Tuesday, May 26, 2015

Illinois’ Candidates for Municipal Bankruptcy

House Bill 298 would allow Illinois municipalities to adjust their debts through the Chapter 9 municipal bankruptcy process. The bill, endorsed by Governor Bruce Rauner, is currently in the house rules com-mittee.
If HB298 was enacted, which local governments might use the new bankruptcy option? To help answer this question, our team reviewed audited financial statements that (all but the smallest) municipalities must file. Most of these financial audits can be found on the state comptroller’s local government finance warehouse.
This article lists five municipalities that appear vulnerable based on information found in their audits. Among the indicators we considered were government-wide unrestricted net position and general fund balance. The first indicator shows the degree to which assets held by the government entity as a whole exceed its liabilities and are not locked up in buildings and other illiquid forms. The second indicator, general fund balance, focuses more narrowly on the government’s main fund – which is roughly analogous to an individual’s checking account. Low or negative general fund balances were cited in the bankruptcies of Vallejo and Stockton, California. It is worth noting that the five municipalities we identified are all located in Cook County, which also faces fiscal challenges. Our list does not include Chicago. Although that city’s financial struggles have made frequent headlines, several of its smaller suburbs appear to be in much greater fiscal distress. The five communities we identified are: Maywood, Sauk Village, Blue Island, Country Club Hills and Dolton.
In its 2013 financial statements, The Village of Maywood reported an unrestricted net position of -$47.4 million, and a general fund balance of -$8.2 million. While we found a number of jurisdictions with negative balances, these levels are quite pronounced for a relatively small municipality.  With general fund revenues of only $23.3 million and government-wide revenues of $44.1 million, it will take the village a long time to eliminate these shortfalls.
The Village’s 2014 financials should have been available by now, but, its reporting has been chronically late. Moody’s withdrew the Village’s credit rating in 2011 citing a “lack of sufficient current financial and operating information”. Despite the lack of credit ratings, Maywood was able to sell $16.3 million of bonds earlier this year.
In its 2014 financial statements, Sauk Village reported an unrestricted net position of -$36.7 million – a very large negative position considering that the village had only $29.6 million in assets and government-wide revenues of $13.4 million. Sauk Village also showed a negative general fund balance and unusually high interest costs. The village’s $2.1 million of interest expense accounted for over 15% of total revenue. In most of the Illinois municipalities we reviewed, the interest/revenue ratio was below 10%. To the extent that interest expenses crowd out spending on resident priorities, political leaders have an incentive to default on debt obligations as a way to shift spending to more popular purposes. Furthermore, the Village received an adverse audit opinion for its reporting of “Aggregate Remaining Fund Information” and a qualified opinion for its reporting of “Governmental Activities.”  The Police Pension Fund information was not included and has not been subject to an actuarial evaluation since May 1, 2011.
The City of Blue Island reported an unrestricted net position of -$15.2 million and a general fund balance of -$10.5 million in its 2013 financial statements – the latest available. The negative general fund balance is especially pronounced because the city only recorded $16.3 million in general fund revenue during fiscal year 2013. The city’s negative net unrestricted position appears to be understated because Blue Island did not report an Other Post-Employment Benefit (OPEB) liability. Government accounting standards require that municipalities report the present value of unfunded OPEB obligations on their balance sheets. This failure to report OPEB obligations resulted in the city receiving a qualified opinion from its independent auditor.
The City of Country Club Hills has yet to file audited financial statements for the 2013 fiscal year – making it the most delinquent filer among the municipalities we reviewed.  The city’s 2012 financial statements show a slightly negative unrestricted net position and a large negative general fund balance. Further, the city’s auditor was unable to render an opinion on the accuracy of these statements, saying:
Since the City did not maintain an accurate accounting of its revenue, expense/expenditure, bank reconciliations, and other assets and liability accounts, and we were not able to apply other auditing procedures to satisfy ourselves as to those balances, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements.
WGN Television has repeatedly unearthed financial irregularities in Country Club Hills.  Most recently, the station reported that Mayor Dwight Welch was being audited by the IRS for not declaring as income his personal use of a city vehicle. The station also reported that the mayor incurred large restaurant bills on a city credit card, and that the city mistakenly retained $6 million in tax revenue that was supposed to be remitted to Cook County.
The Village of Dolton reported a small negative net unrestricted position in its 2013 financial statements – the latest available. Although its general fund balance was positive, the amount was well below Government Finance Officers Association guidelines. GFOA recommends that a government maintain a balance equal to two months of expenditures. Dolton’s $1.3 million general fund balance would cover less than a month of general fund expenditures, which were $22.1 million for the 2013 fiscal year. Further, the village reported a $5.2 million general fund deficit. If this deficit persisted into 2014, Dolton may now be facing a negative general fund balance. Finally, the village also received an adverse audit opinion. According to the city’s independent auditor:
We were unable to examine supporting documentation for numerous expenditures out of various funds of the Village. We were unable to test the Village’s allocation of certain revenues collected by the water fund but belonging to the general fund and sewer fund. We were unable to obtain an aged trial balance supporting the receivable balances in the water and sewer funds. We were unable to obtain sufficient support for certain local revenues. We were unable to determine whether a net pension obligation should have been recorded in the government wide statements with respect to the police and firefighters’ pension funds. We were unable to obtain supporting documentation for certain payroll related liabilities such as compensated absences. We were unable to determine whether a lack of infrastructure assets was the result of a failure to include such information on the financial statements or whether the infrastructure had been fully depreciated in prior years. Due to the omission of financial statements for the discretely presented component unit, we were unable to determine whether the omission is material to the financial statements of the Village nor were we able to perform any auditing procedures on the component unit. We were unable to obtain confirmation from legal counsel as to whether any known actual or possible litigation, claims and assessments should be recorded or disclosed in the financial statements. Finally, we were unable to determine whether bond proceeds from a prior year were spent in accordance with applicable ordinances and requirements.
If HB 298 becomes law, these five communities may be among the first to utilize the municipal bankruptcy option. Regardless we hope that local leaders and active members of each community review the financial records we have referenced, and begin to pursue policies that bring their municipalities back from the brink. As Detroit and other cities filing Chapter 9 have found, municipal bankruptcy is an expensive process that transfers community resources to lawyers and financial advisors. While it may be unavoidable, bankruptcy should always be treated as the least best option.

