Chicago has been running a Ponzi scheme for some time.

"Illinois and Chicago pension beneficiaries are unlikely to see the full benefits they were promised. That is because they were given false promises."

An interesting topic that we’ve seen a lot of news about recently is the status of three different municipal issuers: The City of Chicago, Chicago Public Schools (CPS), and the State of Illinois. Despite their different names, each entity serves the same basic function, faces the same set of legal circumstances governed by state courts, and has a similar liability profile.

We have compiled a historical analysis of distressed state and local government issuers over the past four decades and have concluded that all have faced similar decision-making pitfalls in the course of their budgetary processes, year-in and year-out.

Our findings suggest that the present-day cases of Illinois/Chicago, Detroit, and Puerto Rico, as well as New York City in the 1970s, are all remarkably similar in that each chose to skip pension payments and issue debt in a “scoop and toss” fashion over the course of two or three decades as an alternative to
making difficult decisions like cutting popular programs or raising taxes.

“Scoop and Toss”

The “scoop and toss” we refer to can best be described by the following example, which we borrow from an article titled “Broken Bonds,” published by the Chicago Tribune on November 1, 2013.

Consider taking out a 30-year mortgage to purchase a new car, and making your children repay the principal and interest over time. You use the proceeds from this tactic to pay not only for short-lived assets such as a car but also for groceries and gasoline and, eventually, to make payments on your credit card debt. As time passes and increasing amounts of your income are devoted to repaying your ever-growing debts, you resort to “scoop and toss” transactions repeatedly to roll over and extend out all debts as they come due, buying time but increasing the principal and interest burden on your budget. Those familiar with Hyman Minsky’s “financial instability hypothesis” will recognize this as the third stage in the lending cycle known as Ponzi finance.

“Scoop and toss” has been Chicago’s strategy for managing its budgetary imbalance since the early 2000s. TheChicago Tribune has shown that of the $9.8 billion in general obligation bonds Chicago issued from 2000-2012, most of the proceeds were used to pay principal and interest on existing indebtedness, but close to half was used to cover current expenses such as one-time legal costs, bond issue underwriting costs, or the purchase of short-lived equipment such as police cars.

If such transactions were to be used to finance critical infrastructure assets, with cash flows matching the payments on the bonds over time (e.g., a tolled bridge), then this mode of financing would sustain itself. However, this has not been the case. As the Tribune points out, less than 1/3 of this $9.8 billion actually went toward funding critical infrastructure.

A quick but important tangent: Currently $0.65 of every property tax dollar collected in the City of Chicago is used to service debt. Another way of putting it is that $0.65 cents of every dollar is used to pay expenses like police salaries and benefits incurred 20 years ago, instead of the salaries and benefits of current workers.

We can extend the analysis of “scoop and toss” to Chicago Public Schools (CPS) and the State of Illinois, who find themselves in the same financial predicament, because they are governed by the same group of politicians. For example, the problems the City of Chicago has in funding its police and fire pension systems, the problem CPS has funding its teachers’ pensions, and the problem the State of Illinois has funding its state employees’, teachers’, and state universities’ retirement systems are all essentially the same.

We summarize the financial position of each entity and compare them in the following table:

Cumberland Advisors

The table shows that each entity has lost roughly $1 billion this year as one-to-two-percent revenue growth has not kept pace with rising entitlements. Rising expenses have reduced liquidity to the point where days cash on hand can barely cover current-year operating expenses. Each entity has skipped a large percentage of required payments into its pension funds to halt the compounding of accrued interest on its liabilities. For example, in 2014, Chicago’s payment into its system was only 25% of this needed amount. With the exception of CPS, the funding level of these systems is less than 40%.

Chicago’s “True” Debt Burden

Looking at the numbers for Illinois, Chicago, and Chicago Public Schools individually, however, understates the total debt burden and financial situation of the Chicago-area tax base. On a collective basis, we must account for the fact that these are coterminous entities; that is, they share the same borders and tax the same property.

When analyzing Chicago’s debt situation, it is important to consider the total burden imposed by all of the taxing entities within the boundaries of the Chicago city area. For example, the city itself has $41 billion in total debt outstanding. But this amount is only 55% of the outstanding general-obligation debt that residents of the city are paying out of their own pockets. They must also pay property taxes to Cook County, the Chicago Park District, the Water Reclamation District of Greater Chicago, the Forest Preserve District of Cook County, and the various community college districts.

When you include these entities, the city’s debt burden nearly doubles, to $75 billion. And this is debt payable only out of ad valorem property taxes and doesn’t include sales and income taxes levied on everyday transactions to subsidize the Chicago Transit Authority and Regional Transportation Authority, or sales and income taxes paid to the State of Illinois. Each of these entities has the sovereign power to raise taxes by as much needed to repay their debts.

The driving force behind this high taxation and “scoop and toss” has been the growth in the required contributions needed to support these entities’ pension funds, all of which are in danger of being depleted within the next 10 years. The discussion of pension underfunding in Illinois in toto can start with a discussion of Chicago’s 2016 fiscal year budget, which was passed by the Illinois General Assembly in May of this year and adopted by the city in October – but that was not signed into law by the governor.

Wikimedia CommonsChicago

The Chicago Budget, SB777

To help pay the rising costs of the city’s pensions, which are set to increase by $300 million during the next four years, Chicago’s budget (also known as Senate Bill 777, or just SB 777) includes a $543 million tax increase to be phased in during this time, $200 million of which will come from state assistance. The $343 million in new property taxes is a 63% increase, to be shouldered by the city’s residents.

This budget is very sneaky because it is an attempt to force the state’s hand by including revenues the city is unlikely to receive from the governor; and it seeks to enact a pension funding schedule that doesn’t fully amortize its unfunded obligations, leading to higher obligations down the road. If the city is unable to make the mandated pension payments in full, the budget redirects revenues from the State of Illinois, intended to pay for things like Medicaid and welfare assistance, toward city police and fire pensions.

The connection between Illinois and CPS pension funding and Chicago’s budget stems from what lawmakers define as required “statutory” funding requirements. The current budget seeks to amortize 90% (not 100%) of the city’s unfunded liability over a 40-year (instead of 30-year) schedule. This 90%/40-year combination has been adhered to rigorously by Illinois lawmakers since the mid-1990s on the City of Chicago, state, and Chicago Public Schools levels. Two other bills, PA 98-0641, which was overturned by the Cook County Circuit Court and was heard on appeal by the Illinois Supreme Court in November, and PA 96-1495, which is set be amended by SB777, also assume 90% amortization over 40 years.

There is an almost religious devotion to the concept of the “statutory pension contribution” in Illinois. The story goes as follows: By creating a constitutionally mandated pension funding requirement that falls short of actuarially required amounts, the state can contribute money to the system and sell it to the general populace as “making a full pension payment.” Meanwhile, the unfunded liability and future funding requirements continue to grow. The statutory contribution simply satisfies the state budget requirement, while the actuarial amount is the amount needed to amortize the liability and prevent the fund from depleting.

The results of employing this funding strategy over the past 20 years are pension liabilities for each of the three entities that have grown by the amount of accrued interest on these liabilities each year – amounts that exceed the statutory contribution. This is tantamount to filling up buckets of water on the deck of the Titanic to prevent it from sinking. Lower contributions also mean lower-valued assets in which interest/returns can compound.

Reuters/John GressDemonstrators hold placards during a Chicago Teachers Union protest in Chicago.

In the City of Chicago’s case, simply to arrest growth in the unfunded liability would require contributions to the police and fire pension system equal to four times the amount contributed in 2015. Remember, the city made the contribution needed to satisfy state law, not the actuarially required amount needed to fully amortize the liability over time.

The City of Chicago faces two options right now: “scoop and toss” by phasing in the 90%/40 amortization, which leads to higher future contributions and lower funded level, or higher contributions into the plan now, which would need to be financed out of reserves or debt issuance. This is an unavoidable “catch 22.” The city has low liquidity, equal to 11.7 days’ cash on hand (see above chart), so it would most likely need to draw on a line of credit or issue a short-term note to make the full payment. Our estimates show that a 25% increase in revenues, or $1 billion, is needed to fund the actuarial contribution.

In fiscal 2014 and 2015, CPS used reserves to fund pension contributions. In 2015, the amount was $821 million. However, Moody’s points out in a recent piece that the district’s true financial condition has been obscured by a new accounting schematic it uses to account for deferred inflows.

2 + 2 = 5

Paraphrasing Moody’s, starting in fiscal 2016, the district is now recognizing as “current revenues” those falling within 60 days (rather than 30 days) of the end of the fiscal year. This change means that disbursements to CPS falling within 60 days of fiscal-year end will count as revenues in the current year instead of the next year. There is a specific reason for this adjustment: it will allow CPS to include disbursements Cook County made in August 2015 to CPS in this year’s financial results (which should have been filed in September) instead of in next year’s.

The financial impact of this adjustment is large. Since the change applies retroactively to 2015, revenues received in 2013 as part of the 2014 fiscal year will be shown in the fiscal 2015 adjustment, increasing reserves by $648 million, to $1.1 billion. In FY2015, after the $863 million draw to make CPS’s pension payment, reserves were reduced to $263 million. Had they not made the adjustment, CPS would have recorded a $358 million deficit.

So CPS has found a way to pull revenues for each future year into each current year. This practice will occur into perpetuity, as there will always be a “next year” from which payments scheduled within 60 days can be pulled.

CPS also faces a funding problem, which has been exacerbated by partial pension-payment holidays it took between 2011 and 2013, when it relied on state funds to make these payments. These “holidays,” taken to shore up CPS’s current budget at the expense of pension funding levels, has asymmetrically hurt the fund’s health due to the direct and implied opportunity costs of not having “would-be” assets in the fund.

Moody’s and S&P have stated they intend to downgrade to junk, plans that fund on a pay-as-you-go basis. CPS was the first shoe to drop, with its downgrade to Ba1 earlier this year. The City of Chicago responded by foregoing having its bonds rated by Moody’s altogether, so as not to further reduce the trading value of its debt. We expect more of the same during the next few years.

At Cumberland we do not purchase the uninsured debt of CPS, Chicago, or the State of Illinois – the credit risks are too great. We have limited exposure to their insured, refundable coupon bonds, but this is a play on advance-refundability and the strong credit quality of the active bond insurers. Consider that uninsured Chicago debt trades at around 5.15%, Board of Education (BOE – the main issuing conduit for CPS) debt at approximately 6%, and Illinois GO debt at around 4.75%. When we take the highest-yielding of these three, the Chicago BOE 5.25% due 12/1/41 yielding approximately 6%, it would take only a 40 bps increase in yield to wipe out a year’s worth of coupon income. If this seems unrealistic, consider that yields on this particular security rose from a low of roughly 4% to a high of close to 6.85% during 2015 alone, a 20-point loss.

Illinois and Chicago pension beneficiaries are unlikely to see the full benefits they were promised. That is because they were given false promises. At some point, because of the city’s strong economic and demographic profile, the Windy City is likely to emerge from its present mess. We think there are periods when US state and local governments fail and instances where European-style technocracy would probably solve many problems. This is one of those times.

We watch very closely what goes on in Chicago and Illinois politics. We have reached the conclusion that although future opportunities may arise in sourcing insured debt, the risks are currently too great. Rahm Emmanuel and the Chicago City Council have cleverly found a way to force the state’s hand. By budgeting for state pension assistance that likely won’t materialize, they have won the battle. However, the war rages on and “scoop and toss” rules the day.

Read the original article on Cumberland Advisors. Copyright 2016.