The Gathering Bond Storm in Chicago

Recently the bond rating company Moody’s Investor Service cut their ranking of Chicago to junk status.

The move ticked off a lot of people in the Windy City who think Moody’s overstated the case. I agree that Moody’s is wrong… not because they went too far, but because they didn’t go far enough.

Chicago is not close to bankrupt. It’s completely bankrupt. People are just afraid to say this out loud.

The city’s pensions are underfunded by $20 billion. Moody’s gave a rating that reflects how the city is performing. City officials are just angry Moody’s called them out.

The bureaucrats pointed to Standard & Poor’s, which had Chicago ranked an A+. But after Moody’s released their assessment, Standard & Poor’s lowered their rating as well — just not as low as the Moody’s rating.

It really isn’t all that complicated. Unless there’s a change to how pensions are funded or benefits accrue, the pension liabilities will completely swallow the city and then some.

Chicago has four ways it can offset this financial mess: raise taxes, lower benefits, require higher contributions from city workers, or some combination of the three.

There has been a lot of talk about changing what workers pay into the system, as well as cutting benefits for workers that are still years from retirement… but the Illinois Supreme Court already shot this down when they ruled that similar changes by the State of Illinois violated the state’s constitution. If it won’t work at the state level, then it won’t fly at the local level, either.

Chicago could still try raising taxes high enough to cover its costs. Though I highly doubt voters will support a tax hike big enough for public employees to enjoy their comfortable pensions, when the average private worker still must fend for himself.

That doesn’t leave the city with many options. Which means it has a liability that, at this point, it can’t pay. That sounds like bankruptcy to me.

Still, city officials claim that Chicago won’t grind to a halt, and it won’t. It’s a vibrant hub of commerce.

It’s not Detroit, where residents fled the city and homes sold for $100. It’s not Puerto Rico, which racked up massive debts to fund its unbalanced budget.

But the fact remains that Chicago is unable to pay what it owes. Something has to give, and soon.

As we’ve seen in other cases — Stockton, Vallejo, and Detroit — when there’s not enough money to go around, it’s the bondholders that get the shaft, no matter what their claim on assets.

That’s why Moody’s was right to give Chicago the rating that it did. It’s their business to rate the city such that potential bond buyers can make informed investment decisions. Their business is not to salvage a city’s reputation.

If Moody’s analysts forecast Chicago won’t be able to pay all of its bills, with the result that bondholders likely will take a hit, then the company has an obligation to publish that outlook.

Of course, city officials see things a bit differently. They’ve literally cut the company out of current deals, and are now only using credit agencies that see Chicago in a better light.

It’s hard to feel any sympathy for Moody’s since this firm, as well as Standard & Poor’s, made a fortune during the housing boom by slapping their highest ratings on shady sub-prime deals.

It’s investors who purchase Chicago bonds that deserve some level of protection, or at least quality information, which they get with the junk rating Moody’s assigned to Chicago.

At the end of the day, all of this highlights the same issue — there’s no such thing as risk-free investing.

Chicago bonds are backed by the “full faith and credit” of the city. Given everything we know about their finances and how bondholders have been treated in the past, the words “caveat emptor” come to mind, no matter what the rating of any bond.

Municipal bond buyers and muni bond fund investors should closely inspect their portfolios to see if they have any exposure to the Second City. Better to find out now, before things get worse.


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Categories: Bonds

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.