The potential insolvency of Chicago Public Schools and the stickiness of credit ratings
Is ratings shopping financially rewarded? The answer might be more complicated than it seems.
Photo Credit: Time http://topics.time.com/teachers/pictures/
The Chicago Board of Education (BOE) priced $300 million of bonds on April 21st in a follow-up to its March variable rate offering. Prior to its last offering, the BOE replaced Moody’s Investors Service with Kroll Bond Rating Agency as one of the three rating agencies whose ratings would be published in offering documents. Kroll is a relatively new rating agency in the municipal marketplace.
Standard and Poor’s rated the bonds A-minus (with a negative outlook); Fitch BBB-minus (with a negative outlook); and Kroll BBB-plus (with a stable outlook).
What might prompt the BOE to make this switch? Some market observers, myself included, have suggested that this is an example of ratings shopping.Janney Capital Markets has an excellent piece that explains how ratings shopping works:
Ratings shopping occurs when an issuer chooses to publish a rating from one agency that is higher than another. Sometimes an issuer will solicit ratings and then just choose to publish the highest. Oftentimes issuers will choose to publish a higher rating over a lower rating that was published during a previous financing. Rating shopping is not a new strategy and it is legal. From an issuer’s perspective, it makes all the sense in the world — especially when investors are not paying attention … By shopping for the highest rating, issuers can come out ahead as long as they are not excluding interested buyers by only publishing one rating.
Municipal market yields remain highly correlated with ratings. An issuer that has split ratings — meaning the issuer is rated at different levels by different rating agencies — could potentially have a financial incentive to publish the higher rating because this theoretically reduces the issuer’s borrowing costs.
The BOE has been riding the fence between investment grade and speculative grade (“junk”) ratings. It is likely that the BOE feared their rating would be cut to junk by Moody’s, as the agency has been the most aggressive in downgrading Chicago credits in recent years (although perhaps not enough). So the board opted to go with a rating agency that is trying to increase its market share. The issuer pays, after all.
Can the market spot ratings shopping?
If the board was shopping for ratings, its efforts were not directly rewarded.
The issue was oversubscribed, meaning that there were more than enough interested investors for the bonds to be sold. This is not surprising. Most municipal bond issues, regardless of credit, are oversubscribed now. Furthermore, several years of extraordinarily accommodative monetary policy has created an environment where yield-hungry investors (even ones who should know better) will throw their money at virtually anything.
That said, the yield that the BOE received indicates that market participants do not trust the rating agencies’ assessments. According to the Bond Buyer:
The top yield [on the BOE bonds] of 5.63% on a 25-year maturity landed 285 basis points over Municipal Market Data’s triple-A benchmark.
While the board’s rating remains in investment grade territory, its yields aren't.
Tuesday’s MMD scale put a mid-level, triple-B rated credit at a 3.78% yield on a 2039 maturity, underscoring just how severe a penalty the district paid. The Chicago Board of Education is rated between the BBB-minus level and A-minus.
An issuer with an A-minus credit rating borrowing at +285 is laughable on its face. This is hardly a unique event, however, despite the sharp and universal criticism that the rating agencies and issuers received for this very behavior during the financial crisis. Readers will recall that Puerto Rico was considered investment grade a little over a year ago. As with Chicago credits, Puerto Rico’s bonds were trading at junk levels for a long time before the rating agencies took action.
Although this makes the rating agencies seem reactive rather than proactive, they could legitimately reply that the market should not dictate their opinions.
Credit captivity and the indirect financial rewards of ratings shopping
All financial data and legal terms discussed from this point on come from the BOE’s 2015 offering documents.
The stickiness of ratings as issuers approach junk status is fascinating. When issuers are cut to junk, the number of investors that are willing or permitted to pick up their paper (under normal market conditions) shrinks. An issuer might also have a litany of contracts tied to its ratings — like interest rate swaps and credit lines — such that a downgrade could potentially have a serious impact on the issuer’s operations. An issuer thus becomes a captive of the rating agencies as its perceived creditworthiness deteriorates.
Both the City of Chicago and the Chicago Board of Education are captives in this sense. (I wrote about Chicago’s financial condition in an article on how the city used financial engineering to conceal the magnitude of its budget gap.) The persistent divergence between their credit ratings and the ratings that the yields on their bonds imply raises some interesting questions. Is there a resistance to cut issuers to junk because the rating agencies can profit from an issuer’s captivity? Or are the rating agencies perhaps self-conscious of the consequences of their downgrades? Or both?
