CHICAGO – Chicago’s decision to consider selling pension obligation bonds is a “financial engineering scheme” with the potential to damage its overall financial condition, Municipal Market Analytics said Wednesday.

“In the short-run, the shift of the pension liability to bonded debt may enable the city to realize some budgetary relief,” MMA writes in its weekly outlook. “But in the long-run we suspect that this would—as with most pension obligation-using governments before them—cost taxpayers more money and could weaken the city’s fiscal position despite a ‘savings’ claimed at issuance.”

Lisa Washburn, managing director at Municipal Market Analytics
Municipal Market Analytics' Lisa Washburn is the co-author of a hard look at Chicago's consideration of a pension bond issue

The savings would stem from the arbitrage play intrinsic to POBs that comes from the difference between the city’s borrowing rate and the projected -- but not guaranteed -- returns on the proceeds deposited in the funds.

“Almost a decade into an economic expansion and at the current stock market levels the risk is reasonably heightened that the transaction will not meet the optimistic investment rate assumptions over the long-run,” MMA warned.

The structural details will matter.

“The budgetary relief could be even greater if the city structures its POB with backloaded principal payments," or as a capital appreciation bond, wrote authors Matt Fabian, a partner, and Lisa Washburn, a managing director.

MMA disagrees with Chicago Chief Financial Officer Carole Brown’s argument that fiscal gains on its structural deficit, reserve balances, and the enactment of dedicated revenues to cover near-term increases in pension funding put the city in a better position to now consider a pension financing.

“POBs seem particularly ill suited for Chicago as they add volatility to its future finances: posing a threat to the city’s fiscal recovery plan that is premised on gradual but steady economic growth with no material downside surprises over a long period of time,” MMA writes.

Chicago officials did not have an immediate response Wednesday.

Mayor Rahm Emanuel’s close economic advisor, Michael Sacks, pitched during Chicago’s investors conference last week the idea that the city could boost funded ratios by securitizing nearly $1 billion in new revenue funding for pensions which if leveraged could generate $10 billion to pay down the obligation.

After the conference, Brown said the city was taking a “hard look” at the “feasibility of financing as an option to further stabilize our pension funds.”

The system is just 26.5% funded, with the net pension liability tab at $28 billion. The city is phasing in higher payments to reach an actuarially based payment level in the next few years with another $1 billion then due. Sacks suggested a deal that raises $10 billion issue at about a 5.25% rate could “move the pension ratio” to 53% funded and “put to bed concerns about the looming pension cliffs.”

The improved funded ratio could provide “an optical win ahead of a contested mayoral election early next year,” MMA said. For political purposes that may work, but it also has the potential to remove discipline and “the potential for additional revenue raises would be greatly diminished if not eliminated entirely.”

MMA echoed the Government Finance Officers Association’s position that POBs are not a best practice.

There are alternatives as “the city may be better off issuing a smaller ‘pension oriented bond’ that, instead of having proceeds deposited with high fee asset managers for total return, would be invested directly in high impact local economic development projects so as to grow sustainable city tax and fee receipts which can be committed to pension servicing costs,” MMA suggested.

Brown has said structural details and security options are all on the table but appears to be leaning toward some type of securitization because the city’s sales tax securitization bonds carry higher-grade ratings and lower borrowing costs than the city’s weak general obligation ratings that range from junk to A.

“This would require the sale of yet another revenue stream as security for the new bonds,” writes MMA which has been critical of the securitization structure which it says hurts the value of outstanding general obligation bonds because sales taxes are siphoned from the general fund.

“It’s not hard to speculate about the potential legal challenges that might occur over the sale of another core revenue stream for the benefit of ‘wealthy bondholders’ should the POB be issued, not perform as speculated, and more money is needed to fund constitutionally-protected pensions and maintain basic services,” the report says.

While bankers may endorse such a borrowing, MMA warns city may find few supporters. “Rating agencies have been critical of these financings. Many investors have voiced concerns. The GFOA has warned against their use in its advisory,” MMA wrote.

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