STUMP » Articles » Chicago Watch: Doomed Finances Compounded by Swaps » 11 March 2015, 06:37

We knew about the initial downgrade of Chicago at the end of February, but what have we heard since then?

• Chicago Park District downgraded
• Chicago Public Schools debt downgraded
• Chicago underwater on its swap by $400 million

A sideline on these swaps. First, check out Mish’s remarks:

When a snake oil salesman at the country fair says his potion will cure you of whatever ails you, you can rest assured the following three things will happen if you try some.

-It will taste terrible.
-It will not work.
-You will wish you didn’t buy it.

Similarly, when Wall Street peddles swaps, the following things are highly likely, if not virtually guaranteed.

-The contracts will be extremely one-sided with many loopholes for the Street and none for the city.
-The swaps will cost the city that enters them lots of money, and the termination fees will be excessive.
-Cities will wish they never entered into the agreement.

He’s right, you know.

I had first learned about swap misuse years ago, and then in the aftermath of the credit crunch, a bunch of bad swap set-ups became exposed and I created this discussion thread.)

I noticed the bad swap situation in Chicago about a year ago:

Already facing a host of financial worries, Mayor Rahm Emanuel’s administration could be stuck with a nearly $200 million tab as a result of betting heavily on risky interest-rate “swaps” under former Mayor Richard M. Daley.

The deals required the city to maintain a certain credit rating, but the rating has fallen since the Daley administration made them, putting the city at risk.

The financial institutions involved could terminate the deals and demand immediate payment if the ratings agency Moody’s Investor Service drops the city’s credit rating again — which it has warned it will do unless Chicago’s underfunded pensions are dramatically reformed.

Guess what Moody’s did?

Yup.

This is from September of last year:

Sept. 12 (Bloomberg) — Chicago’s deteriorating credit quality has pushed taxpayers to the brink of paying almost $400 million to Wall Street banks on derivatives contracts that are backfiring.

The city and Chicago Public Schools, both at risk of rating reductions as pension obligations mount, agreed to interest-rate swaps with companies including Bank of America Corp., Goldman Sachs Group Inc. and Loop Capital Markets LLC last decade as part of debt sales. The accords were designed to cap expenses in case interest rates rose. The deals went awry as the Federal Reserve cut borrowing costs during the recession.
….
In Chicago this week, Alderman Roderick Sawyer introduced a resolution in the city council calling for Mayor Rahm Emanuel to file an arbitration claim with the Financial Industry Regulatory Authority to recover payments the city and school district have made on swaps. That could generate more than $600 million and eliminate the need for termination payments, said Jackson Potter, an official with the Chicago Teachers Union.

“The mayor has made a commitment that the city will not enter into any new debt swaps of this kind and has enacted measures to modify and reduce risk to protect the taxpayers of Chicago,” Carl Gutierrez, spokesman for the city’s budget office, said in an e-mailed statement.
…..
The city had its general-obligation rating lowered to Baa1 in March by Moody’s, which cited “massive” pension liabilities. The company also assigned a negative outlook, meaning more cuts are possible. A credit grade one level lower could trigger swaps termination fees of about $173 million, according to documents for a March bond sale.

The school system, the nation’s third-largest, has more breathing room. It needs two rating companies to reach a predetermined rating level for a possible payment of about $224 million. It’s Moody’s rating is two levels from that point.

Oh, the Chicago Public Schools are also possibly on the hook?

I understand the desire to hedge variable interest rate costs with a guaranteed rate. The problem is what happens when one’s credit goes sour and one is trying to unwind these deals. When one is forced out of a swap contract, it’s not merely that counterparties stop making payments.

Nope, it’s that the swap is valued at the point-in-time and the value is made up to the counterparty.

That’s the theory, at any rate.

I don’t see Chicago ponying up $400 million for anything.

For historical interest, while it’s still up at the Chicago website, here is the history of credit ratings on Chicago’s General Obligation bonds, going back to 1954. Yes, it’s gone up and down, but I will point out it reached its pinnacle in 2005, and has been going down since.

