Doubly Bound: The Cost of Credit Ratings

Low Ratings and Accelerated Termination Events

Low Ratings and Accelerated Termination Events

AN ADDITIONAL COST OF THE CREDIT RATING SYSTEM borne by certain local governments is the expense of making termination payments on interest rate swaps when an accelerated termination event is triggered. Rather than attempt to estimate this cost, I will instead describe it with an example.

In November 2007, the City of Chicago issued $200 million in Variable Rate Demand Obligations. At the time, the city carried a Moody’s credit rating of Aa3—after having been upgraded one notch from A1 in 2006.41 Simultaneous with the bond issuance, the city entered into interest rate swap agreements with Loop Financial and Morgan Stanley.42 These two contracts were intended to replace Chicago’s variable rate obligations with predictable interest payments at a rate of 4 percent annually.

The November 2007 arrangement was the last of a number of such deals Chicago and Chicago Public Schools initiated. It is also the most questionable such deal since it was undertaken when the financial crisis was well underway.

The use of swaps and variable rate instruments to achieve lower fixed financing costs poses a variety of risks, but I will limit my focus to those associated with credit ratings. The swap agreements contain terms that protect the counterparty (i.e., the financial institution transacting with the city) in case the city becomes unable to meet its obligations. The November 2007 agreements with Loop Financial (whose interest was later transferred to Deutsche Bank) and Morgan Stanley required the city to make accelerated termination payments in the event that its Moody’s ratings fell below Baa3.

Since Chicago’s credit rating had been stable at Aa3 (in fact it had even been upgraded one notch in 2006), a downgrade into the speculative grade region below Baa3 must have seemed a very remote risk to city financial officials who approved the transaction.

Moody’s maintained Chicago’s credit rating at Aa3 until July 201343, when it began a series of precipitous downgrades—leaving the city with a speculative Ba1 rating in May 2015. As late as April 2012, Moody’s used the following language when affirming its then-current Aa3 rating:

The affirmation of the Aa3 rating on Chicago’s general obligation debt is supported by the city’s long-standing role as the center of one of the nation’s largest and most diverse economies; a tax base that remains very sizeable despite several consecutive years of estimated full valuation declines; significant revenue raising ability afforded by the city’s status as an Illinois home rule community; and its closely managed use of variable rate debt and interest rate derivatives. These strengths are somewhat moderated by the city’s persistent economic challenges, including elevated unemployment levels and a large foreclosure backlog; narrow, though improving, General Fund reserves; relatively low levels of expenditure flexibility, as a high percentage of the city’s operating budget is dedicated to personnel costs for a heavily unionized workforce; and above average levels of slowly amortizing debt.

In the three years since April 2012, Chicago’s fundamentals appear to have remained the same or improved somewhat. The city is still the center of a large and diverse economy and it continues to benefit from a strong revenue base. Although official property valuations (EAVs) are lower, both Zillow44 and the Case-Shiller Index45 show substantial property price gains since bottoming in early 2012. The city’s unemployment rate has also fallen46 substantially. Gradual economic improvement has brought rising revenues. According to the city’s CAFR, general fund revenue grew from $2.8 billion in 2011, to $2.9 billion in 2012 and $3.0 billion in 2013. Unaudited figures in the city’s latest budget47 show further growth to $3.1 billion in 2014 and a projected $3.5 billion in 2015. Although expenditure flexibility continues to be limited, Chicago has cut its retiree health insurance costs by reducing premium support and shifting beneficiaries onto the health exchanges created by the Affordable Care Act.48 These cost saving measures are still being litigated, but had not been overturned as of this writing. Chicago’s pension funds are seriously underfunded, but that is not new. At the end of 2011, Chicago’s four pension funds had a composite funded ratio of 37.9 percent—based on market value of assets. At the end of 2013 (the latest date for which complete statistics were available at this writing), the funded ratio was little changed at 37.0 percent.49

Since Chicago’s credit landscape has not greatly changed since 2012, Moody’s downgrades appear to have some other cause. As reported by The Chicago Tribune50, the downgrades were primarily the result of a new pension liability methodology Moody’s adopted in early 2013. The methodology change involved applying a lower discount rate to municipal pension obligations. Using a lower discount rate makes the present value of pension payments larger. The change had a pronounced impact on Chicago which has large pension obligations (as a percentage of revenues) relative to other cities.

Thus, the ratings downgrades were primarily attributable to Moody’s adoption of a more conservative pension methodology as opposed to any real change in Chicago’s credit position. This methodology “risk” was unforeseen in late 2007 when Chicago entered into the swap agreement now subject to accelerated termination

The cost of an accelerated termination event can be quite large. In May 2015, Reuters reported that Moody’s most recent downgrade could have cost the city $2.2 billion—substantially more cash than the city has on hand.51 Fortunately, in Chicago’s case, a number of its swap counterparties chose to give the city an opportunity to refinance its variable rate obligations before demanding payment. The city may thus be able to avoid most of the potential cost, but has made $129 million in accelerated termination payments thus far. Further, a refinancing under the adverse circumstances Chicago faced in mid-2015 will likely result in the city incurring additional interest costs.

Finally, it is also worth noting that the Series 2007-E, F and G bonds were insured by MBIA, which carried a rating of Aaa at the time. To access the variable rate market—which contains a large number of money market mutual funds—debt issues have generally been obliged to carry AAA/ Aaa ratings. Thus, the structure that Chicago chose necessitated the involvement of an insurer like MBIA. However, at the time the deal closed, abundant evidence suggested that the insurer no longer merited a top rating. For example, the company’s third quarter 2007 earnings report issued on October 25, 2007 showed a significant quarterly loss.52 MBIA’s stock lost 40 percent of its value between the beginning of September and the beginning of November 2007.53 Had MBIA been more accurately rated, Chicago may not have used the variable rate / swap structure in the first place, thereby avoiding accelerated termination payments years later.

While low ratings for municipal issuers have and may continue to trigger swap termination clauses, the frequency and size of these termination events are not readily predicted. Further, the willingness of counterparties to offer forbearance when they have a right to collect accelerated termination payments is likely to be situationally dependent.