by Triet Nguyen, Managing Director
The City of Big Shoulders is carrying a heavier burden these days. On May 12, Chicago received the dubious honor of becoming the only major U.S. city, apart from already-bankrupt Detroit, to be downgraded to below investment grade, or “junk”, as commonly referred to by the media. This came courtesy of Moody’s Rating Services, which took Chicago’s rating down two notches to Ba1 just ahead of a new bond offering from the city. Unfortunately, the rating agency’s downgrade also had the effect of triggering events of default under some of the city’s swap agreements and credit facilities, thus creating a short-term liquidity crisis for Chicago, and raising some interesting issues about the potentially self-fulfilling nature of credit ratings.
The catalyst for the downgrade, according to the rating agency, was the prior week’s Illinois Supreme Court decision invalidating Illinois’ 2013 pension reform effort. While the court ruling only dealt with the state’s problem, Moody’s interpreted it as further constraining the city’s ability to fix its own ballooning pension funding problem.
The downgrade, coupled with growing investor concern about a potential bankruptcy filing by the city, has led to a significant selloff in Chicago GOs and bonds for related local entities, such as the Chicago Board of Education. As the chart below shows, credit spreads on Chicago GOs have blown out to as wide as 300 basis points over AAA before settling in at the end of last week at around +275.
Figure 1: Credit spreads (in basis points) for Chicago 10-year GOs vs AAA (4/1/14-5/18/15)
Sources: Municipal Market Data & Interactive Data Corp
Faced with escalating interest costs, Chicago’s financial team was forced to postpone its planned bond offering while it negotiates a forbearance agreement with the banks who are counterparties to the swap agreements and other liquidity facilities. Fortunately, over the weekend, the city was able to obtain such forbearance and is now ready to proceed with the bond issue as early as today.
Not surprisingly, Moody’s action has restoked the ongoing debate about the role of rating agencies in the post-financial crisis world.
For most state and local governments, the General Obligation (GO)/ Full Faith and Credit rating stands as the ultimate measure of a community’s economic and financial health. No mayor, let alone the chief executive of the third largest city in the nation, likes to see headlines about “Chicago Rated Junk” plastered all over corner newstands (or these days, online news flashes). Predictably, Mayor Rahm Emanuel has lashed out at Moody’s, calling the agency’s action “irresponsible”. Never mind that the Mayor himself had just won a hard-fought re-election campaign by suggesting to the electorate that only he can stop Chicago from becoming the next Detroit!
To be honest, complaints about rating agency downgrades don’t usually revolve around the actual basis for the rating actions–but around their timing. And historically, rating actions, particularly downgrades, tend to come too late, as opposed to too early, at least in the view of market participants.
In that context, could it be that Chicago is paying for the sins of Puerto Rico? Lest we forget, the Caribbean island’s GO rating was still investment grade as recently as February 2014. Barely over a year later, Moody’s rating for the Commonwealth now stands at Ca2, only two notches from an actual “D”, as in “Default”. According to many market observers,particularly those endowed with the tremendous gift of hindsight, if trading levels were any indication, Puerto Rico ceased to be of investment-grade quality many years ago. In Puerto Rico’s case, all the rating agencies were woefully late in recognizing the island’s deteriorating economic conditions and perennially suspect deficit financing practices.
Furthermore, we can speculate that the Puerto Rico situation has sensitized the rating agencies to a new risk factor in munis: liquidity and market access risk.
So isn’t it ironic that, for once, a rating agency tries to be ahead of the curve and ends up being roundly criticized for “acting prematurely”? The folks at Moody’s must think they just can’t win. Although there is still disagreement about whether or not the Windy City deserves its “junk” status, such divergent opinions appear to be coming primarily from embarrassed local politicians and other rating competitors eager to distance themselves from a politically sensitive issue involving a major client. Most independent credit analysts, ourselves included, would tend to agree with Moody’s assessment. The magnitude of Chicago’s pension funding problem is certainly unique among all major U.S. cities, particularly in the wake of the adverse Illinois Supreme Court decision.
Yet the timing question still remains: should Moody’s have pulled the trigger just ahead of a Chicago bond issue to refinance its variable rate debt? In doing so, the rating agency created a self-fulfilling credit event: the downgrade triggered events of default for some of the city’s swap agreements and liquidity facilities, which in turn triggered a short-term liquidity crisis as the counterparty banks gained the right to accelerate those agreements. But let’s face it, any issuer who is susceptible to this kind of short-term liquidity crisis just cannot be viewed as investment grade (exhibit number one: Puerto Rico).
By waiting until after the issue had come to market, Moody’s would have run the risk of sand-bagging the investors who may have bought into the deal. Also, an after-the-fact downgrade would’ve come across as a retaliatory move for not being hired to rate the new issue. Thus, all in all, we believe Moody’s did the right thing under these rather tricky circumstances.
The other rating agencies (S&P and Fitch) had no choice but to follow Moody’s lead with their own downgrades, although they both stopped short of taking Chicago to “junk” level. Kroll Ratings did stick to its guns in re-affirming its “A-” rating for Chicago even as the firm reluctantly acknowledged that “another rating agency’s” action created a liquidity event for the city.
Competitive gamesmanship aside, the problem doesn’t lie in any disagreement among the bond raters. Ratings are just credit opinions, pure and simple, and we should expect to see sharp differences of opinion every once in a while. In fact, why pay for three sets of ratings if they always toe the same line?
No, the true problem once again lies in the fact that agency ratings have become so woven into the fabric of our financial markets that they have become risk factors in and unto themselves. Having been through the “Great Financial Crisis”, we certainly don’t need to beat on that dead horse.
The institutionalization of credit ratings, and the resulting systemic risk, can be laid right at the SEC’s doorstep. As many market observers have pointed out before, by creating the NRSRO standard for any credit rating service, the regulators have effectively created a bond rating oligopoly comprised of the Big Three while marginalizing the smaller, independent players. The requirements for becoming a NRSRO are absurdly circular when you think about it: in order to qualify as a fully staffed, established rating agency by SEC standards, you must already be a fully staffed, established rating agency with a demonstrable record!
Since the financial crash, the regulatory authorities have tried to undo this monster of their own making through Dodd-Frank and other measures. They are forcing financial institutions to stop their blind reliance on agency ratings and develop their own credit opinions, with the help of more independent credit research services, if necessary. However, none of those efforts will really be effective until the regulators end the Big Three’s protected status and encourage greater competition within the credit research business.
Institutional money managers, particularly the mutual funds, are seizing upon this latest example of rating agency “dysfunction” as another marketing opportunity. As their pitch goes, given all the rating agencies’ shortcomings and presumed conflicts of interest, only they can provide investors with the “independent” research efforts necessary to navigate today’s treacherous credit markets.
So who ends up the loser in all of this? Direct retail investors and the independent registered investment advisors with limited resources who are struggling to find a reasonable and cost-effective alternative to agency ratings, at a time when new credit concerns are mounting in the muni space.
As the latest controversy about Chicago’s ratings shows, the oft-quoted low historical default rate of the muni asset class will provide cold comfort to investors as pension funding issues take center stage going forward.