How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
– Ernest Hemingway, The Sun Also Rises
Chicago and Illinois are in dire financial straits today as a result of decades of financial mismanagement. While not yet technically bankrupt, Chicago and Illinois are headed into a bankruptcy-like restructuring of their financial obligations at some point within five years. I provide this opinion without any inside knowledge of Chicago or Illinois politics; I read the same newspaper articles that everyone else reads. I am basing my opinion about a looming Chicago bankruptcy and Illinois bankruptcy on simple math and finance concepts.
What Happens to Chicago as It Approaches the End of the Road?
If you are a saver and an investor, the law of compound interest is a wondrous phenomenon. With compound interest, your net worth grows over time as you generate income on your invested capital which you can then reinvest to generate even more income. It’s particularly important to save early in your life, so that time and the compound interest has more time to grow before you eventually retire.
If you are a significant debtor, as Chicago and Illinois are, the law of compound interest is a toxic force which can drive you into bankruptcy just as soon as its lenders stop providing the financing. Moreover, compound interest is particularly toxic when a municipality mismanages their finances for decades like Chicago and Illinois have. With compound interest, debts and pension deficits compound over time until they eventually become unmanageable.
After many years, the debt level and pension obligations of Chicago and Illinois have become so large that there is no way out, short of a miracle (such as a Federal bailout).
Brief Overview and Quantification of the Financial Problem for Illinois and Chicago
For Illinois, the state has $31.5 billion in general obligation (GO) bonds, $15 billion of unpaid bills that are due, and, most importantly, an unfunded pension liability which grew to $251 billion on June 30, 2016. The Illinois House and Senate passed tax increase over the Governor’s veto in July 2017, but it wasn’t enough to keep Moody’s from putting the state on negative outlook with a threat to downgrade Illinois bonds to a junk rating.
A junk rating means that an issuer’s bonds are too risky and not credit-worthy enough to be considered investment grade; for now, there are no states with a junk credit rating.
Unlike Illinois, Chicago’s bonds are already junk rated (Ba1) by Moody’s and are also under review for another possible downgrade. Relatedly, the deep junk bonds of the Chicago Board of Education, already rated B3, are under review for a further downgrade due to state budgetary pressures. The pension systems of Chicago and the Chicago Public School system are also deeply underfunded, by $35 billion and $9.5 billion, respectively.
Here is how the vicious cycle is currently working:
- Debts are rising exponentially.
- Pension underfunding levels are increasing exponentially.
- Because of #1 and #2, interest payments and pension obligations are consuming state and city budgets.
- Because of #3, taxes and fees keep rising, while service levels keep declining.
- Because of #4, taxpayers are leaving the city and state, making the financial problems even worse.
It’s obviously not a pretty picture. It’s easy to blame current politicians for the current mess, but the truth is that everyone is doing their best to sort through a bleak and impossible-to-fix financial mess.
How Are You Going to be Affected by this Mess?
The fiscal quagmires in Chicago and Illinois will cause significant problems for many people:
- If you are a residentor business owner in Chicago or Illinois, this could affect your taxes and your property value. Services will also keep declining, which means fewer police officers and larger classroom sizes.
- If you are a current or former employeeof the city of Chicago or the state of Illinois, this could affect your job, your salary, and your pension.
- If you are a municipal bondinvestor who bought Chicago and Illinois muni bonds due to the juicy yields they provide, this could affect your ability to get 100% of your principal back.
- If you are a municipal bond insurer, you might have a significant financial obligation if Chicago or Illinois default on their bonds.
- If you are one of the cities and states across the country with similar pension problems as Chicago, this could raise the interest rate that you have to pay for the bonds that your municipality issues.
- If you are a S. policymaker, this could create financial instability that might hurt the fragile U.S. economy.
In short, this is a problem will directly or indirectly affect a lot of people.
The comparison between Illinois and Greece is not an altogether bad one. For both Illinois and Greece, financial insolvency is eroding civic life in both places. In some ways, Greece is actually better positioned than Chicago, because Greece owns a couple of ports which are strategically located in the Mediterranean Sea and coveted by China. Earlier this year, Greece recently sold the Port of Piraeus to China to raise much-needed funds. Chicago has Navy Pier and Oak Street Beach, which are both great places, but China couldn’t care less about them.
