CHICAGO – Chicago hits the market this week with its inaugural sales tax securitization bonds, pushing hard to distinguish the new credit from its own battered bond ratings and quash comparisons to Puerto Rico’s bankruptcy-tainted sales tax credit.

The city – through its new Sales Tax Securitization Corporation – will bring $575 million of taxable and tax-exempt paper to refund existing sales-tax backed bonds. Retail orders and indications of interest on the taxable piece are set for Tuesday with the institutional pricing set for Wednesday, though the finance team on Monday was considering Monday bringing the entire deal Tuesday.

The deal is led by Jefferies and Rice Financial Products Co. In early 2018, the corporation will return to current refund $905 million of GOs.

Chicago held investor meetings in Chicago, Boston, and New York City last week during which Chief Financial Officer Carole Brown sought to make the legal case for the bankruptcy-remote structure that garnered two triple-A ratings, while and stressing differences between Chicago's securitization vehicle and the Puerto Rico Sales Tax Financing Corporation.

While Fitch Ratings issued a report “Chicago's Securitization Program a Far Cry from Puerto Rico's COFINA,” other analysts and buyers remain skeptical that the new credit won’t be dragged through the mud should Illinois eventually adopt a Chapter 9 statute and Chicago lands in bankruptcy.

Howard Cure, director of municipal research at Evercore
Howard Cure of Evercore Wealth Management LLC remains a skeptic of Chicago's assertions that its new securitization credit is truly bankruptcy remote. Bloomberg News

“I was skeptical going in and I’m still skeptical,” although there are structural and legislative barriers in place and the city is far from bankruptcy, said Howard Cure, director of municipal bond research at Evercore Wealth Management LLC, who attended the New York meeting. “It should work right up until the time the city of Chicago is permitted to declare a bankruptcy. Then I think nothing matters but what a judge thinks.”

Concerns aside, the bonds offer an attractive buying opportunity for some given the triple-A ratings and “wide spread” to the AAA they are expected to offer, Cure added.

Fitch said in its special report last week that the COFINA dispute was not relevant to its analysis. The legal structure is somewhat similar but the key issue in dispute in Puerto Rico is whether the legislature had the legal authority under its constitution to carve out the revenues and hand them over to an instrument of the commonwealth.

“Illinois’ constitutional authority to define the powers of its municipalities is not subject to dispute,” Fitch said. State legislation allowing home rule units of government to securitize revenue streams that flow through the state passed the General Assembly over the summer at the city’s urging. The city later established the new special purpose entity and authorized up to $3 billion of borrowing under the new structure.

Puerto Rico collects its sales tax and remits it to COFINA “enabling the commonwealth to interrupt the flows by simply retaining them as part of a strategy to contest the framework,” Fitch wrote. “In the Chicago transaction, the taxes are collected by the state and remitted to the corporation’s trustee. The city cannot commence the dispute by simply withholding the funds from the corporation.”

COFINA’s bonds have been declared in default and are currently rated between D to Ca. Fitch rated the Chicago bonds AAA.

The city’s share of sales taxes that flow from the state -- $660 million in 2016 – will now go directly from the state to the corporation. After deductions to cover debt service and operations, the revenue will flow to a residual account that can be returned to the city. The legislation, ordinance and bond documents offer protections such as a statutory lien and non-impairment provisions on the pledged revenues.

Fitch said it looked at case law to weigh the potential outcome should creditors challenge whether the city’s sale of the assets represents a true legal sale and whether the separate legal status of the corporation could be ignored and assets and liabilities consolidated with those of the city.

“This structure is within the precedents noted in the legal opinion that would treat it as a sale structured by the parties and is blessed by the specific state legislation” which amended the Illinois Municipal Code to empower a municipality to sell certain tax revenues in a defined structure and retain a residual interest in the flows, Fitch said.

Prior case law – including a case challenging New York’s legal ability to allow New York City to sell its tax revenues on the argument it impaired existing creditors’ contractual rights – failed. The court found general creditors lack a claim on any specific revenues or a right to insist that the city have any particular forms of revenue.

Market participants acknowledge the protections but question just how airtight the structure will be if it is tested, and that will weigh on valuations.

“No Chicago creditor should want to find out what happens to STSC bonds, GO bonds, pensions, and other liabilities in a future bankruptcy, if such is ever permitted by a change in state law,” wrote Lisa Washburn, a managing director at Municipal Market Analytics, in a recent weekly outlook.

“While structure and non-impairment language protects bondholders in non-bankruptcy situations, STSC bondholders should assume some risk of being COFINA’d if Chicago does ultimately find itself in Chapter 9. That is, being sued by the city itself, its pensioners, and GO bondholders for access to previously pledged sales taxes,” she added.

Washburn dived into a comparison of programs used by Chicago, COFINA, New York City, and Philadelphia. The Chicago structure and transaction “contains the most structural protections and buzz words of the four entities,” she found.

“While great effort was employed to insulate COFINA from the Commonwealth’s financial situation, the STSC seeks to go a step further, buttoning up perceived legal ambiguities that now threaten repayment or repudiation,” she added.

A key difference between the COFINA, Philadelphia, and New York structures is the ongoing state oversight provided by the state over the latter two. COFINA lacked the oversight and its authority to issue debt was expanded from refinancing to deficit financing.

“The difference in outcomes is striking. Philadelphia and New York City are now solid investment grade ratings," she wrote. "Puerto Rico is in default and COFINA bondholders, who are protected by what was considered to be a state-of-the-art legal security at the time of sale, are now being sued by the commonwealth and GO bondholders for the return of ostensibly ‘sold’ sales tax receipts.”

Chicago could tap a subordinate lien to issue additional debt beyond the $3 billion authorized by the City Council, although council approval would be needed.

“Chicago’s fiscal future hinges on discipline: With this new financing, city stakeholders become even more critically reliant on the current and all future administrations exercising fiscal discipline,” Washburn wrote.

Along with Fitch, Kroll Bond Rating Agency assigns its AAA rating to the bonds. S&P Global Ratings rated the program AA. All three rating agencies rate Chicago’s GOs in the triple-B category. Moody’s Investors Service which was not asked to rate the new corporation has the city’s GO in junk territory.

Bankers have told the city that it can keep spreads to less than 100 basis points above Municipal Market Data’s top-rated benchmark. A pre-marketing pricing scale put spreads on the $175 million tax-exempt piece at a 30 to 45 basis points over Municipal Market Data’s top-rated AAA benchmark. The $400 million taxable piece offered spreads to Treasuries of 70 to 100 basis points. Chicago GOs have recently traded at a 170bp spread, and it paid a record spread of more than 300bp on its last GO sale.

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