In 2002, Warren Buffet called them financial weapons of mass destruction. In 2008, they triggered a severe national recession. And now, in 2014, they are jeopardizing the financial position of the City of Chicago. Like zombies who just won’t die, financial derivatives – put in place many years ago – now threaten to take a major bite out of the city’s reserves. Fortunately, new SEC rules may give Chicago the weapons it needs to ward off this financial Frankenstein.
Between 1999 and 2007, Chicago entered into a series of interest rate swap contracts with financial titans such as Goldman Sachs, Morgan Stanley and Bank of America. These swap contracts allowed the city to issue floating rate bonds while locking in a fixed interest rate - but they also locked the city into binding, long-term contracts, with the financial behemoths, that came with some unexpected risks.
The idea behind the swap contracts was appealing: the city treasury was protected from rising interest rates. At the time, no one knew that interest rates would fall to zero and stay there, obligating Chicago to pay hundreds of millions of swap payments to the major banks.
But there was a simpler alternative to issuing variable rate bonds and then offsetting the interest rate risk with swaps. The city could simply have issued more fixed rate debt. Traditional, fixed coupon bonds remain common in municipal finance and provide a straightforward way to lock in an interest rate.
The problem with simple solutions like fixed rate bonds is that they don’t generate a lot of income for financial intermediaries. In a 2011 testimony at an SEC hearing, financial expert Dr. Andrew Kalotay observed that swap advisers, pricing agents and attorneys all charge substantial fees for their efforts, while banks typically charge a 2% markup on swap transactions. In Alabama, $120 million in swap fees contributed to that Jefferson County’s 2011 municipal bankruptcy filing. Kalotay went on to observe that corporations never finance themselves with a combination of floating rate bonds and interest rate swaps. They apparently realize that this combination is a good deal for Wall Street banks – and not for them.
But excessive fees are not the only downside of these swaps contracts, as Chicago is now learning. Because swap contracts require cities to make payments to banks, they contain provisions that protect the banks in case a city becomes insolvent – as Detroit did.
In Chicago’s case, banks are protected by a clause that allows them to terminate the swap contract if the city is downgraded by Moody’s to a rating of Baa2. If the banks terminate their swap contracts under this provision, the city would have to immediately pay all the rest of the money it owes under the agreements – about $173 million according to Bloomberg.
Recently, Moody’s downgraded the city to Baa1 - one step above the accelerated termination threshold - while maintaining a negative watch. Thus Chicago is in real jeopardy of suddenly being obliged to pay a lump sum of almost $200 million to the major banks.
It is almost surreal when you think about it: banks and credit rating agencies widely blamed for a financial crisis that happened six years ago still hold the power to seriously compromise the city’s finances.
But reforms enacted in the wake of the financial meltdown may be used to protect Chicago. Dodd Frank contained a provision requiring rating agencies to consistently apply their rating symbols. This “universal rating symbol” requirement was recently included in new SEC rule 17g-8.
There is ample evidence that rating agencies have discriminated against government bond issuers vis-a-vis other types of borrowers, including corporations and structured finance vehicles. For example, thousands of AAA-rated mortgage backed securities failed to make complete and timely debt service payments in recent years, while no city or county rated single-A or above has experienced such a payment failure. Evidence of this discrimination was surveyed in a March 2014 comment letter from the Consumer Federation of America to the SEC.
In 2008, the state of Connecticut sued all three credit rating agencies for this discriminatory practice. The case was eventually settled, with two of the three agencies agreeing to rescale their ratings in 2010. But this adjustment failed to fully address the ratings discrepancy and has been fully offset by subsequent downgrades attributed to pension underfunding.
Despite the many scare stories about public employee pensions, they have not played a major role in triggering municipal bankruptcies to date. In fact, since Detroit filed last July, no American city or county has initiated a Chapter 9 bankruptcy process. Moreover, most of the cities that previously filed – including Vallejo, Stockton, San Bernardino, Harrisburg and Detroit – did so because they faced some combination of declining revenue and deficient or negative general fund reserves. Pension obligations were, at most, a secondary issue.
Consequently, it is fair to argue that Chicago’s pension obligations do not justify its low ratings. Moody’s and other credit rating agencies should review Chicago’s ratings to ensure that they reflect the city’s real risk of defaulting over the next few years – which is miniscule. If Chicago’s ratings were properly rescaled, the city would no longer be on the verge of making $173 million in termination fees to the big banks.
Unlike today, the City of Chicago faced the real possibility of default in 1932. At that time, a large principal payment was coming due and the Depression-wracked city lacked the revenue needed to make it. Back then, civic-minded bankers teamed up and worked overtime to find buyers for a new bond issue that allowed Chicago to roll over its debt and avoid bankruptcy. Eighty years ago, financial leaders believed they had a role to play in helping their cities survive financial turmoil; today it seems that the financial industry regards municipalities as just another lucrative source of fee income.