veiled shot at Mayor Rahm Emanuel. "Particularly," she added, "someone who hasn't made our life easier."

The problem, Ms. Lewis said, is that, instead of asking the 1 percent to pay their fair share, Mr. Emanuel is allied with the rich, even though they're bent on "destroying our city like a swarm of Gucci-winged locusts."
Chicago Pensions $20 Billion in the Hole

It's not just the school district in trouble. The Wall Street Journal reports on Chicago's Multibillion-Dollar Pension-Funding Shortfall.
Four pension funds in the nation’s third-largest city are facing a combined funding gap of about $20 billion after years of underfunding and market losses during the recession. In comparison, Chicago has a $3.5 billion annual budget for general operating expenses.

The situation is an example of how municipalities across the country still are struggling to fill gaps in their pensions, which sustained losses on investments during the financial crisis. The troubles are prompting investors to avoid debt from municipalities with large pension-funding gaps, like New Jersey, fearing officials would have to choose between promises made to bondholders and employees.

The pension gap in Chicago has some analysts warning the city could in a decade or more face the same fate as Detroit, which also had pension shortfalls before it filed for bankruptcy protection in 2013. Although Chicago’s economy is more robust, some investors said Chicago needs to address its pension situation.

“Chicago is Detroit 10 to 15 years from now, if they do not deal seriously with this pension problem,” said Tom Metzold, senior municipal portfolio adviser at Eaton Vance Management, with $28.3 billion of assets under management. Mr. Metzold said his firm has “virtually no holdings” in Chicago debt.
Legislative Roadblocks

Illinois desperately needs pension reform, but a Legislative Roadblock is in the way.
Ill. Gov. Bruce Rauner's proposed $2.2 billion pension reform plan needs a thorough review to determine its long-term impact and whether it runs afoul of federal rules ahead of a legislative vote, two Illinois lawmakers said.

State Rep. Elaine Nekritz, D-Northbrook, and state Sen. Daniel Biss, D-Evanston are sponsoring  resolutions that seek a detailed analysis from the pension funds on the potential impact of the proposals and a federal review of their legality.

The two are considered Democratic point persons on pensions in the General Assembly. They helped craft past reform proposals aimed at stabilizing a system saddled with $111 billion of unfunded obligations and a funded ratio of just 39%.

"We need to make decisions on pension reform based on core principles of mathematics, law, and basic fairness," Biss said. "It is unjust to these employees and dangerous for the state to do anything less."
I am wondering what planet Nekritz is on. Since when does any state get a federal review of state pension promises, except in a federal bankruptcy court?

Besides, Illinois does not have time, even if it was possible.

And speaking of "dangerous" what does one call 39% funding of state pensions?

Bond Perusal

On Sunday, I decided to take a look at trade data on EMMA, the Electronic Municipal Market Access site.

Here are four transactions from the first page.

click on chart for sharper image

I did not investigate those deals. Rather, I simply want to point out that A-rated Chicago munis yield as much as 7%. That is in the neighborhood of 300 basis points (3 percentage points) over comparable offerings in other states.

The CBOE is floating two more issues this week, about $89 million or so, each. It will be interesting to see what yield the school district has to pay.

Junk Bonds

Please note that Investors Crazy for High Yield Bonds.

Since general obligation bonds are backed by taxing authority, and since those bonds are A-rated, the Chicago yields are notable given the average junk bond yield is about 6.1%.

Other factors are in play, but the huge penalty Chicago has to pay stands out from more than one angle.

Emanuel a Huge Part of the Problem

The mayor is a huge part of the problem. Emanuel scoffed at Rauner's Suggestion that CPS Consider Bankruptcy, and he also nixed right-to-work.
The mayor was responding to comments Rauner made Tuesday in an interview with Ariel Investments President Mellody Hobson.

"I'm concerned that the Chicago Public Schools could end up needing to go bankrupt," Rauner added.

"That's very possible. We have a mess —" he added, before Hobson cut him off, asking what a CPS bankruptcy would mean. "That they would just have to restructure its debts and its contracts," Rauner said.

Emanuel's dismissal of the CPS bankruptcy idea came on a day that he and Rauner traded some familiar chest-thumping financial rhetoric.

The mayor called for the council to hold hearings and pass a resolution opposing the "right-to-work" zones proposed by Rauner, calling the governor's proposal "a race to the bottom." In right-to-work zones, workers can choose not to join unions or pay related dues in workplaces that have been organized by labor. While the resolution would only be symbolic, it would put aldermen and the mayor on record as firmly against a key piece of Rauner's economic platform.
Prevailing Wages

The right-to-work law is only symbolic because of inane Illinois prevailing wage laws. Together, the current setup 100% guarantees that every project is bid and paid at the highest rate possible. Examples: Road work, school construction and repair.

Prevailing wages laws are also a part of the pension problem given higher salaries and wages contribute to higher pensions.

Emanuel Out to Destroy Middle Class;

"Our goal is to build up the middle class, not to pull a rug from underneath them. Our competition is not Mississippi, Alabama and Kentucky wages. I want to be clear that as long as I'm mayor, Chicago will not be a right-to-work city," Emanuel said.

For starters, Emanuel is making a promise that is not his to make. The legislature could (and should) make that choice for the entire state.

Moreover, overpaying for services and taxing everyone to death to pay for untenable pension promises is precisely the way to destroy the middle class, not save it.

Emanuel is clearly not interested in doing what is best for Chicago. Instead, he is bowing down to the unions even though it's clear the president of the teacher's union can't stand him.

Sensible Statement From Rauner

"The taxpayers of Illinois are not going to bail out the city of Chicago, that ain't happenin'," Rauner said, returning to a note he has hit in recent months. "But there are things we can do to help them restructure and get their government and their schools turned around, and I'd like to help them."

Rauner has the right idea on taxes, on bankruptcy, and on a bailout of Chicago.

Not a penny of taxpayer money should go to fund a lost cause. I find it hard to believe that Emanuel himself does not know the school system is truly bankrupt.

When you are bankrupt, the only sensible thing to do is admit it.

Mike "Mish" Shedlock

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