Is Chicago Really a "Junk" Issuer?

Last week, Moody’s downgraded Chicago general obligation bonds into speculative (i.e., “junk”) territory. As a critic of low municipal bond ratings, I saw a good opportunity to take Moody’s to task. But after diving into Chicago’s financial data, I’m not so sure. The data I compiled are in this Google sheet and my analysis follows.

In April 2012, Moody’s affirmed Chicago’s general obligation municipal bond rating at Aa3. Just over three years later, this rating stands at Ba1 - a cumulative reduction of seven notches. Since Moody’s entire rating scale, which ranges from Aaa to C, contains a total of 21 notches, the Chicago ratings changes have been quite dramatic. The magnitude of this downgrade does not appear justified by changes in the city’s finances..

When it affirmed Chicago’s Aa3 rating three years ago, Moody’s wrote the following:

The affirmation of the Aa3 rating on Chicago's general obligation debt is supported by the city's long-standing role as the center of one of the nation's largest and most diverse economies; a tax base that remains very sizeable despite several consecutive years of estimated full valuation declines; significant revenue raising ability afforded by the city's status as an Illinois home rule community; and its closely managed use of variable rate debt and interest rate derivatives. These strengths are somewhat moderated by the city's persistent economic challenges, including elevated unemployment levels and a large foreclosure backlog; narrow, though improving, General Fund reserves; relatively low levels of expenditure flexibility, as a high percentage of the city's operating budget is dedicated to personnel costs for a heavily unionized workforce; and above average levels of slowly amortizing debt.

Three years later, Chicago’s situation is about the same or slightly better. The city is still the center of a large and diverse economy and it continues to benefit from a strong revenue base. Although official property valuations (EAVs) are lower, both Zillow and the Case-Shiller Index show substantial property price gains since bottoming in early 2012. The city’s unemployment rate has also fallen substantially.

Gradual economic improvement has brought rising revenues. According to the city’s CAFR, its largest fund saw revenue grow from $2.8 billion in 2011, to $2.9 billion in 2012 and $3.0 billion in 2013. Unaudited figures in the city’s latest budget show further growth to $3.1 billion in 2014 and a projected $3.5 billion in 2015.

Although expenditure flexibility continues to be limited, Chicago has cut its retiree health insurance costs by reducing premium support and shifting beneficiaries onto Obamacare. These cost saving moves are still being litigated, but have yet to be overturned.

Chicago’s pension funds are seriously underfunded, but that is nothing new. At the end of 2011, Chicago’s four pension funds had a composite funded ratio of 37.9% - based on market value of assets. At the end of 2013 (the latest date for which complete statistics), the funded ratio was little changed at 37.0%.

That said, Chicago’s pension costs are quite large relative to city revenues. In 2013, actuarially required pension contributions totaled $1.74 billion, or 22.3% of the city’s total revenues of $7.82 billion.  This proportion is very high by national standards - higher, for example, than every single city in California.

I am skeptical of Actuarially Required Contributions (ARC) as a solvency measure, because a city can, in theory, meet its pension obligations on a pay-as-you-go basis. In other words, the city’s pension funds can all have a zero percent funded ratio, and all pension benefits and administrative expenses can be paid out of revenues.

But a review of Chicago’s benefit costs does not offer solace. In 2013, expenditures by the city’s four pension funds, totaled $1.84 billion, or 23.5% of total revenue. (Under current Illinois law, the city will have to pay much more than this in future years because it will be mandated to both meet existing pension obligations and raise its funded ratio to 90% by 2040).

One solvency ratio I find especially useful is the sum of pension costs and interest expenses to total revenues. In studying Depression-era government bond defaults, I found that when interest expense exceeded 30% of revenue, default often occurred. Back then, pension expenses were not that significant - now they are much larger and they enjoy similar or even preferential legal treatment to debt service.

In 2013, Chicago reported $478 million in interest payments, amounting to 6.1% of revenue. If we add this expense to the cost of providing constitutionally protected pension benefits, we get a composite ratio of 29.6% - dangerously close to the 30% threshold.

Even worse, the trend is not in the city’s favor.  Each plan’s actuarial valuation contains projected benefit payments through at least 2041. If we add up these future expenses, we find that they are projected to grow by about 4% annually through 2023. After that, benefit cost growth decelerates, as “Tier 2” beneficiaries - who are entitled to reduced pension benefits - begin to retire. The benefit growth rate from 2013-2023 is faster than the rate of revenue growth the city experienced in the previous decade. Between 2003 and 2013, revenue grew from $5.75 billion to $7.82 billion - an annual rate of 3.1%, significantly slower than projected

If its revenue growth trends continue, Chicago’s pension benefits and its interest expenses will exceed 30% of revenue later this decade. While this situation does not automatically trigger a default or bankruptcy, it leaves the city vulnerable in the event of an economic downturn. With so much of the city’s spending locked in, it would be faced with making deep service cuts or defaulting on its obligations in the event that revenue falls during a future recession.

So while Chicago’s situation is not much different than it was in 2012, the city’s fiscal status was and remains fairly dire. Although a seven notch cumulative downgrade seems inappropriate, the city’s current Ba1 rating does not seem very far off to me. Perhaps the problem lay with more with the city’s 2012 rating than the one it carries now.