By: David A. Smith
When you don’t pay your electric bill, the company shuts off the power. When you exhaust your credit card, the company cuts you off. And when you’re unable to prepay old bond issues, this becomes a problem for you only if you cannot sell new bond issues.
And that is the problem now confronting Chicago, and certain to consume Chicago and Illinois politics, because the bond markets are speaking truth to debtors, as reported via a shot from the Chicago Tribune (February 2, 2016) and a next-day chaser from Reuters (February 3, 2016; red ink font):
Chicago’s troubled public school system on Wednesday had to slash the size of one of the biggest “junk” bond offerings the municipal market has seen in years and agree to pay interest costs rivaling Puerto Rico’s in order to lure investors into the deal.
Troubled Puerto Rico, which I previously profiled, has already defaulted on its bonds, and is heading into some form of colonial bankruptcy whose rules nobody knows.
The Chicago Board of Education managed to sell only $725 million of an originally planned $795.5 million of tax-exempt bonds, and yields on the deal topped out at 8.5%, a massive premium relative to higher-rated debt sold in the US municipal bond market and a clear indication of investors’ view of the depths of the district’s fiscal woes.
When you’re being paired with Puerto Rico, that’s as low as it goes in US government debt markets. And in fact, Chicago Public School debt is now being priced worse than Puerto Rico’s was when it was 21 months away from default.
The 8.5% yield for bonds due in 2044 with a 7% coupon was slightly below the 8.727% yield for 21-year bonds in the municipal market’s last big junk bond sale – a $3.5 billion Puerto Rico issue in March 2014.
But the school district’s so-called credit spread over the market’s benchmark triple-A scale was wider at 580 basis points versus 514 basis points for Puerto Rico in 2014, indicating investors are demanding a stiffer penalty from the Chicago Public Schools (CPS).
As bad as the spread is, worse is the widening of spread in the last two years, as shown by this smoothed graph:
Worse than the state since August, 2013
A little over two years ago, Chicago’s bonds cost 190 basis points above benchmark; now they’re 580 basis point above. That’s three times the spread.
This fulfills a prediction I made a little over two years ago, in A fool and his bond market (December4, 2013), where I wrote about Rahm Emanuel’s protesting the rating agencies’ downgrade of his Windy City
Translating Fitch’s comments into normal language:
1. Chicago is broke.
2. Chicago has not cut its high unionized-labor costs (and 90% of its labor force is unionized).
3. Chicago won’t get help from (equally broke) Illinois.
The state not only has $95 billion in pension liabilities, it also routinely lets accounts payable accrue unpaid, to the tune of $4.2 billion by the end of 2013, according to S&P.
As I posted some years ago, it’s possible for a city to run out of cash, and when that happens, it’s the retirees whose checks stop. Stop dead.
Confident man? Chris Mier
In such commentary I detected the noxious odor of mendacity:
“Mendacity is a system that we live in. Liquor is one way out an’ death’s the other.”
Are the investors who say that ready to buy new Chicago bonds, or do they own current Chicago bonds, and are talking themselves into believing all is well?
A fool and his bond market are soon parted. Or soon should be.
All is well, don’t you get it?
This is happening now, and in fact Chicago was humiliated in its first bond market offering, so it crawled back at higher yields:
Wednesday’s sale came a week after the school system had to pull the deal in its first attempt at an offering amid worry by investors that the district could end up in bankruptcy.
Notice how Mayor Emanuel, who was so full of bluster and bounce two and a half years ago, has gone completely silent?
Sell the image, because the reality is terrible
AHI blog posts on Chicago’s looming municipal bankruptcy
September 13, 2013: Next up, Chicago; 5 parts, predicting bankruptcy in the near term
December 4, 2013: A fool and his bond market; 2 parts, inevitable bond market shutoff
December 31, 2013: Sub-cities; 3 parts, widening spatial Gini coefficient in Chicago
April 15, 2015: A tale of two cities; 12 parts, fiscal collapse and city’s potential breakup
May 18, 2015: Chicago’s first domino, Illinois Sup Ct’s rejection of pension reform law
Readers who are not familiar with the dynamics of financial markets may be forgiven for thinking, Well, eight and a half percent’s high, but that must mean Chicago will pull through somehow. But that’s not how a bond trader looks at it. He or she sees everything in terms of spread and default risk:
In contrast, a top-rated issuer’s debt would yield only around 2.70% on Wednesday, according to Municipal Market Data’s benchmark scale.
