What comes to mind when you think of Chicago?
Sears Tower, 1998. Source: Wikipedia
Some may think of Al Capone, or Lake Michigan, or the Sears Tower. Others think of their many sports teams: the Bears, the Bulls, the Cubs, the White Sox, the Blackhawks. And there’s the legacy of Chicago’s architecture, with Louis Sullivan and Frank Lloyd Wright. Chicago enjoys a special place in America’s history and culture.
But municipal bond investors will now have to think “junk” when they consider Chicago. Yesterday Moody’s Investor Services cut the credit ratings on America’s third most populous city two notches to Ba1 after the state Supreme Court unanimously overturned state pension reforms. The rating applies to almost $9 billion in general obligation debt, sales tax revenue debt, and gasoline-tax revenue debt.
The timing of the rating change may have been a surprise—Chicago’s pensions weren’t directly affected by the court ruling—but it wasn’t a shock. Chicago has a growing and diverse economy, but it has serious problems with its retirement system, $30 billion worth of problems. The City has made pension promises that it simply cannot keep. But it’s not like pensions are the only issue.
Over the years, analysts have noted all kinds of financial shenanigans. Just a partial list includes: 1. issuing long-term debt to pay current expenses; 2. using long term debt to pay court judgements and settlements; 3. taking proceeds from long-term bonds to make current debt-service payments; 4. earmarking bond proceeds to provide funds to City Aldermen for discretionary spending in their districts; 5. structuring interest-rate derivatives to obtain cash for current expenditures. Do you detect a pattern? The City has habitually pushed payments off into the future. Well, the future has arrived.
Of immediate concern now are up to $2.2 billion in swap termination penalties and accelerated debt service that will be triggered by the downgrade. They also need to make a $550 million contribution to a pension fund by year-end. The City has already raided tapped into many of its reserve funds. Chicago will somehow have to scrape together the cash to make these payments. Mayor Rahm Emanuel is furious, calling Moody’s action irresponsible and far away from reality. But he also acknowledged that the City’s financial crisis is now “at the doorstep.”
Chicago isn’t Detroit. Its problems are financial, not structural. As noted, they have a diverse, growing economy, and a large tax base. But finance—and corruption—matter. If their leaders can’t figure out how to balance the books, the Windy City is likely to face a financial tornado.
Douglas R. Tengdin, CFA
Chief Investment Officer
Leave a comment if you have any questions—I read them all!