This article was written by Marc Joffe on behalf of CivicPartner LLC.  CivicPartner is a Chicago-based startup that collects and analyzes government financial disclosures. Joffe is an independent researcher studying state and municipal fiscal conditions.

Monday, May 18, 2015

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.

Friday, May 15, 2015

Short Selling & the Squeeze

In the aftermath of the 2-minute Swiss franc movement earlier this year -- and with so much attention surrounding the Herbalife short-squeeze (on Bill Ackman's Pershing Square) -- we have put together a short & sweet presentation describing the concept of the short squeeze. 

We have included some examples towards the end, like Sears stock in November 2014 and that "exciting" day when Volkswagen suddenly became the world's most valuable company: thanks to its stock jumping over 300% in a day. 

Welcome to the world of short squeezes. May you never be on the wrong side!


A brief thank you goes out to our outgoing intern Mr. Ferreira for his helpful work preparing this set of slides.

Tuesday, May 12, 2015

Flash Spoofing, and "Normal" Market Operations

The criminal case filed by the DoJ against U.K. trader Navinder Sarao is the latest case to capture the media’s attention in what must be the early stages of a series of investigations into what we’ll broadly term “issues of market manipulation.”

 The potential for manipulative behavior has been garnering more attention over the past year since Michael Lewis’s “Flash Boys” more forcefully drew regulatory attention to issues around high frequency trading (HFT) activities and current market structures.

