Wednesday, May 13, 2015

Moody’s Downgrades Chicago Debt to Junk: More Pension Woes

Moody’s Downgrades Chicago Debt to Junk: More Pension Woes

Last week the Illinois Supreme Court struck down pension reform for the State’s pension plans, which raises immediate questions about the legality of similar reforms enacted for Chicago’s public pensions.  As a result, Moody’s downgraded Chicago’s debt by two notches, to junk.[1]  Even if the reforms aren’t reversed, Chicago faces a looming pension problem because it has failed to properly fund its public pensions.

Mayor Rahm Emanuel had the typical politician’s reaction to Moody’s decision:

This action by Moody's is not only premature, but it is irresponsible to play politics with Chicago's financial future by pushing the city to increase taxes on residents without reform.

If ratings agencies are to be useful to investors, they must anticipate changes in the creditworthiness of borrowers.  If they wait until there is unequivocal evidence of a financial problem, we’re going to go back to the days of the mortgage crisis when the rating agencies only reduced their ratings after subprime mortgages were under severe stress.  If Moody’s waits to see if the mayor can enact new reforms (raises taxes) that cover both the existing pension deficit plus the additional liability if the Supreme Court strikes down the previously enacted benefit reductions, their services as a rating agency will be useless.

The mayor had a chance to put forth a proposal to fund the pension plans, but he didn’t want to jeopardize his re-election chances by proposing tax increases.  Moreover, it’s hard for me to see how Moody’s is playing politics.  Chicago has a long history of making pension promises and failing to fund them.  Over the years, Moody’s has repeatedly cut its ratings as the city continued to increase its borrowing while failing to address its financial issues.  Moody’s made a judgment like any other reasonable analyst would of an uncertain financial situation.

Mayor Emanuel contends that Moody’s decision will increase Chicago’s borrowing costs because any new debt issuances will have to reflect the junk rating.   While Moody’s ratings have a certain degree of influence over Chicago’s borrowing costs, it ought to be patently clear to investors that Chicago has a major problem that has been exacerbated by the Illinois Supreme Court’s ruling.  In other words, the portfolio managers at mutual funds and hedge funds that buy municipal debt should have no problem coming up with their own assessment of Chicago’s situation, which will determine the city’s borrowing costs.  To be clear, the money managers are going to demand higher yields in exchange for investing in Chicago’s debt, irrespective of Moody’s view.

The real puzzle is why S&P and Fitch still rate Chicago as A+ and A-, respectively.  According to Bloomberg News long dated Chicago general obligation debt yields over 7% about four percentage points over the benchmark yield.  In other words, the market has spoken and Moody’s, rather than its competitors, are reflecting that reality.

Is Chicago the next Detroit?  Chicago is a rich city with a vibrant economy.  It has the resources to structure a long-term financial plan to deal with its pension woes and properly fund city government.  However, the businesses and citizens of Chicago are also state taxpayers, and Governor Rauner has his own set of financial woes to address.  Moreover, Chicago and Illinois have a long history of ignoring fiscal imbalances.  I’m betting the crisis will deepen before it finally gets better.  I don’t think Chicago is another Detroit.  However, the test for a junk (non-investment grade) rating isn’t a high probability that a municipality will go bankrupt.  Chicago’s fiscal, legal, and political environment warrants the rating.

Instead of blaming Moody’s, Mayor Emanuel should get the city’s financial house in order.


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