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GMS SPECIAL REPORT: Chicago has the means to resolve its pension problems

Monday, Sep 21, 2015

Chicago’s well publicized pension woes make it a prime hunting ground for aggressive investors seeking higher yields. Before considering the high yields offered by the various Chicago issuers, aggressive investors must identify the distinct credit features which differentiate rating agency rhetoric from the actual source that pays debt service on specific bond issues.

CHICAGO’S THRIVING ECONOMY CAN PROVIDE SUFFICIENT REVENUE… Among U.S. cities Chicago has one of the largest and most diversified economies.  Chicago’s productivity, income and wage levels consistently exceed U.S. averages. Chicago has a gross regional product of $500 billion placing it third in the nation, after New York City and Los Angeles. Chicago is the only inland American city with a global footprint. There are over 2.6 million people living in Chicago, a quarter of which are below age 18. The city’s significant convention and tourism events annually drive $1.2 billion to the city. A difficult political environment has stigmatized the economically driven city.  With 90% of city employees unionized, the city faces a steep hurdle in keeping costs down.  However, the third largest U.S. city has many options. It is a home rule city which means it can raise property taxes without limitation. It even considered building a casino dedicated to pensions. Much needs to be done to bring structural, financial balance back to Chicago; fortunately city leaders have the necessary resources to meet the challenge. 

PENSIONS AND POLITICS… "We’re going to raise taxes in a fair and progressive way.  If you’re asking me, do I believe we’ll get it done, the short answer is yes because I actually believe aldermen are up to the task of charting a new course for Chicago’s future” said Mayor Emanuel, as the city prepares for the largest property tax hike in modern Chicago history.  Mayor Emanuel’s bid for reforming municipal employees’ and laborers’ pensions stalled after an unfavorable county court ruling. Chicago’s well known pension problems are reflected by recent rating downgrades. Absent pension reform, Mayor Rahm Emanuel is confident the city will raise property taxes to meet a larger pension bill. The proposed $450 to $550 million tax hike would increase the average homeowners tax bill around $500. The city’s widely publicized financial situation the tax hike has been expected. The mayor also plans to push a new garbage collection tax, a new per-ride fee on taxis and ride-hailing services such as Uber and a new tax on electronic cigarettes and smokeless tobacco products. Pension reform is one of the most pressing issues facing Illinois and the majority of U.S. cities and states. Disputing speculative grade ratings assigned by Moody’s, the city has dismissed Moody’s from rating recent issues. Moody’s rating approach, which caps all municipal bonds of an issuer under an umbrella rating, has not found accord with many analysts and issuers nationwide.  As liens are segregated, unique cash flows or security pledged to specific municipal bonds sheds light on the credit quality of the various Chicago bonds. Across America the most populous cities have a gap of $217 billion between what they promised retirees and what they have accumulated. Without reform, growing pension costs will continue to crowd out necessary spending. The problem: bigger government is doing less while citizens are paying more. Often there is strong political resistance to reform. Public worker compensation consumes 70% to 80% of local government budgets. A steep fiscal cliff will eventually force politicians to take dramatic action. Defying politics 25 states including Wisconsin, Michigan and Indiana have cut union power through Right to Work Laws that reduce union revenues. Wisconsin Governor Scott Walker signed Act 10 of 2011 forcing higher employee contributions and removing healthcare as a subject of collective bargaining despite massive protests, lawsuits and a recall election. Determined politicians can get the job done. The Rhode Island Retirement Security Act of 2012 is a national landmark in pension reform. Chicago has the tools needed to resolve its pension problem. Politicians must put these powerful tools to work.

