A few years ago, Meredith Whitney predicted a blood bath in the US municipal bond market due to looming defaults. She may ultimately be vindicated but her timing was way off: muni prices rose steadily after the Crash until this year. Now they are falling for various reasons, including credit worries.
The list of distressed or troubled issuers continues to grow: Stockton, Vallejo, Detroit, Harrisburg, Chicago, Illinois, Birmingham, and others. The general storyline is a shrinking tax base in the face of rising retirement benefits. Not only are cash retirement expenses growing rapidly, they have been grossly understated in many cases. As the unfunded liability grows, the pressure rises to increase the level of annual contributions to a sustainable rate. This is a time when many states and cities are having conversations with “stakeholders”: creditors, guarantors, unions, retirees, about making adjustments.
There are a number of options for such situations: (1) higher taxes; (2) budget cuts; (3) pension reform; (4) “give-backs”; (5) bankruptcy and (6) a bailout from the state or the federal government. In many cases, especially in cities with a growing tax base, there is still plenty of room to make adjustments without the need for bailout or bankruptcy. California has appeared to right its ship with a big tax increase and the Facebook IPO.
But in the more distressed cases, such as Detroit and Chicago, the time for adjustments has passed. Detroit is now bankrupt and seeking to default on its debt. Detroit is the poster child for muni credit risk, but it is an extreme example. It has huge debts and no tax base.
Chicago is the more interesting case. Chicago has been underfunding its pensions for years. So what’s new about that? What’s new is that, starting next year, they will have to increase their contribution by an amount that is very large in relation to the city’s budget.
Here is what Moody’s says: “Had the city fully funded the required pension contribution in 2012, operating reserves would have been entirely depleted. To fully fund the plans’ annual required contribution, Chicago’s administration would need to nearly double the property tax levy, or enact commensurate expenditure reductions. We recognize the political implications and practical considerations that would accompany a tax hike of this magnitude. ”
How about that? Sounds like something big is about to happen. Moody’s calculates Chicago’s unfunded pension liability at around $30B, and observes: “Chicago’s adjusted net pension liability is sizeable on a nominal basis and relative to the city’s operating budget. In 2012, the city’s ANPL was 8.0 times greater than the city’s operating revenues.”
Chicago would seem to be on the verge of a full-blown financial crisis. The only prediction I can make is that something will have to give. The pension liability is constitutionally protected, so that will not be a part of the solution. The city could raise taxes, which is inevitable (and required by law). The state could help out was well, except for one thing: Illinois has the same problem. It has the same A3 rating as Chicago. Moody’s comment: “The General Assembly's inability to steer the state off its current path toward fiscal distress demonstrates not only the magnitude of the state’s unfunded benefit liabilities, but also the legal and political hurdles to significant reforms.” That doesn’t sound promising as a solution.
And then there’s the federal government. Back when Obama had the $900B stimulus money, he could have helped out (and indeed he did). But the stimulus is exhausted and the discretionary budget is sequestered. It should go without saying that Obama would love to bail out his hometown, now governed by his former chief of staff. Here it comes: “We need a new push to rebuild rundown neighborhoods. We need new partnerships with some of the hardest-hit towns in America to get them back on their feet.”
Unfortunately, Obama’s call for “new partnerships with some of the hardest-hit towns in America” does not echo very loudly at the House GOP caucus. It doesn’t appear at all on John Boehner’s to-do list. Chicago has very little representation on the red side of the aisle. No money from Uncle Sam unless the Dems win the midterms.
This drama will play out in Chicago, Springfield and DC over the next year. But back to Meredith Whitney: is there a Minsky Moment in store for the broader muni market? Well, there already is a Minsky Moment happening in Michigan, where a number of bond deals have had to be pulled. If Detroit gets away with defaulting on its GOs, that could impact the national market. The idea that debtholders are subordinated to government unions won’t go over well in the credit market. Credit spreads will widen, especially for “some of the hardest-hit towns in America”. They’re on their own.