Time for Bond Investors, Especially in Chicago, To “Know What You Own”

Four U.S. cities went belly up recently, and all declared bankruptcy largely due to unaffordable government pension costs. The outcomes of these bankruptcies should make everyone think twice about lending money to cities with serious public pension debts.

The graphic below shows the outcome of the municipal bankruptcies in Vallejo, Detroit, Stockton, and San Bernardino, respectively.

Source: The graphic appeared in an excellent article on the status of public pensions in the United States by Ellie Ismailidou of MarketWatch titled “The Next Greece May Be In The U.S.

In Vallejo, Stockton, and San Bernardino (pending), the “plan of adjustment” left pension benefits intact. Pensioners were spared a haircut or even a slight trim.

Detroit was the exception. Motor City pensioners will take an 18 percent hit to their total benefits. This outcome should be worrisome to any current or future government retiree of a U.S. city with financial problems. But this 18 percent reduction is small change compared to the hurt inflicted on bondholders, who contested vigorously the final plans.

In Vallejo, bondholders were clipped 40 percent, while Stockton investors took a 59 percent hit. Detroit bond investors lost 88 percent of their holdings, while San Bernardino investors will likely be wiped out in the final agreement.

In Stockton’s bankruptcy, Franklin Templeton lost 59 percent of its holdings. In San Bernardino, Ambac Assurance Corp. and EEPK will likely lose 99 percent of their holdings.

Now let’s turn to Chicago, the nation’s third-largest city. On May 12, Moody’s Investors Service downgraded Chicago’s credit rating to junk status, making it the only major city to carry a junk bond rating from Moody’s. The downgrade applies to $8.9 billion of outstanding city debt, almost all of it general obligation bonds.

In June, Chicago Public Schools (also downgraded by Moody’s) said it will borrow $1 billion to make a $688 million payment to the teachers’ pension plan. The Chicago Public School Teachers’ Pension and Retirement Fund is underfunded by $10 billion. Chicago’s six public pension plans are collectively only 40 percent funded with a combined unfunded liability of $30 billion. The public pension plans in Chicago would likely collapse if not for infusions of money from bond investors.

In its May 12 downgrade announcement, Moody’s said that it expected:

Chicago’s credit quality will weaken as unfunded liabilities of the Municipal, Laborer, Police, and Fire pension plans grow and exert increased pressure on the city’s operating budget. In the near term, Chicago’s administration must comply with a 179 percent contribution increase to its Police and Fire pension plans in 2016.

To shore up police and fire pension funds, Chicago Mayor Rahm Emanuel is now proposing “the largest city property tax increase in modern history,” according to the Chicago Tribune. But there is no guarantee the Illinois state legislature will approve the tax hike.

Given all we know, I don’t want to hear a single complaint from a bondholder—qqqnot a peep—qqqafter they get burned in the next Chicago fire: a financial meltdown of historic proportions. Everyone should now know the rule: You lose your principal if you lend money to a city whose finances implode because of overwhelming public pension costs. The old chestnut applies: “Know what you own.”

Lawrence J. McQuillan is a Senior Fellow and Director of the Center on Entrepreneurial Innovation at the Independent Institute. He is the author of the Independent book, California Dreaming: Lessons on How to Resolve America’s Public Pension Crisis.
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