CHICAGO BOARD OF ED CHICAGO PUBLIC SCHOOLS (CPS): MOODY’S BA3, S&P BB, FITCH BB+… The $6 billion municipal bonds outstanding consist of (i) $5.8 billion Unlimited Tax General Obligation municipal bonds (Alternate Revenue: Pledge State Aid)  and (ii) $196 mm Public Building Commission Leases. CPS is the nations’ third largest school district serving 400,000 students in 664 schools. CPS G.O. municipal bonds are double-barreled: secured by a lien on Pledged State Aid, to the extent Pledged State Aid is insufficient for debt service the municipal bonds are secured by pledged ad valorem taxes. Chicago Board of Ed has not needed to levy ad valorem taxes for bond debt service as alternate revenues have been sufficient.  Pledged State Aid are payments received by the Chicago Board of Education under Article 18 of the Illinois School Code.  CPS G.O. municipal bond debt service is ultimately secured by the district's pledge to levy a property tax that is unlimited as to rate or amount and exempt from Property Tax Extension Limitation Laws. CPS’s property tax supported debt is extremely low at less than 1% of the legal debt limit. G.O. municipal bonds are direct general obligations to which Board of Ed has pledged its full faith and credit and unlimited taxing power. CPS is required to set aside debt service a year in advance for general state aid funded debt and one and half years in advance for personal property replacement tax funded debt. These funds are held with the bond trustee. Because of this set aside requirement the majority of current year appropriations are amounts paid from revenues set aside in previous years. CPS covenants under the indenture to collect and apply pledged General State Aid (GSA) revenues up to 1.10x for Board of Education General Obligation bond debt service. For the last five years CPS has received up to 89% of its statutory limit or claim on GSA.  Despite funding delays and lower appropriations, the Board has received appropriated GSA payments over the last decade. Despite cutting nearly $1 billion in expenses since 2011, CPS faces a budget deficit of $1.1 billion in FY16 largely from pension costs of $675 million: of this approx. $200 million is the normal cost and the remainder stems from past reductions in contributions that took CPS pensions from being 100% funded in 2001 to 52% now. CPS has not received contributions from the state to an extent deemed fair when compared to other Illinois school districts, who in aggregate receive $3.7 billion a year from the state. Despite statutes requiring employees to cover 9% of salary to pensions, CPS picks up 7% leaving only 2% to be paid by employees. CPS expects the state to contribute $475 mm to pensions and is negotiating with teachers to pay their fair share.CPS has been forced to borrow to meet pension costs. While bond debt service accounts for $500 million or 11% of CPS operating expenses, salaries, benefits and pensions make up a whopping 68%. Without state help layoffs of 3,000 teachers, bigger classes and shortened academic year could be in store. Starting school this year without a contract, teachers are looking at frozen salaries and more job cuts absent pension reform. New leadership appointed this year is expected to make breakthrough political decisions. Rating agencies have frowned on CPS use of $400 million in non-recurring revenue to close budget gaps. FY16 budget assumes $480 million of state funding for pensions will come through. Absent pension reform, CPS is faced with a challenging environment to maintain ratings. Since state aid is an appropriation rating agencies do not adequately address the sufficient security of  the Pledged State Aid backing the CPS G.O. backed municipal bonds. To date, property taxes have not been needed for the CPS G.O. debt service pledge. 

CITY OF CHICAGO GENERAL OBLIGATION MUNICIPAL BONDS: MOODY’S BA1, S&P BBB+, FITCH BBB+ $9 BILLION… The G.O. municipal bonds consist of (i) $8.4 billion Tax Levy Municipal Bonds, (ii)$547 million Alternate Revenue Municipal Bonds and (iii) $90 mm Pledged Revenue Municipal Bonds. G.O. municipal bonds are paid from an annual property tax levied on city property valued at $207 billion:  0.78 mills or 58% of the city property tax of 1.327 mills is dedicated to bond debt service. The remaining city millage of 0.54 mills funds pension contributions. As a home rule local government unit under the Illinois Constitution, the City is authorized to levy taxes that are not subject to a state tax cap. As direct and general obligations of the City, the G.O. municipal bonds carry the full faith and credit pledge of the City. Budget gaps or a shortfall in revenues needed to cover operating expenses have decreased to $297 mm in 2015, about half of 2012 levels. The progress is due to strong economic recovery and cost efficiencies. The city faces a yet to be determined budget gap that could range from $83 million to $801 million. The biggest variable is pension reform. Chicago’s four pension plans are funded at 36% in aggregate. The city has historically contributed about a quarter of annual actuarial pension requirements. Absent reform, 2016 would require the city to contribute an additional $550 million to police and firemen pensions. An appeal of the Cook County Court’s decision to strike down reform of municipal employees’ and laborers’ pensions is likely. The next 6 months are crucial; the mayor is expected by analysts and investors to raise property taxes $450 to $550 million to close the gap. 

CHICAGO PARK DISTRICT (CPD): MOODY’S BA1, S&P AA+, FITCH AA-… The $806 million CPD municipal bonds outstanding include $333 million General Obligation Unlimited Tax bonds (GOULT) supported by alternate revenues and $473 million General Obligation Limited Tax bonds (GOLT). General Obligation municipal bonds are direct and general obligations of the district and carry a full faith and credit pledge. CPD’s tax base is coterminous with the City of Chicago. CPD is one of the largest municipal park districts in the world, comprising 8,300 acres of green space in 585 parks, 231 field houses and 26 miles of lakefront property. Private cultural institutions that operate facilities on district property include the Museum of Science and Industry, Field Museum of Natural History, DuSable Museum of African American History, Adler Planetarium, John G. Shedd Aquarium and the Art Institute of Chicago. CPD has achieved success in pension reform. Effective Jan 1, 2015 CPD implemented pension reform that remains unchallenged.  CPD’s part-time workforce and flexible capital plans are strengths. The district finished 2014 with an $18.6 million surplus, increasing unrestricted fund balance to $203.1 million, or a high 73.1% of expenditures. Ratings opinions on CPD differ. Strong reserves and Chicago’s thriving tax base are among the reasons behind CPD’s “AA-” ratings from S&P and Fitch. Although Moody’s recognizes CPD’s manageable debt levels and healthy reserves, Moody’s “Ba1” rating ties CPD municipal bonds with City of Chicago’s rating.   

