The combination of Chicago, the Chicago Public schools and the Illinois state government is a perfect example of credit cluster risk, said Triet Nguyen, head of public finance credit at NewOak Credit Fundamental

CHICAGO -- Chicago's widening spread penalties may not ease until the state cleans up its budget mess and Chicago Public Schools shores up its rocky finances.

That's because the city's fortunes are now more closely linked to the distressed district and a dysfunctional state government in what's known as "credit cluster risk," say market participants.

The higher spreads Chicago had to pay on its January general obligation bond sale – despite some good news from three rating agencies after Mayor Rahm Emanuel pushed through tax hikes to improve pension funding – illustrate the market's imposition of the cluster risk contagion on its GO paper.

"The credit cluster concept goes beyond simple geographic location and includes other fundamental credit interdependencies," said Triet Nguyen, head of public finance credit at NewOak Credit Fundamental. The city, school district and state government trio is a "poster child for this concept, due to the overlapping tax base as well as the fiscal interdependence between the state, the city and the school district."

The credit cluster concept wasn't the only factor in Chicago's January pricing; it faced also rough market conditions on the day of pricing.

But the condition of the school system and troubles of the state government appeared to weigh on investors, marking a reversal for the city. Its spreads on past new GO deals had moved in tandem with its own fiscal headlines.

Taxing capacity for credit is constrained by the overall overlapping tax and debt burden and "even on the thorny issue of pension funding, both the city and CPS continue to look to the state for a permanent solution," Nguyen said.

"Buyers underplayed the positive initiatives taken by the city to address its pension cuts, raise taxes & fees and make other strategic reforms," said Richard Ciccarone, president of Merritt Research Services, because they were concerned about the intertwined involvement and potential adverse impact of issues related to CPS and the state.

"The combination of outstanding debt and pension liabilities at the state, city, school and county levels presents a formidable long-term burden on taxpayers for years to come," Ciccarone said. "If Illinois and Chicago's fiscal issues are not fully stabilized and economic erosion becomes more than a threat, then the cluster effect will likely grow worse relative to credit perceptions and borrowing rates."

The city's $9 billion of GO debt, combined with the $10.4 billion issued by Cook County, Chicago Public Schools, Chicago Park District, and others, bring the total overlapping burden to $19.4 billion for a debt per capita figure of $7,211, according to the city's 2016 annual financial analysis. Unfunded pension liabilities for Chicago and its overlapping taxing bodies including the schools, parks, county, forest preserve district and water district total $41.6 billion, representing a debt per capita of $13,810, according to the city's offering statements and a figure considered high compared to other jurisdictions nationally.

The city has said it has no plans to return to the market with a GO issue until 2019.

The city's yield penalties hit a previous high of an almost 300 basis point spread to the Municipal Market Data top-rated benchmark on its nine and 10-year maturities in deals in May and July of 2015 after Moody's Investors Service downgraded Chicago GOs to junk.

The downgrade came after the Illinois Supreme Court overturned state pension reforms. A court ruling also loomed on the city's own reform plan that most believed would go against the city. The downgrade to junk triggered a potential $2.2 billion liquidity crisis due to defaults on various credit contracts. Its longer bonds landed at a 264 bp spread in the May deal and 252 on its July sale.

The penalties narrowed on a January 2016 sale after Emanuel pushed through a record $543 million annual property tax hike as part of fix for the city's two pension funds that cover public safety workers, landing at 253 basis points on its 10 year and 229 basis points on its longer maturity.

In secondary market trading, spreads further tightened until later in 2016.

Fast forward to January of this year: the city had resolved its liquidity crisis, shed its floating-rate GO exposure, narrowed its structural deficit to the lowest level since Emanuel took office, and passed a water-sewer tax to rescue its other two pension funds that cover municipal employees and laborers. Three rating agencies shifted their outlook to stable on ratings in the triple-B category.

At the same time, CPS' woes had intensified despite winning some additional state funding and the state budget impasse had dragged on for more than 18 months.

On the January 2017 deal, the city's spreads jumped to 347 basis points on its 12-year bond and 339 basis points on its 21 year bond.

The city also dropped traditional 5% coupons in favor of a high coupon/discounted price structure based on investor demand. The structure offers quicker appreciation should the financial picture for the city, CPS and state improve.

The city's deep concessions and spread widening to get the sale done "are a point of concern both for the city and for the market at large, according to Municipal Market Analytics.

"In effect, the city is being forced at CPS levels: an effective opinion not out of tune with MMA's own view of the two entities needing to be tied more closely together in investor perception," MMA wrote in its weekly outlook. It drew a comparison to the Puerto Rico Electric Power Authority's "beginning-of-the-end 7%'s in 2013" and said it raises "concerns that the city is in the first stages of losing economic market access."

Chicago's own ongoing strains were a contributing factor as new revenue must be found when actuarially required contributions begin in 2021 under the city's pension fixes. Gov. Bruce Rauner's threat to veto Chicago' municipal and laborers' pension bill also didn't help.

More than half of the $1.16 billion tax-exempt and taxable sale went to cover widely frowned-upon financial practices that the Emanuel administration says it will no longer continue after this sale, such as "scoop-and-toss" issuance of new debt to roll over old debt.

The deal proceeds provide $365 million in project funding.

Another $77 million will cover capitalized interest, $225 million is funding judgments and settlements, $9.3 million is for issuance costs, and the remainder goes into escrow for scoop-and-toss restructuring and some traditional economical refunding, according to the final offering statement that posted last week.

"While the city has taken strong steps forward, it has undermined its own progress by continuing to allocate GO bond proceeds toward the payment of bond interest, engaging in scoop and toss budget gimmicks, and providing little detail about its own plans for affording the coming increases in required pension contributions," MMA wrote.

The city's spat with Moody's, asking it in a December letter to withdraw its ratings, didn't help; a rough market and uncertainty over what lies ahead under a Trump administration also may have contributed.

Borrowing rates could improve if "meaningful actions" are taken that resolve the state's budget deadlock and the state raises CPS funding levels. The city must also follow through on its pledge to shed scoop-and-toss and borrowing for operations, Ciccarone said.

"Violence in the city doesn't help its image, its economy, its cost to the run the government, not to mention the adverse effect on its citizens," Ciccarone said. The city's 2016 homicide rate marked a 19-year high.

Locally, cluster risk is far from new, although the January sale more clearly showed the spill-over effect on Chicago. Credits throughout Illinois have been hit with what's been known in recent years as the "Illinois effect" which imposes a penalty that ranges from 20 to 30 basis points.

Illinois is at the epicenter of cluster risk at the moment but it's far from the first.

"Recent experiences in Detroit, Jefferson County, Puerto Rico and Illinois have elevated these fears to levels not seen since the late 70s and early 80s, when New York City cast a negative light on the muni market," Ciccarone wrote in a report on cluster risk presented at the Brookings Institute Municipal Finance Conference last July.

Ciccarone wrote that finding the right elements is the key to identifying the most vulnerable cluster risk city-locales.

Population, debt burden, pension liability, tax burden and infrastructure age are primary risk factors that make some areas more prone than others, and the most important factor in determining the risk for contagion lay in the shared dependency on the same economic base, the report said.

"Both the market and policymakers often don't properly recognize or address cluster risk and contagion until distress becomes advanced and more difficult to solve," Ciccarone wrote.

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