Regulators have received their fair share of criticism for taking nearly five years to investigate the Flash Crash, finally getting around to examining orders, and not just executions

While Mr. Flash Crash protests that he has “not done anything wrong apart from being good at my job,” regulators clearly have their sights on spoofing.  Just last week came news of the CFTC bringing civil charges against two prop traders in the UAE for allegedly spoofing in the gold and silver futures markets. All of this comes on the heels of several other low-profile players charged with spoofing over the past couple of years, such as Panther Trading

Spoofing, sometimes referred to as “hype & dump,” is basically when a trader enters orders with the sole purpose of influencing market prices and with no intention of actually executing those orders. 

Obviously the law does not require traders to openly state their intentions regarding whether they are buying or selling, and how much. Likewise, we don’t play poker with our cards face up. But what type of bluffing is kosher? To what lengths can one go to cloak his intentions so that others don’t run ahead, increasing transaction costs?

Kraft was recently hit with a CFTC complaint regarding its wheat futures trading, and this case seems to be more of a gray area.

But there's more to come, no doubt.

The general areas of interest concern front-running, spoofing, time advantages, and trading on insider information. Just a couple of weeks ago, we saw a situation which must fall smack in the middle of the realm of the regulatory whip: the Aussie dollar moved significantly just (milliseconds) before the announcement by the Reserve Bank of Australia (RBA). But even worse – this has now happened three consecutive times!

Let’s have a look at the overall movement, just before 3am, and then we’ll focus on the movement and its occurrence just before news came out.

Here's the movement, generally, at 00:30.

But the important note is the movement occurs just moments before (any) news is released.  See all the news items at the top?  Each news item corresponds to a blue box in the graph.

The first one, the rate decision, "flashes" into our screen, just AFTER the movement.

It's worth mentioning that we're not alone in discovering this market movement. The Australian Securities and Investment Commission is on top of things, having opened an investigation into these wild, yet accurate, swings.  Notices have purportedly "been sent to many financial institutions and platform providers to understand the basis of the trading on these markets at the point in time of interest." More troubling, however, is that preliminary findings have revealed to ASIC that:
"moves in the Australian Dollar ahead of the announcement to be as a result of normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement. The reduction in liquidity providers is a usual occurrence prior to announcement in all markets. Much of the trading reviewed to date was linked to position unwinds by automated trading accounts linked to risk management logic and not misconduct." 
Call us skeptical (or sceptical, given they're in Australia).

One more likely explanation is that the news was leaked, or sold, to one or more firms that could execute quickly based on an incredibly fast network connection, likely linked to an algorithm. (If not, why wait for the seconds or milliseconds before the announcement – why not execute a minute before, or two minutes before?) 

So that opens up the door to the question of “time advantages” – more specifically, whether some preferred clientele can buy early access to the news. Let’s just say, it’s a little like gambling on a football game, in which most people are watching on tape-delay, but some gamblers are allowed to see the game “real-time.” The real-time gamblers can add or remove bets once the game is really finished, while the other gamblers with the lagged connection don’t yet know the final result. Can we call that a rigged market? 

The next legal question becomes: do the ordinary gamblers know that the preferred gamblers have a time advantage, or whether they know that they’re on a lagged connection (and that others are not). In other words, there’s the question of proper disclosure. Whether or not the market is rigged in favor of some parties, should the “unfavored” parties have been made aware of their material disadvantage?


For more on Time Advantages in the Financial Markets, and corrective actions taking place, visit any of the following links:

The Crucial Piece of Information That Big Traders Get Before Everyone Else

Firm Stops Giving High-Speed Traders Direct Access to Releases: Warren Buffett Involved in Berkshire Unit Business Wire's Decision to End Practice

Traders May Have Gained Early Word on Fed Policy, Study Finds

Thomson Reuters ends early access to key market data

Behind One Second of Trading Mayhem
(Article chronicles impact of earnings results released to paid clients milliseconds before news services released earnings, while those results impacted closing price of shares.)