When were those swaps entered into? From the article I have found:

Two $100 million swaps are tied to a $200 million 2007 sale. They are floating-to-floating rate swaps each negatively valued at $8.7 million. The contracts have an effective date in 2014 due to amendments adopted last year.

The third is a $136 million floating-to-fixed rate swap tied to a $202 million 2003 sale with a negative $20.8 million valuation.

The city reported in the new filing that it has posted as collateral a letter of credit issued by PNC Bank in connection with a 2005 sale/leaseback transaction the city entered into in 2005 on the city-owned portion of the Orange Line rail transit route to Midway Airport. The lease deal expires in 2031.

….
The city has 26 liquidity support, letter of credits, and direct purchase facilities on more than $2 billion of floating rate bonds from issues between 2002 and 2014 sold under its GO credit, Midway Airport second lien, O’Hare International Airport third lien, water, wastewater, sale tax credit, and tax-increment financing bonds.

The banks include Royal Bank of Canada, Bank of New York, Barclays, Bank of Montreal, Wells Fargo, Citibank, JPMorgan, PNC Bank, US Bank, Northern Trust, Bank of Tokyo and State Street Bank. The rating thresholds for events of default on most are triggered at a rating below the BBB-minus level with the exception of four totaling $372 million. Several require ratings at or below the mid-triple-B level by two rating agencies. Expiration dates range from this year through 2018.
…..
The Moody’s downgrade impacted $8.38 billion of general obligation debt, $542 million of sales tax bonds, and $268 million of motor fuel bonds, and $1.5 billion of wastewater debt.

Right, so, again, the only way Chicago is coughing up $400 million is that it will be borrowing from somebody else.

Good luck with that.

Where is this money going to come from?

Some think that a tax raise is in the cards:

A post-election property tax increase is inevitable to solve Chicago’s $20 billion pension crisis, one of Mayor Rahm Emanuel’s most powerful City Council allies warned Monday, arguing that anybody who claims otherwise is living in a dream world.

Nine aldermen allied with Emanuel joined his campaign co-chair, City Clerk Susana Mendoza, at a City Hall news conference to put the heat on mayoral challenger Jesus “Chuy Garcia” for making $1.9 billion in promises that, they claim, would force the owner of a $250,000 home to pay $1,900 more in annual property taxes.

But Ald. Carrie Austin (34th), chairman of the City Council’s Budget Committee, inadvertently put the spotlight on Emanuel when she acknowledged under questioning that Chicagoans need to brace for a property tax increase in any event — even if Emanuel wins the April 7 runoff.

Thing is, will they be able to actually squeeze more blood out of the stone?

In my last Chicago post, I pointed out the following:

Chicago has been shrinking in population for some time. I checked the most recent estimates, and saw an estimate the Chicago population was (barely) growing again…. but to a level still below the population in 2000, forget about their peak year of 3.6 million. The current estimate sets Chicago at about a million fewer people than their peak.

That’s a huge drop, in both an absolute and relative sense.

Of course, some of that drop was due to populations moving to the suburbs. So no biggee — they need more money, they can extort it out of Illinois government, right?

Sure, Illinois has had a growing population, or at least growing faster than Chicago’s (easy to do), but it’s been pretty anemic of late. Checking the latest estimates, it seems Illinois shrank a little between 2013 and 2014, even though 2014 is still an increase compared to 2010.

But that shrinking could continue, especially with talk of increased taxes.

To be sure, they could try to threaten the rest of the country, a la Greece, that they will flood the other states with ‘economic migrants’, but I’m not seeing what the threat is.

Other states are used to taking refugees from Illinois. It’s not only in the past couple years, but for quite some time:

In 2009 alone, Illinois lost residents who took with them a net of $1.5 billion in taxable income. From 1995 to 2009, Illinois lost out on a net of $26 billion in taxable income to out-migration.

I am sure other states are going to be so scared of receiving tax-paying ex-Illinoisians.

Of course, people may not be happy if said ex-Illinoisians bring their Illinois politics with them, but as we can see, this is a self-correcting problem.

Chicago and Illinois: there will be no bailout.

The bills are coming due.

Choices have consequences.

Compilation of Chicago posts.