June 19, 2014
The City of Chicago currently has the lowest rated credit of any major city in the country according to Moody’s Investors Service. At Baa1, the long-term bond rating is still several levels above falling out of investment grade, but the City is at risk of having to pay large liabilities if it is downgraded again.
According to an investigative report published by the Chicago Sun-Times, many of the derivative contracts in the City’s swaps portfolio associated with variable rate bonds have termination clauses if Moody’s lowers its rating below Baa1. The report states that the liability triggered by early termination of the deals leads to liabilities totaling $110.4 million for lowering one notch to Baa2, an additional $60.1 million if lowered to Baa3 and another $28.4 million if lowered to Ba1.
Since downgrading Chicago’s long-term bond rating three notches nearly a year ago, and one more notch in March 2014 to the current level of Baa1, Moody’s has maintained a negative outlook on the City’s credit, indicating a likelihood of additional downgrades if its financial condition does not improve.
Citing documents obtained through a Freedom of Information Act request, the Sun-Times report said that the City was taking steps to try and reduce its exposure to its derivatives, also known as swaps, which are associated with its outstanding variable rate debt. However, updated information on the City’s exposure is not currently available on its debt management website. Although there is some information available regarding the swaps portfolio, the most recent valuation of the contracts is dated September 30, 2013. The master agreements and associated schedules that define the termination events and bond rating thresholds are also not publicly available.
According to the swaps information that is available online, as of last fall the City of Chicago’s total swaps portfolio had a negative value of $397 million. Swap agreements generally are signed when the City sells long-term bonds with a variable interest rate, to protect from potential interest rate increases. A separate agreement is used to obtain an artificial fixed rate where the City agrees to pay a set interest rate percentage to the other party in the swap, usually a large bank, on the notional amount of the outstanding debt. In return, the bank agrees to make a variable rate payment to the City, typically based on the LIBOR or SIFMA index similar to the rates included in the City’s bond sale. This insulates the City from any increases in interest rates but also exposes it to a higher payment if the variable rate that the bank pays is lower than the artificial fixed rate charged to the City.
Due to a historically low interest rate environment over the past several years, the City’s artificially fixed rate payments have remained higher than the actual variable rate that it would have paid based on the original loans. This loss is reflected by the negative market value of the swaps.
Under normal circumstances a derivative portfolio with a negative value is not a liability that must be paid. Instead it represents a present value calculation based on the current interest rate environment extrapolated over the remaining years of the deal. Some of the City’s current swaps will remain in effect through 2042. Over time the value may improve if interest rates increase and can decline as the remaining life of the deal gets shorter. However, if the deal is terminated early due to the City’s bond rating falling lower the threshold determined in the swap contract, it must pay any negative market value at that time to the other party in the swap. After the swap is terminated, the City would have to continue to make variable rate payments to bond holders based on the original bond sale.
Based on the difference from the data presented in the Sun-Times article and publicly available documents associated with the City’s March 2014 bond sale, it appears the City has changed the termination thresholds for some of the swaps. According to the bonds documents, all but one of the swaps associated with the Chicago’s outstanding General Obligation bonds had a termination threshold based on a credit rating of Baa1. Under these terms, if lowered one more notch by Moody’s the City would have owed counterparties $140 million as of January 1, 2014. The documents showed only one contract with a lower threshold at the time. The swaps associated with a 2002 bond sale would be triggered for termination at Baa2 and would have led to an additional liability of $33 million. However, the documents explaining the changes to these contracts and which deals have been amended have not been published.
The remaining City swaps, outside the General Obligation bonds, are related to revenue bonds sold based on enterprise funds including Midway Bonds, Water Bonds and Wastewater Bonds. None of these swaps are in immediate danger of termination due to terms based on each separate type’s bond rating. These bonds are all rated either A2 or A3.
Similar to its Debt Management Policy, the City also maintains an informal Interest Rate Swap Policy on its website. This policy has not been updated since 2006 or formally adopted by the City Council. The City’s Chief Financial Officer and Comptroller, who are appointed by the Mayor, have complete discretion to approve swap contracts with no immediate oversight by the City Council.
The current swaps policy also does not account for recent regulatory changes made in the 2010 Dodd-Frank Act, which add additional transparency requirements and mandate that governments first consult with a qualified independent advisor before entering into new swap agreements.