July 30 (Bloomberg) -- Detroit’s bankruptcy filing is bringing added scrutiny to the finances of Chicago, as the Illinois city’s struggle to contain its murder rate and swelling pension costs leave it with the lowest credit grade in 26 years.
Moody’s Investors Service dropped Chicago’s rating three levels on July 17. A cut of that magnitude is unprecedented for a U.S. city as populous as Chicago, according to Moody’s data since 1990. Detroit, about 280 miles (450 kilometers) to the east, filed the nation’s biggest municipal bankruptcy the next day as $18 billion of debt compromised its ability to protect its citizens.
Chicago’s fiscal strains are taking a toll on its debt. In the $3.7 trillion municipal market, the extra yield buyers demand on some city bonds jumped 25 percent the week after Moody’s move, pushing interest rates to a two-year high. The credit rank of the third-biggest U.S. city is A3, four steps above junk and the lowest since 1987.
Detroit “should be a real warning sign and a great opportunity to get the political will behind them to really make some meaningful changes” in Chicago, said Paul Mansour, head of muni research at Hartford, Connecticut-based Conning, which oversees about $9 billion of local debt. “They’re not on a sustainable path.”
The timing of Chicago’s rating cut and Detroit’s bankruptcy highlighted similarities between the localities. Among the 20 largest U.S. cities, Chicago trailed only Detroit in the rate of population decline from 2000 to 2010. The number of Chicago residents sank 6.9 percent in the decade, to 2.7 million, Census data show.
The cost of fighting crime has added to Chicago’s financial stress. Chicago recorded 506 homicides in 2012, the most in four years. The city cut its homicide rate by 29 percent in the first half of 2013, partly by paying 400 officers overtime to police crime-ridden neighborhoods.
Democratic Mayor Rahm Emanuel, 53, told the Chicago Sun-Times in a July 20 article that Detroit’s bankruptcy “should be a wake-up call for all of those who try to put their head in the sand and say that we don’t have a problem” with employee pensions.
The mayor also drew contrasts with Detroit.
“Our economy is diverse, which is our strength,” he also said in the article. “We’re not tied to the auto industry.”
Kathleen Strand, a spokeswoman for the mayor, said via e-mail yesterday that she would reiterate what Emanuel told the paper.
Chicago’s annual pension obligation would jump from $467 million in 2014 to $1.2 billion a year later if state lawmakers don’t restructure the retirement system. The Chicago pension funds were created by the state, and changing them requires legislative approval.
Moody’s outlook on Chicago is negative because of the rising pension burden, meaning the city’s rating could be cut again. The New York-based company placed the city under review in April as part of a new way of analyzing retirement obligations that uses “market-determined” discount rates and asset values. Suburbs Evanston and Elk Grove Village lost their top grades under the new methodology.
Illinois’s biggest city now shares the state’s rating, which was lowered last month by Moody’s after lawmakers failed to restructure state pensions saddled with almost $100 billion in unfunded liabilities.
Chicago has advantages that insulate it from following Detroit’s path. Its citizens are wealthier, allowing the city to collect revenue to offset budget shortfalls, said Tom Metzold, who helps oversee about $28 billion as co-director of munis at Eaton Vance Management in Boston.
The median household income in Chicago from 2007 to 2011 was $47,371, compared with Detroit’s $27,862, Census Bureau data show. The median home value in Chicago over the period was $260,800, more than triple Detroit’s $71,100.
“Chicago has a spending problem, but they have the revenue to pay their bills if they make cuts,” Metzold said. “Even if Detroit made cuts, they still would have no way to raise revenue. That’s why the cuts have to be so severe.”
Detroit shows cities “have got to nip their problems in the bud,” said Richard Ciccarone, chief research officer at Oak Brook, Illinois-based McDonnell Investment Management, which oversees $8 billion of munis. Chicago has “serious issues that are going in the wrong direction.”
The additional yield investors demand to own Chicago general obligations maturing in January 2034 jumped 0.31 percentage point to 5.28 percent the week after the ratings cut, data compiled by Bloomberg show. The spread over benchmark munis widened 25 percent to 1.32 percentage points in that period and rose to about 1.5 percentage points yesterday.
In addition to Chicago’s $8.2 billion of general-obligation and sales-tax securities, Moody’s this month reduced its grade on $3.3 billion of water and sewer debt, $6.3 billion of bonds issued by the Chicago Board of Education and $876 million from the Chicago Park District. The combined tally of $18.7 billion represents more than 0.5 percent of the municipal market.
By comparison, Detroit has about $5.4 billion of utility debt and $2.5 billion of general-obligation bonds and securities for pension funding.
The cities’ schools illustrate how Chicago’s fiscal woes echo those of Detroit, though to a lesser degree.
Chicago’s public-school system, which Emanuel controls, faces a projected $1 billion budget deficit for this fiscal year, as Emanuel seeks to close 50 schools. In Detroit, about 200 buildings have been shut as enrollment fell in the past decade. The district has its own emergency financial manager.
Democratic Illinois Governor Pat Quinn, 64, has suspended pay to lawmakers in the fifth-most-populous state until they address the worst-funded pension systems in the U.S. Lawmakers failed to act July 9 during the latest special session Quinn called to address the issue -- the third time in the past 11 months they’ve done so.
“The problems in Illinois and Chicago-area credits are not incurable,” Mansour said. “The difference between Detroit and Chicago is they have more time to solve the problem. But every year it’s getting worse and worse.”
Issuance this week is set to slow as yields set a two-year high. Massachusetts is among municipalities selling a combined $5.1 billion, down from $5.5 billion last week.
At 2.92 percent, yields on benchmark 10-year munis are close to the highest since April 2011. The interest rate compares with 2.6 percent for similar-maturity Treasuries.
The ratio of the yields, a gauge of relative value, is about 112 percent. The greater the figure, the cheaper munis are compared with federal securities.
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