Although the BOE’s debt is already trading at junk levels, formal downgrades are what has, and will continue to, jeopardize the board’s operations and destroy value for bondholders.
Downgrades from Moody’s and Fitch have already given the BOE’s counterparties the right to terminate the board’s outstanding interest rate swaps. The board is underwater (meaning it would be obligated to pay) approximately $228 million on these contracts. The last I heard was that the BOE is currently negotiating outcomes with its counterparties.
The board’s counterparties might be compelled to help the board navigate its financial situation, but that is not self-evident. There are resources available that the board could use to make these payments, including property tax revenues and the board’s debt service stabilization fund.
The BOE has reserved $174 million as a buffer to make debt service payments in the event that its budgeted revenues do not materialize. However, these funds have not been specifically pledged for the repayment of bonds and the board has not covenanted to maintain the debt service stabilization fund at any given level. Bond documents explain that the board has identified the fund as a potential source of liquidity to satisfy what it owes under its swap agreements. It is possible that the board’s counterparties will decide to take what they are owed before they have to fight other stakeholders for payments in court.
(One could argue that, perversely, the absence of a statute authorizing bankruptcy makes the latter a more attractive option, since any creditor-driven litigation in state courts is likely to be messy and unproductive.)
The BOE has approximately $1.1 billion of bonds and other borrowings that bear interest in a variable rate mode. Variable rate debt is extremely sensitive to an issuer’s perceived creditworthiness.
At least some of the board’s outstanding variable rate debt is structured akin to auction rate securities. It is unclear why any issuer would deem it appropriate to borrow in this fashion after the spectacular collapse of the auction rate securities market, but there you have it.
Variable rate debt has a nominal long-term maturity, but its coupon rate is reset periodically through the remarketing of the bonds. Investors have the option to put the bonds back to the issuer (technically, the tender agent) at any time with a specified notice. This is essentially forcing the issuer to buy its own debt, unless other investors are willing to step in to purchase the bonds themselves.
Typically, when an issuer uses a variable rate structure, the issuer obtains some sort of credit facility to backstop their debt — a letter of credit or a standby bond purchase agreement, for example — in the event of a failed remarketing. A failed remarketing occurs when there is not sufficient demand for the bonds. When a credit facility is in place, the debt does not carry the rating of the issuer. Instead, the debt carries the rating of the financial institution providing the credit facility.
Some of the BOE’s variable rate offerings do not include a credit facility. I would assume that this is because the board could not locate any financial institutions that would be willing to take on the board’s credit risk themselves. They would, on the other hand, be willing to transfer that risk to investors.
Because there is not a credit facility, the BOE would have to pay penalty interest rates upwards of 9% in the event of a failed remarketing. This would increase the board’s required debt service payments significantly. The increased debt service on these bonds would then crowd out the board’s ability to meet its other long-term financial obligations. Obviously, being cut to junk could potentially make this worst-case scenario a reality.
The BOE has $211 million of credit lines that are tethered to its ratings. Recent downgrades have already increased the interest rates the board pays. A cut to junk would be considered an event of default for some of this debt, which would give the banks various remedies, including increasing interest rates within a range of 9% to 13.5%.
This is all a very big deal for the BOE because the board depends on short-term borrowing to address its cash flow needs. According to the Chicago Tribune, state officials recently identified Chicago Public Schools as one of the 32 school systems in the state that had less than 30 days cash on hand.
If the BOE was ratings shopping, it is not a mystery why. Regardless of whether the board has a higher yield on its recent offering, it’s the rating agencies that could potentially set off a downward spiral.
The state Board of Education plans to give Chicago Public Schools a $33.3 million cash infusion from a $97 million pool that lawmakers created to help financially challenged schools. This will be a temporary source of relief.
Chicago Public Schools currently has a $1.1 billion funding shortfall. For the sake of comparison, this gap represents one-sixth of the school system’s operating budget. The BOE has little ability to transform its revenue situation. Approximately 43.8% of its budget comes from property taxes. State aid makes up 33.1% and federal funding makes up 17% — some of these funds are formulaic, but subject to appropriation, and some are discretionary, but they are mostly sources of funds that the BOE cannot control.