Navy Pier, Chicago, Illinois.
A Framework for Interpreting Future Events as they Unfold
As this the finances of Chicago and Illinois continue to worsen at an accelerating pace, it’s important to keep the following four ideas in mind:
#1: Illinois and Chicago policymakers will do their best to kick the can down the road to delay a reckoning. Both Democrats and Republicans do not want to see a bankruptcy on their watch. Instead, they will continue to provide band-aids, hoping that they will be out of office by the time a default happens. Politicians never choose to make unpopular decisions until outside forces force the issue, and all of the choices they currently face are unpopular ones.
#2: Two chances exist for a grand compromise fix: slim and none. In the current partisan environment, Republicans will almost certainly avoid compromises that result in higher taxes, while Democrats will resist any compromises that cut spending. Also, even if there is a grand compromise, the toxic force of compound interest is too large to stop at this point.
#3: The longer the wait, the worse it will be for all stakeholders: The delay until an eventual default is bad for almost all stakeholders involved except the politicians. With continued delay…
- …the pension underfunding situation will worsen, harming pensioners who are counting on Chicago and Illinois to deliver on their promises.
- …city and state services will continue to decline, which will affect the effectiveness of the schools, public safety, and the quality of life.
- …more taxpayers will flee the state due to declining services and higher taxes.
- …and the debt burden of Chicago and Illinois will worsen, as the city and state issue more bonds to push off the inevitable.
#4: There’s a reasonably good chance for a Federal bailout. The Federal Reserve does not want to create financial instability because the U.S. economy is just too fragile to handle it. To provide financial stability, the Federal Reserve has already provided capital to support or bail out banks, the housing market, stocks, bonds, and mortgage-backed securities during the past decade. The municipal bond market is an enormous, $3.7 trillion market, and, according to Bloomberg, the municipal pension under funding situation nationwide is approaching $2 trillion. These figures are easily large enough to get the attention of Congress and the Federal Reserve.
The Math of Compound Interest Applied to Pension Funds
#5: If a default occurs, expect a wealth transfer from creditors to debtors. Investors in Chicago municipal bonds and Illinois municipal bonds, who are typically high net worth individuals in the highest income tax bracket, will see steep haircuts on their investment principal. Pensioners, which include middle-class retirees, many of whom used to be teachers, policemen, and firemen, should fare much better.
What is the Likely Catalyst for a Chicago Bankruptcy or an Illinois Bankruptcy?
As long as bond investors are willing to buy the bonds issued by Chicago and Illinois, the party will continue as the financial distress slowly worsens. To use Hemingway’s terminology, Chicago and Illinois are still in the gradual phase of becoming bankrupt.
The sudden phase of bankruptcy, in all likelihood, occurs when one or more of the following occurs:
- The economy enters another recession, which would suddenly have a detrimental impact on tax revenues.
- The stock market declines significantly, which would suddenly blow a large hole in pension plans that are dependent on 7% annualized investment returns.
- The bond market decides it doesn’t like risk anymore, which would suddenly make it difficult for municipalities with a risky credit profile to issue more debt.
How Does this Affect Your Financial Situation?
I don’t know what your individual financial situation is, so it’s impossible for me to provide specific personalized financial advice. However, I will provide make some general comments.
- If you are a resident of Chicago or a resident of Illinois,you should prepare and budget for higher taxes. Illinois just raised income taxes, but you will probably experience more tax hikes in the coming years.
- Ifyou are a municipal bond investor, you might want to consider investing in municipal bonds outside of Illinois where the risk/reward profile looks more attractive.
- If you are a former employee of Chicago or Illinoisand you have the option to roll your Chicago retirement plan into an IRA, you should consider doing so. I have a client who is a former teacher that did exactly this.
- If you are a current or prospective investor in Chicago real estate, you should prepare and budget for your property taxes to rise.
How do you think the end game plays out?
This information is prepared for informational purposes only and is not intended as an offer or solicitation for any service. The comments should not be construed as a recommendation of any particular strategy. There is no guarantee that the type of investments or strategies discussed herein will outperform any other investment strategy in the future. The views expressed are those of the authors as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions.