Chicago Is One Recession Away From Going Bankrupt

With the Puerto Rico default fresh in the news, there’s a far bigger danger looming on the horizon: the potential bankruptcy of America’s third largest city . Moody’s, a professional rating agency that assesses the creditworthiness of borrowers, recently downgraded the city’s debt to junk status. City officials are desperately trying to downplay the possibility that the city will not be able to pay it’s bills, but the reality is one good recession will destroy the financial solvency of Chicago. Everyone knows that Chicago is full of shady political practices and backroom deals, but the financial crisis in Chicago is so bad it puts thousands of retirees, students, public workers, and taxpayers at risk.

Just How Bad Is It?

I used to be a bond trader for one of the two largest managers of municipal bond assets in the world. Before I left in July 2015, the situation was rapidly unraveling and the city had to seek backstops in the price of their bonds from major Wall Street banks and hedge funds, aka lenders of last resort.  They barely were able to get market access in their most recent deal, and a further deterioration would leave them unable to finance their deficit to pay for their massive unfunded pension bill.

Chicago doesn’t like releasing recent financial statements because it would show how fast the situation is coming apart at the seams. The most recent public info I could find shows a $30 billion pension shortfall from the City and the City’s Public School District. How bad is this? Really bad. You would need to sell about 23 Sears Towers to make up the gap. The last numbers I saw from the internal calculations we had at our investment firm showed Chicago’s pension funding ratio around 25%. That means $3 of every $4 the city owed was not paid for. Furthermore, the Illinois Supreme Court just ruled that the pension reform proposed by Illinois lawmakers including the former White House Chief of Staff, now Mayor Rahm Emanuel, was unconstitutional.  It is amusing to me that public employees aka Illinois Supreme Court judges get to decide that their retirement benefits are inviolable. The same court said that retiree healthcare benefits were sacrosanct as well. I wonder why they are so protective of retiree benefits.

To put the costs in perspective, the Chicago Public School District’s payments to the Teacher Pension Fund went from $200 million to $700 million over the course of 10 years. These payments now represent something like 12 to 14 percent of the total budget of the District. That’s right, the bare minimum pension payments on a horribly underfunded pension take out over 10% of every dollar that supposed to go to kids’ education.

What’s Going to Happen When the Next Recession Strikes

Chicago is trying. They just made a $634 million dollar payment to the teachers’ pension fund, only to request to borrow $500 million of it back the next day . Holy cow that’s terrifying. They don’t even have the money to pay their pensions now and the economy by most measures is doing great. The stock market has run into some hiccups but it’s chugged along really well the past five years. The dollar is strong, city tax revenues are at pretty high levels, and people are buying cars, apartments, and spending money again, all leading to higher current tax receipts.

If we have another recession, property tax collections might go down, spending definitely will be cut back, and sales tax revenues for Chicago will fall. The city has a $754 million shortfall right now all while not paying what it’s supposed to towards its massively underfunded pensions. Chicago is already dealing with lenders of last resort, who do they turn to when the shortfall doubles and their pension fund assets decline 25% because of a bear market? The pension fund might go from 25% funded to 20% or even 15% funded, in which case the constitutionally mandated benefits they are supposed to pay would be impossible to beg, borrow, or steal for to honor. Since no one will be willing to lend to Chicago, the city would be forced to explore a couple of avenues to survive financially.

Who Do You Screw Over? The Taxpayers, Retirees, or Investors?

The political answer here is obvious. You want taxpayers to like you and maybe elect you to higher office, so you don’t want to hurt them. The retirees have a powerful judicial branch protecting their benefits. The only group that seems like they are going to get obliterated therefore seems to be investors that hold Chicago bonds, who in many cases are retirees themselves or mutual funds with Chicago exposure that are owned in retiree portfolios.

The remedy that investors have is the federal court system. As in Detroit, the people that lent money to the City of Chicago have the right to look at any and all assets the city might own and try to seize them. Any piece of artwork, Field Museum dinosaur skeleton, parking garage, or anything else titled under the City’s name would be fair game for investors to try and seize. Investors might also try to compel the courts to force the City to raise taxes on residents. Chicago is not nearly as decrepit as Detroit, so there might be a legal argument that the city could sustain tax increases that would be mandated by courts.

The only way around years of legal fights and asset seizures would be for Chicago to preemptively raise taxes to pay its bills. By all measures it could do this. The property taxes would be among the highest in the nation, but it could theoretically be done. I doubt this happens because why would politicians do this unless they were forced to.

Pensioners Could Still Lose Out Thanks To Federal Court

When a City has to file for bankruptcy, the people that hold the IOUs don’t want the self interested state courts deciding if they get paid, so they take the battle to the Federal Government. In Detroit, the precedent was set that pensioners can have their benefits cut regardless of what the state constitution says. I would expect something similar if Chicago pushes the city to a bankruptcy. A judge could rule that contracts that promise payment from the full tax revenues of the city mean that bondholders get paid first.

What this means in practice is the average retired teacher or fireman living off a $35,000 a year pension could see that cut to $30,000 or maybe less. How did it get to this point? Politicians like Richard Daley the younger decided to not make the payments he was supposed to in the 2000s and each year the compounding effect of the non payment increased even more than the year before. If you want to blame someone, blame Richard Daley. Rahm Emanuel mostly inherited this crisis. Maybe if we start redefining the legacies of former politicians that created modern day pension crises, the current ones would be intimidated into doing the right thing.

 Action Steps If You Live in Chicago

First, I would not buy an expensive piece of real estate. The new property tax that might be forced upon residents would probably cause real estate values to fall in double digit percentages. Buy something much smaller than what you think you need or just rent.

Also if you happen to serve on the boards of any City cultural institutions I would review the titling of all the assets under your care. If any of the assets are owned by the City of Chicago I would frantically try and re-title them to some form of a non profit trust before the hedge fund lawyers start looking through papers to see what they can seize. This could include paintings, buildings, rare artifacts, or really anything that says City of Chicago as the owner. Who knows maybe the Millennium Park will have an entrance fee in a few years all thanks to Mr. Daley and the other incompetent pols who failed to steward the city’s finances.

A Comic Example of Mismanagement: Derivative Swaps

To show how terrible the management of the City of Chicago really is, one not need look any further than the derivative contracts the Public School District entered into with big Wall Street Banks that are currently worth around negative $263 million . Because the City wasn’t doing so hot, school officials decided they knew how to bet on interest rates better than the top minds on Wall Street. They entered into contracts that theoretically would protect them if interest rates rose, but they didn’t understand that the value would move against them if interest rates fell. Perhaps the big banks share some blame in getting the School District to buy these contracts, as it mean millions of dollars in fees for the banks. When you get really smart bankers with million dollar bonuses on the line into a room with desperate and financially naive public officials, nothing good happens.

Theoretically it might make sense to hedge your borrowing costs, but only if you are a healthy school district with no funding problems. If you decide that you want predictability in borrowing costs for future capital projects it might make sense to enter into an interest rate swap. If the derivative contract declines you have the money to pay for it and the swap did its job of protecting you against higher interest rates. However, if you are a sickly patient on life support like Chicago, the derivative values moving against you at exactly the wrong time are the last thing you can afford to have happen.

Why were a bunch of public servants taking taxpayer funded bets on the movement of interest rates? Why? Are they hotshot Wall Street traders trying to collect millions of dollars in bonuses or are they trying to perform a public service of educating schoolchildren? Because they mismanaged the finances so badly in the City, their rating fell to junk, which mandates that they pay the market value of the derivative contracts. Think of it as the banks inserting a clause to proactively protect themselves if their borrower starts coming apart at the seams. As of a few months ago, the swap termination payments that they owe correspond to roughly the entire amount of cash on hand in the School District account.

A Warning For the Rest of Us

Chicago is hardly alone in its financial troubles from years and years of not paying what it needed to to meet pension fund obligations in the future. There are several other municipalities and states that could be in trouble over the next few years. The State of Illinois is in a similar situation to the City of Chicago but without the legal ability to file for bankruptcy so no clue what’s going to happen there.

Right before I left my position as a municipal bond trader, I looked at other entities and found that states like Connecticut, Kentucky, Pennsylvania, New Jersey, and others are facing similar pension problems that could implode their finances, especially if Chicago’s troubles go mainstream and become a household joke.

The lesson for the Millennial generation is that rock solid pensions are probably going to be a thing of the past unless you work in the federal government or military. If you’ve got a federally funded pension you’re going to be fine. With all likelihood if you have a state or city funded pension you will probably get paid as well. However, the recent example in Chicago shows that the best way to make sure you get to live at a reasonable standard of living in retirement is if you save for yourself.

Sure you could invest poorly and be victim of a stock market crash, making even a questionable pension fund the better option. I would just encourage you with all the high debt burdens and pension time bombs that haven’t exploded yet that you supplement your pension plan with a Roth IRA or Traditional IRA. I wouldn’t want my family to depend upon politicians, especially if yours look like the ones in Chicago.

At least they don’t have the 2016 Olympics to pay for as well. There’s always a bright side to life!

Travis