CHICAGO — Chicago’s pension woes are so burdensome and its options so few that borrowing up to $10 billion to pay down the $28 billion unfunded liability tab may make sense if part of a broader plan, says Citi’s municipal research team.
“Chicago has a serious pension problem that needs a dramatic, innovative solution,” Citi’s municipal strategy team — Vikram Rai, Jack Muller, Loretta Bu — write in Citi Research's Municipal Weekly. “We believe that there is a philosophical justification to pursue the POB mode of financing and maybe even a practical justification.”
Citi believes some market participants and analysts have too quick to dismiss the idea since Chicago’s chief financial officer, Carole Brown, said she was mulling an up to $10 billion POB after the Aug. 2 city investors’ conference.
Brown — who was holding meetings with city council members Thursday on the subject — has said she expects by late this month or early next to make a recommendation to Mayor Rahm Emanuel on the borrowing.
Critical reports have labeled POBs a financial engineering tool, citing the risks that investment earnings will fall short of interest on the taxable bonds, the Government Finance Officers Association’s position against POBs, and haircuts suffered by bondholders in bankruptcy.
“We disagree with almost all of these negative opinions,” the new report says. Citi's team cautions its assessment is preliminary as the city has not announced a deal plan. Brown has said the aim would be to improve the funded ratio to 53% from 26% and ease but not eliminate the burden of covering upcoming payment spikes.
Citi’s willingness to support a borrowing is conditional.
“Assuming successful interest rate arbitrage and also assuming that rating agencies accept the debt swap and do not downgrade the underlying GOs, we are cautiously positive on the potential POB deal,” Citi writes. “But, our positive sentiment is contingent upon the POB deal being a part of a comprehensive solution” along with tax increases and a renegotiation of collective bargaining agreements “to address the city’s pension problems.”
Citi — which along with most Wall Street firms is an underwriter of Chicago debt — said its municipal research analysis is independent of the firm’s public finance banking and “views the negatives and positives of debt objectively.”
Citi warns against the use of proceeds to plug deficits as the state did with about $2.7 billion of its $10 billion 2003 pension borrowing. Brown said in a recent interview the city’s intention is to pay down the unfunded liability.
The researchers don’t believe a deal would “result in a downgrade” of the city’s general obligation credit because the rating agencies view the pension obligations as constitutionally protected. The city is rated from a low of junk to a high of single-A.
Arbitrage success is a linchpin of any deal. An investors’ conference presentation from mayoral advisor Michael Sacks suggested the city could obtain a 5.25% rate. The pension funds use a discount rate in the 7% range.
Citi suggested Chicago could possibly achieve a lower rate than the 5.84% its long-dated taxable paper currently trades at but historical evidence on investment returns “points to a less sanguine outlook.” The Center for Retirement Research at Boston College found that on average, pension bonds earned a 1.5% return for the governments on issues between 1992 and 2014.
The weight of Chicago’s pension burden is illustrated by data cited from Moody’s Investors Service that puts Chicago’s pension liability at four times the median of all rated cities.
“As a result, Chicago has had to chart a very aggressive course just to avoid total depletion of pension assets,” Citi writes of the funding overhauls adopted into state law over the last several years.
The overhaul raised contributions to move toward an actuarial level in 2021 for two funds and 2023 for the other two to reach a 90% funded ratio for all by 2058. The ramped-up contributions are being covered by a property tax hike, an emergency phone surcharge, and a water-sewer charge.
The city now has few options to further chip away at liabilities given state Supreme Court rulings banning any benefit cuts, that current revenues can’t support the actuarial shift without damage to existing services, and because further tax hikes would hurt the city’s competitive edge, Citi says.
“Revenue raising efforts will be constrained by the already high taxes” and a “continued increase in taxes could lead to a vicious cycle of population loss followed by the need for even more taxes,” Citi warns. The city’s 2019 contribution of $1.18 billion will jump to $2.1 billion.
Citi acknowledges the haircuts that stung POB holders in some recent bankruptcies but contends direct comparisons shouldn’t be made to a possible Chicago deal.
San Bernardino, California, holders are receiving 40 cents on the dollar, the insurer of Stockton, California’s pension bonds is receiving a 50% to 55% recovery rate, and Detroit’s pension bond insurers settled for 13.9%.
“In our view, investors can be less wary of the Chicago’s POB’s” as Chicago is a respected brand with improving finances, Illinois lacks a Chapter 9 statute, its debt service schedule begins to decline after 2022, it benefits from a large and diverse economy and ample liquidity, and Moody’s recent outlook shift to stable from negative.
A strong security is expected and taxable paper will draw international buyers.
“A dedicated revenue pledge will seemingly serve to ring-fence the POB investors from the malaise of the underlying GO credit and thus enable the city to lock-in a higher rating. The higher rating will appeal to even the high-grade buyers and help the city secure a lower cost of funding,” Citi writes.
Brown has said a securitization structure — approved by the state last year allowing home rule units to create bankruptcy-remote special entities to securitize revenues that flow from the state — offers the most affordable vehicle.
The city’s securitized bonds carry high-grade ratings and trade 200 basis points better than city GOs, Citi says. Chicago has leveraged most of its sales taxes but could tap $240 million of state local share income taxes, $148 million of personal property replacement taxes, and $54 million of motor fuel revenues.
