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Thursday, May 28, 2015 2:31 AM

"Bond Girl" on Chicago and the Quality of Credit Analysis in the Municipal Bond Market

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On May 13, Moody's shocked the municipal bond market by downgrading Chicago to junk.

At that time S&P rated Chicago five notches higher, the widest spread between bond raters in history.

Kristi Culpepper, AKA "Bond Girl" comments on the event in What Chicago’s Fiscal Emergency says about the Quality of Credit Analysis in the Municipal Bond Market.

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.

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.

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 absolutely the case with Chicago.

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.

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.

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.

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?

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 alderman to undertake projects in their respective areas (i.e., pork).

Chicago has incurred literally billions of dollars of debt where residents have nothing to show for it.

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.”

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.

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.

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.

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.
Damning Report

There is much more in Culpepper's report, and all of it damning.

Chicago is on the verge of shrinking. Meanwhile, Illinois is already losing jobs to Indiana, Texas, and Wisconsin. A number of Illinois cities are on the verge of bankruptcy (more on that point in a subsequent post).

And what does Illinois have to show for all this?


Bankruptcy is the only sensible answer.

Mike "Mish" Shedlock

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