Mayor Rahm Emanuel has suggested that the state provide $700 million of income tax revenues to offset Chicago Public Schools’s pension obligations. Given the scope of the state’s funding shortfall and its own pension issues, this will probably be a difficult sell. On top of all of this, the school system is the subject of a federal corruption investigation, the scope of which remains unknown. It’s also not the first time this has been an issue.
How significant is the threat of bankruptcy?
It seems most conversations about Chicago credits keep coming back to this question. I believe there is a much stronger risk that the BOE ends up in bankruptcy than the City of Chicago. Let me explain why.
Governor Rauner has recently suggested that the BOE should be given a means of restructuring its obligations and legislation has already been introduced to authorize Chapter 9 filings in the state. For a municipal entity to be eligible to file for bankruptcy, the use of Chapter 9 has to be specifically authorized by the state in statute.
In my opinion, Detroit was the first strategic use of Chapter 9 that the municipal bond market has seen. Bankruptcy was hardly a last resort for Detroit. Even if one excludes the city’s prized art collection, which conveniently captured all of the headlines, the city had a large number of assets that could have been disposed of to meet creditors’ claims.
Some might argue that the BOE has several options for closing its funding shortfall. The logical extension of this observation is that a Chapter 9 filing would be strategic, not necessary. I am skeptical that these options will be sufficient if the board waits until it is cut to junk by more than one rating agency to pursue them. Furthermore, many of the solutions that have been proposed would provide non-recurring resources that would only delay the BOE’s insolvency.
As I have explained in previous essays, part of the political appeal of authorizing Chapter 9 is that it seems to present an opportunity for a municipal entity to adjust its pension liabilities, even when doing so is prohibited by statutory or constitutional provisions and has been fought by labor groups. Pension liabilities are one of the main forces driving the BOE’s current predicament.
Another part of the political appeal is the new phenomenon that bankrupt entities have not been locked out of the market. Market discipline might change, however, when/if the Federal Reserve restores some sanity to the credit markets.
A state bailout of the BOE could potentially require over a billion dollars, which the state doesn't have and state taxpayers are unlikely to embrace. It is worth noting that in all recent bankruptcies, states elected not to intervene. The Alabama legislature was so opposed to tax increases that it nixed one of Jefferson County’s primary sources of revenue, even though the county was insolvent.
Practically speaking, it does not matter whether a municipality is authorized to file for bankruptcy or not — the municipality can still be functionally insolvent. It is foolish to believe that the absence of a Chapter 9 authorization protects bondholders.
The reason Chapter 9 was created was to stop creditors from piling on an insolvent municipality in state courts to the extent that the municipality could not provide essential services to constituents. A government cannot be liquidated; it was established to serve a population in perpetuity. Chapter 9 allows a municipality to address claims through an organized process that (with the exception of Detroit) preserves value for everyone involved.
Illinois can fail to authorize Chapter 9 filings for political or well-founded moral reasons. But if the BOE continues on this trajectory, it will find itself sparring in state courts individually with unions (86% of the school system’s employees belong to unions), bondholders, swap counterparties, liquidity providers, you name it. And then the cost of saving the school system will only escalate. At some point, financial realities will eclipse the political climate.
Everyone should find the strategic use of Chapter 9 abhorrent and concur that it will not become any more attractive. Regardless of what financial market tourists say about the municipal bond market, there won’t be a landslide (avalanche/tsunami/insert miscellaneous hysterical metaphor here) of insolvent governments. Most state and local government issuers manage their finances effectively and value their creditworthiness.
But municipal market participants need to adapt to a new era, where it has become untenable for the costs of some governments’ years of over-borrowing, political dysfunction, and corruption to be redistributed to a larger population. One can no longer say that Chapter 9 cases are so rare and idiosyncratic that there are no legitimate precedents for anything. There are.
As a side note, one of the more interesting debates underway in the market is whether a state (or territory) can adopt laws permitting municipalities to undertake a large-scale restructuring that could result in the retroactive adjustment of their liabilities. This would apply to both Puerto Rico and Illinois. (See Bloomberg’s Municipal Market Brief, April 22, 2015) This is another thing to consider when handicapping the success of such legislation. Investors in recent offerings cannot claim that they did not know bankruptcy risk existed, however — a change in state law was explicitly listed a risk in the BOE’s official statements.
