Detroit went bankrupt. NYC almost went bankrupt.
Detroit went bankrupt in 2013. The spiral it was on started back in the 1970s when the auto industry made some terrible strategic decisions, and at the same time the state of Michigan and the city of Detroit made terrible decisions.
Chicago finds itself deep in debt. Combined city and state debt is $85k per citizen. Of course, the city and the state both just passed record spending in their budgets. Government doesn’t know discipline, and is almost immune from market discipline.
Economist John Cochrane posted a series of pieces on national debt, inflation rates and expectations. I think you can take some of what he wrote and apply it to state and city debt. A big key to it all is that is productivity growth and the expectation that the debt can actually be paid off.
It’s the microeconomics that matters, not the macroeconomics.
NYC would have gone bankrupt but President Gerald Ford made a political decision and bailed them out. As we have seen, bailouts do nothing to instill discipline and rigor. The entity getting bailed out always seems to need bailing out again. Look at places like Argentina. Fortunately for Argentina, they have a president who understands economics and is implementing classical economic reforms vigorously.
Whether you think the 2020 election was stolen or not there was a motive beyond “Orange Man Bad” for stealing it. Covid shutdowns crushed productivity and economic growth for all states and cities. One underlying motive for stealing the 2020 Presidential election was debt. Blue states and cities were horribly in debt and starting to teeter. The Democrats mortgaged the future of every US citizen issuing more federal debt to shovel free money to blue states who transferred it to their cronies. Their cronies are government unions.
This is a quote pulled from a recent City Journal article about Chicago’s debt.
Like many large cities, Chicago got lucky during the pandemic. President Joe Biden’s American Rescue Plan dispensed funds to cities by a formula that gave preference to older, and generally more Democratic, municipalities. Chicago was a major beneficiary, receiving about $2 billion in federal aid. Thanks to the support, in 2022, the city ran a $300 million surplus and, for the first time, put in the required contribution for all four of its major pension funds. This led Moody’s to remove Chicago’s junk-bond status.
But Chicago retains by far the worst debt rating of any of the largest American cities, and it has done nothing to reform its bad habits. In 2022, the city saw a delay in property-tax receipts, and, despite the flush times, money proved so tight that the pension funds could not pay current retirees. The city had to provide an advance of over $500 million just to get the checks out the door. In September 2023, Mayor Johnson’s office announced a $538 million budget hole for the next year, almost three times what the previous mayor had expected, and a potential $1 billion deficit for 2025.
People who are rational and follow markets wonder, “Why is there a market for debt issuance for cities like Detroit and Chicago?”
It’s easy to see how the debt is totaled up, bond issuance and to calculate how much each citizen owes. The problem is no citizen ever thinks they are actually going to pay that number. It’s all fake. Even if the city were to go bankrupt, they don’t think they are on the hook for it.
Except, in a way, it does come back to bite them.
Look at Detroit. Taxes on everything went higher. Citizens have to pay for that. Of course, they could move away and avoid the higher taxes and the consternations that come with post-bankruptcy. However, their property values took a larger hit than the cost of the debt per person.
But, the post-bankruptcy environment was so bad and so severe, people would pay the opportunity costs to get out even though it far exceeded the actual cost per person of debt.
That’s something Chicagoans ought to learn.
But what about the market? Why would any rational entity buy Detroit or Chicago muni debt? There is an answer.
There are billions of dollars sitting in ETFs, Mutual Funds and other investment vehicles like them. In those fund formation documents, they specify how much of that particular fund must be fully invested at all times in municipal debt. Most are close to 100%.
The reason investors put money in muni debt is not altruistic. It’s a way to earn interest on money and pay no tax.
Chicago and Detroit and other profligate debt-ridden areas like them will always have a market ready to purchase their debt. The issue is this. What’s the interest rate going to be? Muni debt is usually priced below US Treasury rates. The reason, taxes. Federal debt is taxable. For what it’s worth, commercial paper carries higher interest rates than both because it is taxable and the risk is significantly higher.
If you look at the interest rates that Illinois and the city of Chicago muni bonds pay, they are much higher on a percentage basis than the rest of the United States. They have a market. Additionally, the fine print of the bonds matters. Investors want assurance they are going to be repaid absent a federal government bailout which is messy. Hence, the city of Chicago puts covenants in their bonds that allow for automatic tax increases paid by citizens if the city cannot generate enough tax revenue to pay.
Chicago teacher’s pension bonds have that covenant. City property taxes are automatically increased to pay any shortfall.
If there is no covenant or insurance on the bond, the rates go up further. At O’Hare, some bonds are paying over 4.7% tax-free. But, they are uninsured with no promise to pay so it might look like a charitable contribution at the end of the day.
The other financial engineering play that cities like Chicago or states like Illinois engage in is flip and toss. They issue new debt to pay off old debt. All that does is extend the duration of the debt. The problem with that strategy is that suppose you issued debt when interest rates were next to 0%. Now with interest rates above 5%, you are paying off almost 0% interest with interest closer to 5%, and putting it on the backs of your citizens.
Going back to John Cochrane’s analysis, how much more marginal productivity do you need to realize out of businesses and citizens inside the city borders to pay it off? Bear in mind that the more the city or state raises taxes, the more incentive there is for businesses and people to leave.
That’s how a terribly run city figures out its finances. But, there is always a market for terribly run cities, until there isn’t.
Municipal debt is a lurking time bomb and cities like Chicago -- like Detroit and NYC in the past -- are going to get a knot jerked in their tutu. They could literally fail financially and that may be the only way to reform them.
In the current interest rate environment -- meaning high interest rates -- there will be no refundings that will relieve the pressure.
Since 2017, a municipality cannot refund a tax exempt issue with a new tax exempt issue (advance refunding) but can refund with a non-tax exempt issue. This makes it even worse as, of course, non-tax exempt interest rates are higher, much higher.
There is a limit to how much a municipality can withdraw from the local economy before the impact is the dramatic contraction of the economy.
When NYC went broke, Pres Ford famously said "Drop dead" for a year until NYC (aided by Felix Rohatyn of Lazard Brothers who was the brains of the operation) figured out how to get NYC's ship in order and then the Feds lent them $2B which was real money in those days.
The dirty little secret right now is exactly as Monsieur Carter deftly reveals -- the bloody sugar high created by the massive intergovernmental transfers from the Feds directly to failing Dem cities. That money is mostly gone and the chickens are coming home to roost.
Why do financiers buy shitty muni debt? Cause they all know the Feds will not allow a default on those instruments.
You could have made a bloody fortune on Mexican Brady Bonds, cetes, and tesebonos during the difficult times in the 1980s and early 1990s in Mexico because the US gov't wasn't going to let Mexico fail. You could have collected interest rates of 65% subject solely to a currency conversion risk of 1% per month. That really happened.
States like Illinois will continue to issue muni debt until the state collapses.
JLM
www.themusingsofthebigredcar.com
Timely post, sir.
Two things on the “specialness” of IL Muni debt and why it’s priced a scootch weaker (higher yield) vs other states’ debt in the eyes of those Inst Inv that “have to own”. One, IL specific muni funds are a waste of time because, last time I looked, only two issues receive beneficial tax benefits from IL Dept of Rev, IL General Obligation and IL Housing Finance. Kinda shrinks the availability pool, and at the same time concentrates the risk. Second, beyond the biggie of perennial default risk, is issuance risk, IMOO. IL has more layers of taxing authorities than about any other state, and ALL can issue debt. So there’s always a risk of an impending flood from the jackbooted can kickers.
And we’re stuck here, for the duration.