Chicago's Fiscal Turnaround: Is The Glass Half Full or Half Empty?

Triet Nguyen

August 10, 2018

The City of Chicago hosted its annual Investor Conference last week. Unlike in prior years when the proceedings tended to be serious, sobering affairs on the theme of “Hang in there, we’re making progress”, this year’s meeting turned into a full fledged victory lap, complete with plans for...yes, even more debt. So, is Chicago really out of the fiscal woods?

The key event at the Conference was undoubtedly the panel discussion, which included Michael Sacks, a close political ally of Mayor Rahm Emanuel, and our friend Rich Ciccarone, President of Merritt Research Services, LLC. As many of you know, Rich is a long time public policy advocate and a fairly vocal critic of both the City and the State of Illinois. As such, Rich was surprised he was even invited to speak on the panel. Apparently, the Conference organizers wanted to include someone with a critical view of City finances just so Mr Sacks, speaking on behalf of the City, could provide a counter-argument (Truth be told, as far as presumed critics of the City go, you really couldn’t find a nicer, less abrasive person than Rich Ciccarone!)

As it turned out, Rich just went with a more positive and conciliatory tone and let the numbers speak for themselves. Why not? the numbers don’t lie and they still look quite dismal, as you will see from the full presentation. Among all the great charts put up by Rich, this one was, in our view, the most eye-opening:

Source: Merritt Research Services, LLC

For those readers who may not be aware of our prior position on the Chicago credit (purely from an investment standpoint, not from a public policy standpoint, which we try to stay away from), ever since spreads on Chicago bonds hit their widest point at about 300 basis points (bps), back in early 2015, we’ve been recommending Chicago G.O. bonds as a relative value buy. This was predicated on the notion that such spreads were more indicative of a below investment grade credit than not. In fact, from a fundamental analysis standpoint, our own assessment of the credit has been more aligned with Moody’s than with the other rating services and the market apparently shared the same opinion, based on trading levels. And we’ve found ourselves actually defending Moody’s stance against attacks from the City’s political leaders, in an article published on May 26, 2015.

Fast forward three years and Chicago bonds have rallied significantly, primarily on the back of the massive rebound in the entire Illinois bond complex, but also based on several modest steps the Rahm Administration has taken to address the City’s less-than-stellar fiscal practices (such as “scoop-and-toss”) and, of course, its pension issue. At the current spread of about +150 bps, it’s fair to say Chicago GOs now trade more like a borderline “BBB/BB+” name and they should be a comfortable “hold” for most investors for the time being. We do reserve the right to change our mind, however, if the City indulges in further securitizations of existing revenue sources, a practice that we believe is ultimately harmful to the interests of the regular Full Faith & Credit GO bondholders.

Interestingly, Chicago’s fiscal stabilization was actually picked up by an analytical tool that we had the opportunity to develop while at NewOak Capital, the MuniScore™ system. As the chart below shows, the composite MuniScore™ for Chicago has steadily improved over the past 3 years, although the current score of 7.01 out of 10 still places the City in the bottom decile of its peer group (i.e. all large cities with more than 250,000 in population). In terms of the component scores, the so-called “Income” component showed the greatest improvement (more green color as it were, signaling an improving trend), and the “Leverage and Liquidity” component continues to linger deeply “in the red”, dragging the overall score down.

Source: NewOak Capital/MuniScore & Bloomberg Data

As a side note, we suspect the City's liquidity position might actually be in better shape than is reported in the General Fund. Here's a hint: Follow the TIF (Tax Increment Financing) revenues!

It wouldn’t be right if we didn’t address the $10 billion Pension Bond ("POB) proposal floated by Chicago CFO Carole Brown at the tail end of the Conference (one participant wondered why this obviously important idea was not even mentioned until the very end of a full day of site visits and presentations). We won’t rehash the well-worn arguments why Pension Bonds are (almost) always a bad idea, particularly in the hands of politicians running for re-election in fiscally stressed cities: (1) the inherent rate of return “arbitrage” may not work, given the taxable interest rate the City will likely have to pay on the POBs; (2) the conversion of a relatively “soft” liability (although not so “soft” if you ask the municipal unions) into a hard liability, i.e. bonded debt; and (3) the relief of pressure on city officials to stick with a disciplined funding scheme. This bear case is well summarized by Ted Dabrowski and John Klingner in a recent Wirepoints article.

Rich Ciccarone also expressed his reservations in a recent Bond Buyer interview, however, given the dismal 26% funding ratio for the City’s retirement systems, he believes that no option should be dismissed out of hands. He might be convinced to go along with a Pension Bond scheme if offered as a catalyst for a more comprehensive funding plan. More specifically, Rich would prefer to see the POB proceeds dedicated only to fund the unfunded liabilities, while current liabilities and OPEBs continue to be paid from current operating revenues. This, in his view, would keep the pressure on city officials to maintain fiscal discipline over the long run.

Not surprisingly, given the relative success of its recent sales tax securitization transactions, the City may consider a similar scheme for the pension bond issue, assuming it can identify yet another revenue source that is “securitizable”. Of course, if such a dedicated revenue source can be found, why not just use it directly to pay down retirement costs without having to take on even more debt? The official rationale, of course, is that getting a big chunk of money upfront may help investment performance, a rather debatable assumption. Or it may just help the Mayor’s re-election campaign if he could point to a big percentage point improvement in the pension funding ratio.

Thus, our bottom line on the Chicago credit is as follows: to give credit where credit is due, the Emanuel team has done a good job of stabilizing city finances in the areas it actually had control over, primarily on the General Fund operating side of things. Unfortunately, the balance sheet side (which of course includes debt and pension policy) is where the Administration’s efforts continue to fall short. That’s not likely to change any time soon unless a comprehensive, long-term solution to the pension problem can be found, with full buy-in from all local (and perhaps also state) constituencies. Proposals such as the one advanced by Rich Ciccarone need to be taken seriously and vigorously debated. Any proposal that sacrifices long term fiscal discipline for a short term quick fix will negatively impact the City's cost of capital.

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