Chicago is in the throes of a New York-circa-1970s-style fiscal crisis. Abetted by Illinois' government, the Windy City is adopting one of the borrowing tools that helped New York get its finances in order: a complex municipal bond, structured to protect investors in a possible bankruptcy.
But unlike New York, Chicago and Illinois are using this invention to delay reform.
Chicago has spent two decades digging itself into a hole. Back in 2000, the city had racked up $12.3 billion in debt, in current dollars; now, it owes $20.2 billion. Back then, the debt burden per person was roughly $4,400; these days, it's $7,500.
“Chicago has less money set aside in its pension funds today than it did a decade and a half ago.”
Even scarier is what Chicago owes to pensioners: $31.5 billion, up from $5 billion in 2000. Last year, Chicago's pension funds took in $900 million from the city and its employees and earned nearly $541 million in investment income, but the fund paid out more than $2 billion.
Chicago has less money set aside in its pension funds today than it did a decade and a half ago.
Chicago has zero hope of fixing this mess if it keeps to its current path. Since 2000, it has run a surplus once (in 2002).
Illinois and Chicago did try to reform the city's pension plans in 2014. But the Illinois Supreme Court struck down the changes, observing that, though "fiscal soundness is important," the state and city could "not utilize an unconstitutional method" — impairing benefits that the state constitution protected — "to achieve that end."
You would think bondholders would worry. Yet last February, they lent Chicago a fresh $1.2 billion, despite warnings in bond documents that "the retirement funds have significant unfunded liabilities and low funding ratios" and despite the city holding a junk rating.
Customers were willing to buy the bond, maturing in 2029, at about 6% annual interest — above the 3% rate that New York could borrow, but not sufficient to deter Chicago.
Chicago worries that interest rates will rise even higher. The credit cutoff would serve as a powerful signal. Chicago keeps telling retirees and workers, including recent hires, that it can pay pensions that it can't afford.
The city won't stop doing that — until it is forced to.
Rather than heed the marketplace's muted alarm, Chicago and Illinois are trying to turn the alarm off. In August, to maintain the city's ability to borrow cheaply, Illinois passed a law allowing Chicago to issue debt under a more complex structure than "general obligation" bonds.
Some background: A healthy city borrows to build or to maintain infrastructure. It typically has two ways to give investors confidence that it will repay that debt.
First is a "revenue bond," backed by specific user revenues. If a city builds a water-treatment plant, residents and businesses pay a fee for the water, and investors can count on that money to repay the debt.
Second, in cases where infrastructure doesn't pay for itself — local roads — the city will borrow under a "general obligation" and pledge its "full faith and credit" to repay the bond. The implication is that the city will raise taxes or slash spending, or both, if other repayment efforts fail.
When investors no longer believe in that "full faith and credit," a city can borrow money through a third method, pioneered by New York during the 1970s crisis. Saddled by social-welfare obligations, New York could no longer repay its debts, yet it needed to borrow more to provide services while it figured out its budget mess.
New York's financial industry solved this problem by inventing a hybrid bond that combined the strongest features of revenue and general-obligation bonds.
The state would set up a nonprofit entity, known as a "Municipal Assistance Corporation." MAC, as people called it, would borrow the money — and give it to the city.
To repay the debt, MAC would first collect the city's sales taxes from the state, use those revenues to pay its debt obligations, and only then deliver any leftover money to the city.
The sales taxes, in other words, were "securitized" — pledged to protect a certain kind of debt. The new instrument comforted bondholders. They no longer trusted New York City to pay back its own borrowing.
But they felt that they could depend on the new state-chartered corporation to collect the city's money to pay the debt.
The structure, in legal terms, was "bankruptcy remote." New York could file for insolvency — as was then a risk — but the sales taxes would continue to repay the special MAC debt, even in such a bankruptcy.
Ratings agencies approved the new financial instrument, awarding it "A" ratings even as they suspended the city's ratings in the face of default.
The ability to borrow through a safer instrument can buy a distressed municipality time to reduce its spending or raise taxes, or both, in an orderly fashion. After its 2013 bankruptcy, Detroit turned to a MAC-style mechanism.
