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Sunday, March 01, 2015 11:25 PM

Chicago's Fiscal Freefall: Moody's Cuts Chicago Credit Rating to Two Steps Above Junk; Snake Oil and Swaps; It's All Junk Now

Last week I wrote an article for the Illinois Policy Institute on the hugely unfunded and deteriorating nature of numerous Illinois' pension systems.

I will post the article on Monday. 

My article was on on state pension systems, not Chicago's, and was written well ahead of downgrades of Chicago's debt by Moody's on Friday. I was not surprised to see the downgrade.

Let's take a look at some articles on the debt downgrade starting with Chicago Credit Rating Cut by Moody's to Two Steps Above Junk.

Chicago had its credit rating cut to within two steps of junk by Moody’s Investors Service because of mounting pension liabilities, underscoring the city’s fiscal stress as Mayor Rahm Emanuel faces an unprecedented runoff.

The one-step reduction to Baa2 affects $8.3 billion of general-obligation bonds, which were already the lowest-rated among the 90 biggest U.S. cities, excluding Detroit. The outlook remains negative, signaling more cuts are possible, New York-based Moody’s said Friday in a report.

“The city’s credit quality could weaken as unfunded pension liabilities grow and exert increased pressure on the city’s operating budget,” Moody’s analysts Matthew Butler and Rachel Cortez wrote. “We expect substantial growth in unfunded pension liabilities even if the city’s recent pension reforms survive an ongoing legal challenge.”

The third-most-populous U.S. city has $20 billion in unfunded pension obligations that it can’t address without the approval of the state legislature. State lawmakers in June restructured two city pension plans with about $9.4 billion in underfunded liabilities for about 60,000 municipal workers and retirees by making them pay more and reducing benefits. The changes didn’t apply to the police and fire systems.

Labor unions in Chicago sued to block the law in December, and the litigation was put on hold pending the outcome of an Illinois Supreme Court ruling on a state pension overhaul.
Chicago May Owe Wall Street $58 Million After Moody’s Rating Cut

To add insult to injury, Chicago May Owe Wall Street $58 Million After Moody’s Rating Cut
Chicago may have to pay $58 million to unwind interest-rate swaps after Moody’s Investors Service cut the city’s credit rating within two steps of junk because of mounting pension liabilities.

The reduction on Friday to Baa2 affects $8.3 billion of general-obligation bonds, which were already the lowest-rated among the 90 biggest U.S. cities, excluding Detroit. The outlook remains negative, signaling more cuts are possible, underscoring the city’s fiscal stress as Mayor Rahm Emanuel faces a runoff election.

Because of stipulations in four of the city’s swaps contracts, which it entered into as a hedge, the rating cut may terminate the agreements early and trigger the $58 million cost, Moody’s said in a report. The city is also closer to ratings that may force an additional $133 million of payments.

“This is a very significant, negative development for the city of Chicago’s financial position,” Laurence Msall, president of the Civic Federation, a nonpartisan research group in Chicago, said in an interview. “This is a very big deal.”

Swaps agreements, which issuers enter into with banks, exchange fixed interest payments for floating ones. They’re designed to cut borrowing costs. They can backfire when interest rates move in an unexpected direction, as happened in the U.S. with the Federal Reserve keeping its overnight target close to zero since 2008. Most swaps can be ended if one party fails to maintain a minimum credit rating, requiring payment of the entire amount due.

Chicago has 15 agreements tied to variable-rate general-obligation debt and one to variable-rate sales-tax bonds, according to Moody’s. While the company said the city has the resources to cover the $58 million payment, it said the cut moves Chicago closer to further termination payments triggered by going below Baa2 or Baa3.

Chicago, like Illinois, has struggled with rising pension costs. The city is obligated to pay $600 million into four pension funds in next year’s budget, though Standard & Poor’s said the contribution may be delayed after Feb. 24 elections led to a runoff vote between Emanuel and Jesus “Chuy” Garcia.
Fiscal Freefall

Reuters has still more gloomy details in its report Chicago Nears Fiscal Free Fall with Latest Downgrade.
Chicago's finances are already sagging under an unfunded pension liability Moody's has pegged at $32 billion and that is equal to eight times the city's operating revenue. The city has a $300 million structural deficit in its $3.53 billion operating budget and is required by an Illinois law to boost the 2016 contribution to its police and fire pension funds by $550 million.

Cost-saving reforms for the city's other two pension funds, which face insolvency in a matter of years, are being challenged in court by labor unions and retirees.

State funding due Chicago would drop by $210 million between July 1 and the end of 2016 under a plan proposed by Illinois Governor Bruce Rauner.

Moody's said Chicago's rating could be cut if Illinois courts find pension reform laws enacted to shore up the state's financially ailing pension system and for two of Chicago's retirement systems are unconstitutional. A ruling by the Illinois Supreme Court on one of the laws could come as early as this spring.

S&P warned of a multi-notch downgrade if the city fails to come up with a sustainable plan this year to pay its escalating pension contributions.

In a report, Moody's noted that the downgrade to Baa2 moves the city closer to termination of 11 more swaps deals. Termination on those contracts would potentially cost Chicago an additional $133 million, Moody's noted.
Snake Oil and Swaps

When a snake oil salesman at the country fair says his potion will cure you of whatever ails you, you can rest assured the following three things will happen if you try some.

  1. It will taste terrible.
  2. It will not work.
  3. You will wish you didn't buy it.

Similarly, when Wall Street peddles swaps, the following things are highly likely, if not virtually guaranteed.

  1. The contracts will be extremely one-sided with many loopholes for the Street and none for the city.
  2. The swaps will cost the city that enters them lots of money, and the termination fees will be excessive.
  3. Cities will wish they never entered into the agreement.

Musical Tribute

As music fans might have expected, I have musical tribute to honor the city of Chicago and the state of Illinois. Although I like "My Kind of Town", I have a more appropriate offering in mind.

Link if video does not play: Paper Lace - The Night Chicago Died (Live)

Blue Ribbon Awarded

Illinois gets the blue ribbon for being the lowest-rated state. However, credit raters differ on Chicago.

  • Moody's rates Chicago at Baa2, two steps above junk.
  • S&P grades the city A+, the fifth-highest rank and four levels above Moody’s. 
  • Fitch Rates Chicago two steps higher than Moody’s. 

The S&P and Fitch have it wrong. Both will eventually catch up.

And if the pension crisis is not fixed (it won't be), Chicago and numerous other Illinois cities will all be junk rated.

In retrospect, I offer this thought "It's All Junk Now!". All that remains is for the credit rating agencies to catch on.

Mike "Mish" Shedlock

7:09 PM

Austria "Bad Bank" Goes Bad, $8.5 Billion "Bail-In" Underway

This entire notion that you can take bad assets from a bank and put them in a "bad bank" to make everything well, is ridiculous. Today we see yet another failure of the construct.

Reuters reports Austria Imposes Debt Moratorium on Heta "Bad Bank"

Austria's Financial Market Authority stepped in on Sunday to wind down "bad bank" Heta Asset Resolution and imposed a moratorium on debt repayments by the vehicle set up last year from the remnants of defunct lender Hypo Alpe Adria.

The step, allowed by new legislation that gives banking supervisors more power to intervene, followed an outside audit of Heta's balance sheet that exposed a capital hole of up to 7.6 billion euros ($8.51 billion) which the government was not prepared to fill, the FMA said.

The moratorium on repayment of principal and capital lasts until May 31, 2016, giving the FMA time to work out a detailed plan to ensure equal treatment of all creditors, the FMA said in a decree published on its website.

More than 9.8 billion euros worth of debt is affected, including senior notes worth 450 million due on March 6 and 500 million on March 20.

The finance ministry noted that creditors can be forced to contribute to the costs of winding down Heta - or "bailed in" - under new European legislation that Austria adopted this year so that taxpayers do not have to shoulder the entire burden.
Not Insolvent?!

In an absurd statement, the finance ministry added "Heta was not insolvent".

In summary: Repayments on Heta's bonds have been suspended, there is a capital shortfall of $8.5 billion, a bail-in is needed, and taxpayers do not have to share the "entire burden", but the bank is not insolvent.

And by the way,  isn't separating out the "bad bank"  supposed to make what's left of the "good bank",  good? I ask because Heta is what's left of the "defunct" lender Hypo Alpe Adria.

It seems the good bank and the bad bank are now effectively defunct.

Mike "Mish" Shedlock

2:37 PM

Australia's Mining Bust Turns Towns Into Ghost Towns; Expect Interest Rate "Shock and Awe"

As Australia's mining boom turns to bust, Towns are Dying the Death of a Thousand Cuts as Miners Leave in Droves.

Locals say the main street of Dalby resembles a ghost town these days – a sad indication of a mining boom ending too soon for some.

Things have taken a turn for the worse since the glory days of the mining construction boom, with companies responding to falling commodity prices by pulling the plug on new projects and laying off workers across the Surat Basin.

The increasing exodus of workers, investment and money from the mining towns has left houses empty and businesses struggling, with many of those left behind wondering what to do next.

Di Reilly, owner of Mary’s Commercial Hotel on Dalby’s Cunningham St, said much had changed since 2013 when thirsty miners packed into the pub every Friday and Saturday night.

“We used to open the old bar up and the whole place would be chock-a-block,” she said.

Things were going so well that Ms Reilly began a revamp of the pub before the numbers tapered off, leaving her with a half-renovated bar and plummeting income.

The old bar now sits unrenovated and empty, a dusty reminder of plans gone awry.

“They were saying it was going to last 10 years but it hasn’t,” she said.

“I was going to do the whole pub up, so I was banking on it that they would be here a little longer than they were, but it just stopped all of a sudden. It just got cut off.”

The impact on her bottom line has been astonishing, with turnover last December down $100,000, slashed in half from the previous year.

Down the road, electronics retailer Colin Fountain speaks of the boom in the past tense.

“I’ve definitely noticed a slowdown. Sometimes when you look down the street you’d think you were in a ghost town,” he said.

Further west in Chinchilla, the effects of the mining construction boom have mainly been felt in the real estate sector, where rents and house prices doubled from cashed-up workers arriving in the town.

Long-term residents said many pensioners had been forced to leave because of high housing prices and now that prices had fallen some weren’t coming back.

One real estate agent said “a hell of a lot” of property was on the market – about 400 houses were for rent or sale and buyers were scarce.
Record Low Interest Rates

On February 3, and in response to tumbling oil and mineral prices, and irrational deflation worries, Australia Cut Interest Rates to Record Low.
Australia cut its benchmark interest rate to a record low of 2.25% Tuesday, joining a procession of central banks that have eased policy settings this year in response to the deflationary impact of tumbling oil prices.

The 0.25-percentage-point cut represents a dramatic shift for the Reserve Bank of Australia—which ended 2014 with a message to financial markets that interest-rate stability was likely to feature again in 2015, to help underpin certainty for businesses and support the economy as a mining-investment boom fizzles out.

The Australian dollar fell sharply on the announcement of a cut, dropping to a fresh 5½-year low, while the stock market surged to the highest level since May 2008.

The Reserve Bank of Australia joins the Monetary Authority of Singapore, Reserve Bank of New Zealand, European Central Bank, Bank of Canada and the central banks of India, Denmark and Switzerland in either announcing substantial policy shifts or easing monetary settings—in some cases dramatically—since Jan. 1.

Throughout last year, Australia’s central bank repeatedly stressed it would be appropriate for rates to remain stable for some time. It removed that reference on Tuesday, leaving open the door to more cuts.

In Tuesday’s statement, Mr. Stevens said the jobless rate—currently 6.1%—would likely peak a little higher than had been anticipated.
Definitions Needed

I need a definition of "little" and also a definition what had been "anticipated".

The statement made by Stevens can literally mean anything. Most likely, little really means little. And given that central bankers are totally clueless, it's highly likely what had been anticipated was far too low.

Thus, vagueness aside, I will bet on the "over" line, "way over" in fact. With no recession in 23 years, and with wages and prices of goods dramatically out of line with the rest of the world, and with one of the world's biggest property bubbles, the upcoming recession in Australia will be a doozie.

Expect Interest Rate "Shock and Awe"

Australia has room for 9 quarter point cuts before zero is hit. But cuts won't happen that way. Accompanied by some sort of shock-and-awe statement, I expect Australia to cut rates 100 basis points or more at some point.

Addendum - "Houses and Holes" - Tweet from Steve Keen

Shortly after finishing the above, I heard from Steve Keen who emailed ...

"Good read mate--I've tweeted it. It's rather weird to watch my home country as an observer from England now. A colleague describes Australia's economic policies as 'Houses and Holes', and that about sums it up. Now all that's left is a property bubble and flogging our real estate to overseas borrowers--which coincidentally pretty much describes economic policy in the UK as well."

Mike "Mish" Shedlock

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