Detroit's bankruptcy filing in July sounded an alarm for much larger Chicago and investors with stakes there.
The Windy City's fiscal woes are not as dire as Detroit's, but they are broad and deep, analysts say, with massive unfunded pension liabilities stockpiling at a time when economic activity is modest and tax revenue is difficult to grow.
On July 17, in the same week that Detroit threw in the towel and filed for Chapter 9 bankruptcy protection, Moody's Investor Service slapped Chicago with a three-notch downgrade of its general obligation and sales tax bond ratings, from "Aa3" to "A3." It also assigned a negative outlook, indicating further downgrades are likely.
Moody's estimated that Chicago's pension liabilities total $36 billion in today's dollars, which are only half-funded even by the city's own accounting.
With the city's budget "already burdened by high fixed costs, including unrelenting public safety demands and significant debt service payments," Chicago is ill-prepared to keep pace with required pension contributions, a team of Moody's analysts led by Rachel Cortez said in a note outlining the reasons for the downgrade.
Just A Band-Aid
Chicago metro-area GDP was $548 billion in 2011, up from $508 billion in 2009. But the city's costs are rising even faster. Chicago has a $340 million shortfall for the coming fiscal year. Mayor Rahm Emanuel has vowed to cut spending and close the gap. But without pension reform, the cuts would amount to a Band-Aid on a gaping wound.
In 2012 alone, the analysts said, Chicago underfunded its annual required contribution by more than $1 billion. With Illinois state law requiring the city to boost its contributions to its public safety pension plans by 2015, the situation is poised to worsen.
That, the Moody's analysts say, will place "tremendous strain on the city's operating budget.
Mounting pension liabilities lie at the core of Detroit's financial troubles. So it should not surprise anyone that the Motor City's efforts to minimize that burden via bankruptcy amplified worries about Chicago, Jack Ablin, chief investment officer at BMO Harris Bank, said in an interview.
"The pension imbalance is enormous," he said of Chicago, "and while everyone knows something must be done, things have to change to get something done.
Back To The Future
The lesson from Detroit, Ablin said, "is that you can't just focus on the present without regard to the future. You have to recognize what is wrong and begin to take steps to address it.
Detroit, Ablin said, failed to do that. It allowed its financial troubles to mount over decades as its population dwindled and its tax revenue shrank with the steady decline of the auto manufacturing base that drove its economy.
Chicago, with its much larger population and far more diverse economy, still has time and more levers to pull, he says.
"For Chicago, this is something that can still be solved over a matter of years, not months," Ablin said. "I can't say what the likelihood of a solution is, but it is more possible now because we are all now fully aware of the problem" thanks to the Moody's move.
"And that's the first step, right? Recognizing the problem and just how serious it is. I think that's a big step.
Ablin said in a note to clients that Chicago has some room to breathe. Its population is down about 7% from 2000, according to U.S. Census statistics, but nothing like the 25% plunge in Detroit. The economy in Chicago is nearly three times the size of the Detroit area's. No one sector accounts for more than 13% of employment, he said, citing numbers used publicly by Mayor Emanuel.
"Lastly," Ablin noted, "Chicago's municipal borrowing rate, while relatively high (vs. most U.S. cities), is substantially below the rate Detroit paid for similar maturity bonds, even before the bankruptcy. A Chicago general obligation bond maturing in 2025 is yielding just over 4%, a far cry from a similar maturity Detroit obligation of over 7% nowadays.
So what must Chicago do now to avoid bankruptcy ever getting on its table? "Chicago needs legislative help from the state," Ablin said, noting that there is very little appetite for tax hikes to fuel increased pension spending.
The Illinois Constitution explicitly protects pension benefits from cuts, so any attempt by the city to reduce current benefits would face an uphill court battle.
Legislative action at the state possibly could change that and, over time, provide an avenue for pension beneficiaries to make concessions needed for Chicago to bring its expenses in line with its revenue.
"If current pensioners see they might ultimately lose their footing" because the city could end up in bankruptcy and the courts could slash benefits, "they might be more apt to negotiate a lesser payout rather than risk no payout at all" if state law allowed, said Sam Pappas, president and CEO of Mystic Asset Management. "You'd at least have a say in your own destiny.
But Illinois is embroiled in a pension crisis of its own. The state has a roughly $100 billion unfunded pension liability over 30 years. Gov. Pat Quinn has repeatedly called on legislators to craft a reform measure, even withholding their pay as of Thursday. But no final plan has bubbled up yet.
And pension liabilities are not all that ails either Chicago or Detroit. The latter, for example, owes nearly $6 billion in retiree health care costs. Cities and states have largely ignored budgeting for such health benefits, which enjoy less protection than pensions.
As part of Detroit's bankruptcy efforts, it is looking to push those who are not old enough to qualify for Medicare out of city-run coverage and into new health coverage markets that are soon to open under President Obama's health care reform law. That and other health care cost curbs could save tens of millions of dollars.
Chicago, too, has looked at such possibilities. If a bankruptcy judge signs off on Detroit's ObamaCare plan, it could serve as a template for the Windy City.
But pension costs are the city's biggest hurdle, Pappas says.
Short of reform, Chicago could eventually have to hit up bondholders to accept less than full repayment, which is another path that Detroit is on. Already, with the Detroit matter, "This is something that will reverberate across the entire muni-bond industry," Pappas said.
"This is an entirely new learning process," he added, "but ultimately this could change the way everybody views the muni market." Cities' borrowing costs could spike.
But one thing seems all but certain, he says. If a major economic hub such as Chicago ever followed Detroit's lead, "there'd be a huge shake-out."