State governments can also use the power that the mechanism affords to oversee local finances, whether through bankruptcy, as in Detroit, or outside of it, as in New York.
Yet the potential for irresponsibility is evident in Chicago. Thanks to the new Illinois law, Chicago is following New York's 1970s lead, creating a MAC-like organization to issue bonds this fall. Like Gotham, Chicago is securitizing the bonds with sales-tax revenues.
The state will pay the interest on the new debt before sending the remaining funds to Chicago, so as "to achieve higher credit ratings and reduce debt-service costs," noted The Bond Buyer. "The program is designed to bypass the city's weak bond ratings by insulating the bonds and assigned revenues from the risk of being dragged into bankruptcy."
The bond structure will mark the second time in a year that Chicago has issued structured debt. Last winter, Chicago's school district — a legally separate municipality, despite the same tax base — issued a half a billion dollars in bonds through a new instrument designed, as Reuters put it, "to separate the debt from the district's severe financial woes and protect it in a potential bankruptcy."
Yet this mechanism works in the long term only if fiscal reforms accompany it. New York state let New York City issue MAC bonds only if it acceded to a state takeover of its finances. Gotham had to pare spending and hike taxes — and then the city struck luck in the early 1980s, when Wall Street took off.
Chicago, by contrast, will continue to manage its own finances. Further, the city faces a more severe long-term financial outlook. Seventies-era New York experienced a liquidity crisis, which could be solved with higher revenues and a temporary reduction in services.
Chicago is looking at a solvency crisis: Even with tax increases and service cuts (both of which could drive away residents), the city is unlikely to make good on its pension commitments. Illinois, with its own credit rating hovering just above junk and with pension problems in other municipalities, is in a weaker position to help than New York state was.
It's not clear that this bankruptcy-remote structure would protect against losses if Chicago defaults on its general-obligation bonds, anyway. True, New York's bond structure worked; investors were repaid.
But these bonds worked less because of their airtight design than because New York is in a solid fiscal position. Elsewhere, municipal borrowers that issued similar bonds aren't faring so well.
Take Puerto Rico, before Hurricane Maria hit. In 2007, it owed 70.2% of GNP, and the government had shut down the previous year in a battle over a nearly billion-dollar deficit.
“Even with tax increases and service cuts (both of which could drive away residents), the city is unlikely to make good on its pension commitments.”
Officials approved the territory's first-ever sales tax, but Puerto Rico didn't trim its budget. Instead, it issued $1.3 billion in new bonds, backed by the sales tax, via a MAC-style outfit, Cofina.
The government warned investors that the borrowing was not backed "by the full faith, credit and taxing power of the commonwealth" — but it reassured them, too, that it would collect more than enough from the sales tax to cover payments. Investors bought the bonds later that year at below 6% interest.
Investors comfortable with Cofina made it possible for Puerto Rico to raise $17 billion, almost as much as it owed in general-obligation bonds. By 2012, the territory owed nearly 100% of its GNP — and its economy was in trouble. Five years later, it would be bankrupt.
Cofina's structure failed to help Puerto Rico establish financial stability, and it failed to protect investors too — the territory defaulted not only on its general-obligation bonds but also on Cofina debt.
It may be years before Cofina bondholders know whether they will do better or worse than general-obligation investors.
Cities and states have an incentive to favor holders of general-obligation bonds. An entity like the one that Chicago has created to issue sales-tax-backed debt has no purpose but to issue such bonds. Like a corporation, it could default and vanish. Chicago, by contrast, will stick around. The city would want to maintain its ability to issue debt after any bankruptcy.
MAC-style securitized debt for municipalities is a good idea if it helps them avoid radical cutbacks — shutting off streetlights at night — in favor of gradual change.
It's not a good idea when it delays change. In devising legal structures to protect bondholders from a crisis, Chicago may make its crisis worse.
This piece originally appeared in the Investor's Business Daily
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Nicole Gelinas is a senior fellow at the Manhattan Institute and contributing editor at City Journal. Follow her on Twitter here. This piece was adapted from the Autumn 2017 Issue of City Journal.
This piece originally appeared in Investor's Business Daily