Up to date spreads
So a trader thinks, I can get 2.70% for an instrument at par, but if I buy one at 8.50%, how much value can it lose and still be better than 2.70%? The answer is, a 68% drop, because 8.5% x 32% = 2.7%.
True this analysis oversimplifies, in that the yield it’s evergreen and the loss of principal eventually makes a difference, but it does so to make a point – the market is pricing in expected default. We saw this in Jefferson County, Alabama, which went into and out of its bankruptcy a few years back.
AHI posts on Jefferson County
Out of the muck (January 6, 2014); 5 parts
And the deal Chicago just did doesn’t solve the problem, or even begin to solve it – it just buys time, at premium rates, and with imminent potentially toxic consequences.
I can handle 8.5% — you got anything stronger than that?
CPS officials said bond proceeds will reimburse the district’s operating fund for out-of-pocket capital costs and free up $206 million by pushing out debt service payments. Portions of the deal to restructure variable-rate debt to fixed rate and finance-related interest rate swap termination fees were postponed.
So far nothing’s closed the deficit gap
“Along with the tough cuts announced yesterday and earlier this year, the sale of these bonds will produce sufficient proceeds to mitigate our cash flow challenges through the end of the fiscal year,” said CPS Senior Vice President of Finance Ron DeNard in a statement.
Explaining how making it to next year is the best they can do: DeNard
This news the Teachers Union greeted with its customary wisdom and restraint:
One day after the Chicago Teachers Union rejected a contract proposal from Chicago Public Schools, district officials said they would slash school budgets and stop paying the bulk of teachers’ pension contributions, CTU President Karen Lewis said the district’s action was retaliatory and an attempt to coerce union members into signing on to a deal.
Apparently saying ‘there is no money’ constitutes ‘an act of war’
“Due to their attack, we have no choice but to express our outrage at this latest act of war by rallying against CPS and the bankers who are siphoning off millions from our schools,” Lewis said.
CTU President Karen Lewis’s is opposed to tightening fiscal belts
Republican Governor Bruce Rauner on Wednesday condemned the district’s second attempt at borrowing, but denied trying to sabotage the system’s bond issue by publicly advocating bankruptcy for CPS.
Rauner urges Chicago to surrender to bankruptcy
“The numbers don’t lie,” he told reporters. “CPS has been a financial disaster for years. The balance sheet is stunningly bad. Now they’re looking at borrowing more money to cover operations.”
Chicago’s insolvency has long consumed the Illinois State Legislature and is likely to keep consuming it, with Governor Bruce Rauner pushing for the same type of state powers that Michigan Governor rick Snyder used to prepare the way for Detroit’s bankruptcy.
“[Mayor Emanuel] caved in the teachers strike 4½ years ago, and he’s sending the message right now [in contract talks that] he’s going to give them what they want and then say, ‘State, pay for it.’ We are not going to let that happen,” the governor said.
With Chicago and Cook County representing roughly half of the 118 state legislative districts, the city’s insolvency is going to dominate state politics, in not only an election year but also a Presidential election year.
The political arithmetic still says blue, but the city’s finances say red
Though the mud splatter will likely stop at Mayor Emanuel, his tenure as President Obama’s chief of staff, and President Obama’s touting of his deep Chicago roots, will encourage political opponents to pick up big handfuls of the Chicago mud and lob them at Democratic candidates.
Now, candidates, let’s have a reasoned discussion, shall we?
Late on Tuesday, the district tried to assure prospective investors that revenue pledged to pay off the debt could continue to flow to them should the school district end up in bankruptcy court in the unlikely event the Democratic-controlled Illinois legislature would pass a Republican-sponsored bill permitting the move.
Chicago is broke; more than broke, it’s about to be cut off entirely from the capital markets. When that happens, it’s like cutting the body off from water – death seizures commence. All the idiotic lawsuits being mooted will not change this. Eventually political survival will cause the state legislators, especially those from beyond Cook County, to disengage from defending the Windy City, and then bankruptcy will swiftly follow.
Not financial death, the liberation of a spirit trapped in chains of past debts