Photographer: Jeff J Mitchell/Getty Images

School of Debt: How to Bankrupt Public Education, Chicago-Style

  • Nation's third-largest district is drowning in pension bills
  • Retirement fund is $9.6 billion short after skipped payments

Most people in Chicago’s City Hall probably recall a moment of clarity, a little voice whispering, this can’t last.

Maybe it came in 1979, when the city’s schools nearly went broke. Maybe it came in the late 1990s, when no one funded the teachers’ pensions. Or maybe, finally, it came this month, when the nation’s third-largest public school district, with almost 400,000 students, once again slid toward the brink.

Today the Chicago public schools are in such dire straits that officials from the Illinois governor down wonder aloud about its solvency. Yes, a few other big-city systems, like Detroit’s, are in worse shape. But nowhere else in American public education have local mismanagement and Wall Street engineering collided so spectacularly.

The numbers tell the story. The teachers’ retirement fund is short about $9.6 billion. The school system owes more than $6 billion to its bondholders. On Wall Street, Chicago schools have the makings of following the same path as Puerto Rico, which is struggling with a $70 billion debt crisis.

“They’ve run out of road,” says Dick Simpson, a former city alderman who teaches political science at the University of Illinois at Chicago.

How did it come to this? Among the many culprits, real or perceived, are recalcitrant unions, inept administrators, feckless politicians and self-interested bankers. But, in the end, the simple answer is this: too much debt. The budget math is sobering. Since 2007, actual district spending has soared by more than a third, even as enrollment has fallen 4 percent.

It might be tempting to blame the people running things now. In truth, this crisis has been decades in the making. And, by the look of things, it will drag on and on, with one patchwork fix after another, until Chicago, the state of Illinois or Wall Street demands otherwise.

Rahm Emanuel, the current mayor, was still studying dance in college when the bottom fell out the first time, in 1979. That year, the city’s schools were shut out of the bond markets and couldn’t pay their teachers. The answer was to create the Chicago School Finance Authority, a new entity to oversee budgeting, the following January.

Almost two years later, the school board bought peace with the Chicago Teachers’ Union, by agreeing to cover almost all pension contributions. That wildly generous deal was supposed to last a year. Instead, officials renewed it every year for decades -- the first in a series of decisions some warned would prove disastrous.

“Projected costs become infinite,” Walter John Hickey, a research associate with a local fiscal watchdog, the Civic Federation, told the school board at a public hearing in 1983. “This is an unnecessary expenditure this system cannot afford.”

By the late 1980s, Chicago’s schools were being held up as a national disgrace. William Bennett, then U.S. education secretary, called the system the worst in the country.

Before long, Chicago was reaching for a Plan B. In 1995, Jim Edgar, then governor of Illinois, and the state legislature effectively pushed aside the finance authority and handed control of the schools to Mayor Richard M. Daley. The idea was to put more power into local hands.

For awhile, the plan worked. Paul Vallas, Daley’s first schools chief, was widely praised for shoring up the system’s finances and keeping the pension plan funded.

But in giving Daley control over the school board, Edgar and the legislature also allowed the district to reduce or skip pension payments. Which is exactly what it did -- every year from 1996 to 2005, a period when the district should have contributed $2 billion, according to actuarial estimates compiled by the pension fund.

“If you look at CPS, you see the same pattern of deferral, of borrowing, of negotiating collective bargaining agreements you can’t afford,” says Vallas, who went on to oversee school districts in Philadelphia, New Orleans and elsewhere. “You can almost chart the course of the decision-making and the financial deterioration.”

The Chicago board started making contributions in 2006 but by 2010 was asking for another “pension holiday.” Within three years, that left the pension fund short by an additional $1.2 billion.

Looking at today’s crisis, Edgar points to an obvious problem: a desperate lack of financial discipline. In that regard, Wall Street didn’t help. Like Detroit and others, Chicago embraced financial derivatives that were supposed to protect its school system against an abrupt rise in interest rates.

The district sold $1 billion of auction-rate securities that were mostly tied to interest-rate swaps from 2003 to 2007, pushed by officials including David Vitale, chief administrative officer of the schools under Daley and later board president under Emanuel. As outlined in a three-part series by the Chicago Tribune, units of Bank of America and the Royal Bank of Canada enjoyed hefty interest payments from the schools’ bonds even as the market unraveled.

When rates plummeted during the financial crisis, Chicago’s wrong-way bet drove the system even deeper into trouble. In the last year alone, exiting the swaps has cost the district hundreds of millions of dollars. Similar deals helped drive Jefferson Country, Alabama, into bankruptcy and exacerbated the problems in Detroit.

Things could be worse before they get better. Illinois Governor Bruce Rauner, a Republican, has been calling for the state to take over the Chicago school system, which recently delayed a bond sale because of the anxiety over its finances.

“We are in a position partly because of things that were done in years past,” Emanuel, a Democrat, told reporters at City Hall last week. He suggested that the governor’s recent comments have made matters worse. Rauner, who knows how the capital markets work from his previous life in private equity, promoted bankruptcy authorization as a fix for the schools in the days leading up to the latest borrowing.

No clear answer is in sight. For years, Chicago’s school system has pledged to cover a far greater share of its teachers’ pension contributions than its counterparts in New York and Los Angeles. As of this month, that practice is ending. And for Chicago, Illinois kicks in just $31 per student per year. Other districts in the state get nearly $2,300 per student.

Remarkably, student performance has improved as the financial condition crumbled. The graduation rate in Chicago public schools climbed to almost 70 percent last year, compared with just under 57 percent in the 2010-2011 school year. Last year’s average ACT score of 18.2 was the highest measure on record, according to the district’s data.

But school officials have warned that these hard-fought gains could be jeopardized by the financial crunch. Almost 50 schools were closed in 2013, and, since July, more than 1,000 employees have been let go.

Edgar lays the blame squarely at Chicago’s feet. “I think they kind of blew it,” he says.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE