Weekend Economists Piece for Peace April 3-5, 2015

[Demeter]

14. How Chicago has used financial engineering to paper over its massive budget gap

http://finance.yahoo.com/news/how-chicago-has-used-financial-engineering-to-paper-over-its-massive-budget-gap-144515066.html

Kristi Culpepper is a state government official with the Commonwealth of Kentucky. She handles the structuring and sale of bonds for schools across the state among other things. This post originally appeared on Kristi's excellent Tumblr. You can also follow her on Twitter.

(Editor’s note: The City of Chicago Mayor's office did not respond to multiple calls and emails seeking comment on the matter.)

This article explains that the City of Chicago has concealed how it has dealt with its budget gap over the past decade. The city failed to cut its recurring expenditures to match its recurring revenues after it blew through its reserve funds. Instead, two administrations have:

• Used long-term debt to finance everyday expenses and maintenance;
  
  
• Used long-term debt to finance judgments and settlements, including police brutality cases, and retroactive wage increases and pension contributions for its unionized employees;
  
  
• Restructured the city’s existing debt to extend the maturities on its bonds far out into the future in order to avoid having to pay the debt as it was coming due;
  
  
• Borrowed more money than it needed in order to make payments on the bonds its was issuing to avoid debt service expenses, essentially using debt to pay debt; and
  
  
• Possibly used the city’s portfolio of interest rate derivatives as an ATM.

State and local governments typically issue bonds to finance the construction of buildings and infrastructure that will benefit residents for generations. This article explains how Chicago residents have billions of dollars of debt and nothing to show for it.

***

Chicago made headlines at the end of February after Moody’s downgraded the city’s general obligation bond rating to Baa2. Moody’s has cut Chicago’s rating five notches in less than two years. This downgrade, however, placed the city’s credit below the termination triggers on some of its outstanding interest rate swaps. The city has been working to renegotiate the terms of those contracts with its counterparties. If Chicago’s general obligation rating falls below investment grade, the city’s credit deterioration will become a self-fulfilling prophesy. The city risks nearly $400 million of swap termination payments and the acceleration of its $294 million of outstanding short-term debt. Unsurprisingly, some of Chicago’s bonds are already trading at junk levels... That said, the rating agencies and most other market participants still appear to be light years away from understanding the true scope of Chicago’s financial problems. The city has a very — well, let’s just call it unconventional — approach to borrowing money and probably should not be considered investment grade.

Some budget history

In order for you to follow my discussion of Chicago’s borrowing shenanigans, it is necessary to understand the fiscal machinery behind its bond issues. Please be patient with me here. This story will blow your mind shortly...Chicago’s budget is divided into seven different fund classifications, but only three funds are relevant to our narrative: the Corporate Fund, Property Tax Fund, and Reserve Funds.

The Corporate Fund is Chicago’s general operating fund. This fund is used to pay for essential government services and activities (e.g. public safety and trash collection). Corporate Fund revenues are derived from a wide variety of sources, including: (1) local tax revenue from utility, transaction, transportation, recreation, and business taxes; (2) intergovernmental tax revenue, which represents the city’s share of the state’s sales and use taxes, income tax, and personal property replacement tax; and (3) non-tax revenue from fees, fines, asset sales, and leases.

Chicago’s property tax revenues do not go into its general operating fund. These revenues go into a Property Tax Fund, which is used to make debt service payments on the city’s general obligation bonds; make required employee pension contributions; and (to a minor extent) fund the library system. The fund also includes tax increment financing revenues that flow to projects in designated TIF districts.

The city used some of the proceeds from long-term leases of city assets to establish Reserve Funds. The Chicago Skyway reserve funds were established in 2005 in the amount of $975 million. The Metered Parking System reserve funds were established in 2009 in the amount of $1.15 billion. Of these funds, $475 million of the Skyway reserves were designated for budgetary uses. What remained was $500 million for the Skyway; $400 million for the Metered Parking System; and $326 million for a budget stabilization fund.

There has been a structural gap in Chicago’s Corporate Fund budget since at least 2003. Although most governments are required to balance their budgets on a cash flow basis each fiscal year, a structural budget gap can arise when recurring expenditures are greater than recurring revenues. Some of the city’s offering documents suggest that this gap is a legacy of the last economic downturn, but in reality the gap pre-dates the economic downturn by several years. The impact of economic downturns on tax collections tends to have a considerable lag anyway...So, Chicago’s structural budget gap is a political, not economic, creature. Rather than cut expenditures to a level that could be supported by recurring revenues, the city mostly used non-recurring resources to fill the gap from one fiscal year to the next. This is not surprising. Most of Chicago’s Corporate Fund budget goes to salaries and benefits for its employees, and 90% of the city’s employees belong to around 40 different unions. Attempts to adjust expenditures tend to have well organized opposition.

Between fund transfers and drawing down its reserves, the city blew through its financial cushioning quickly. The $326 million budget stabilization fund was exhausted by 2010. From 2009 to 2011, the city used $320 million from the Metered Parking Reserves. The city’s budget gap was at its widest in the wake of the last economic downturn, at over $600 million.

Chicago’s dysfunctional debt program

Now things start to get interesting. Transfers from reserves and other funds have not been the only means Chicago officials (across administrations) have devised to subsidize the city’s Corporate Fund. The city has effectively been using its general obligation bond offerings and interest rate derivatives to accomplish the same thing.

AND IT GOES ON AND ON AND ON....LIKE DETROIT, WITHOUT KWAME.