CITY OF CHICAGO SALES TAX BONDS: MOODY’S BA1, S&P AAA, FITCH BBB+  $542 MILLION OUTSTANDING… The municipal bonds carry a first lien on sales tax revenues: the city's 1.25% home rule sales and use tax and the city's 16% allocation from the state's 6.25% sales tax and 4% of the use tax. A strong track record of sales tax collections of $646/$688 million (FY14/2015) results in  coverage of maximum annual debt service of 16x/17x.  Home rule sales tax and the local share of state sales tax are capable of independently covering debt service. Moody’s “Ba1” ties sales tax bonds to the city’s G.O. municipal bonds stating an absence of separation. S&P believes a segregated fund and pledged lien segregates the two.

MOTOR FUEL TAX BONDS: MOODY’S BA1, S&P AA+, FITCH BBB+ $268 MILLION OUTSTANDING… The municipal bonds are secured by a first lien on 75% of motor fuel taxes distributed to the city by the state, subject to annual appropriation by the state legislature. Additional revenues from recreational activities at the city’s Riverwalk are also pledged to the Motor Fuel Tax Bonds, giving annual debt service of over 3x.  Separation of liens protects revenues dedicated to gas tax bonds from city’s general operating budget.  A reliable and adequate revenue stream supports the gas tax bonds. Moody’s “Ba1” rating is tied to the city’s rating.

CITY OF CHICAGO WATER MUNICIPAL BONDS… Senior bonds: Moody’s “Baa1”, S&P “A”, Fitch “AA+” $38 million outstanding. Subordinated Bonds rated Moody’s “Baa2” S&P “A-”,  Fitch “AA” $2.3 billion outstanding.

CITY OF CHICAGO SEWER MUNICIPAL BONDS… Senior Bonds: Moody’s “Baa2”, S&P “A” $35 million outstanding. Subordinated Bonds: Moody’s “Baa3”, S&P “A-”, Fitch “AA” $1.4 billion outstanding. A strong track record of rate hikes is positive for Chicago water and sewer bonds self-supported by user charges. Extending beyond Chicago, the water system serves 5.3 million people covering senior bond debt service 15x and total debt service 2.6x. Sewer system debt service coverage is 1.9x. Projected debt service coverage for water and sewer bonds is at least 2x in 2016 and liquidity is strong. Unlimited rate setting powers, a large and stable customer base and strong revenues are factors for investment grade ratings on all Chicago water and sewer municipal bonds.

THE CITY OF CHICAGO HAS THE MEANS TO RESOLVE ITS PENSION PROBLEMS… Investors must not confuse an issuers’ budget deficit with funds available for debt service. All Chicago bonds are well secured by pledged revenues. Illinois state law does not allow municipalities to file for Chapter 9 bankruptcy. Cash flows securing Chicago municipal bonds are not directly affected by the city’s pension deficit. Chicago’s ability to meet bond debt service is unquestioned.Just a few years ago, a California bankruptcy was the topic of uninformed pundits and the media. With political will and a strong economy, the Golden State put its fiscal house in order. Voters approved tax hikes known as Proposition 30: what followed was a tremendous rally in California bonds as ratings were restored Moody’s “AA3” / S&P “AA-”. Today, Chicago is a hotbed of speculation. Unfair comparisons to Detroit and Puerto Rico make headlines. What sets Chicago apart from these isolated situations is the Windy City’s top notch economy and its home rule status which allows unlimited property tax hikes. Informed aggressive investors who invested in maligned California municipal bonds several years ago will take advantage of maligned Chicago municipal bonds. Until a way forward is found, bond ratings and opinions will vary.  Away from the rhetoric of headlines, informed aggressive investors will weigh the pledged revenue stream linked to specific Chicago municipal bonds.

This report is not an offer to buy or sell any securities. Although taken from sources deemed reliable GMS does not guarantee its accuracy and does not purport to include all available information. Bonds noted as “aggressive” volatile in nature and may not be suitable for all investors.


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