The next Greece may be in the U.S

[thenews]

When Chicago Public Schools announced on June 24 that it would borrow $1 billion to make a $600 million-plus pension payment due June 30 an eerie feeling spread across bond investors and taxpayers alike.

It was the same feeling that gripped investors when Moody’s Investors Service downgraded Chicago’s credit rating to junk based almost entirely on the city’s pension problems.

The fear was that elevated pension costs, in cities like Chicago, might push these public entities into insolvency, wiping out much of the holdings of municipal-bond investors.

Once a sleepy corner of the municipal bond market — often not even properly reflected on cities’ balance sheets — public pensions have recently turned into the biggest headache for taxpayers and municipal-bond investors, threatening to bring down the finances of U.S. cities and states.

In some places, like Puerto Rico, Illinois, New Jersey and Chicago, entire balance sheets of cities or states hang in the balance.

Detroit, as well as three Californian cities — Vallejo, Stockton and San Bernardino — had to declare bankruptcy because of their overwhelming pension costs.

In those cases, the courtroom turned into a brutal battlefield pitting bond investors trying to save the money they invested in those cities’ municipal bonds on one side. And on the other side have been public employees trying to save the dwindling pensions that were promised to them.

Recent cases have shown that bond investors are clearly losing this battle.

In the bankruptcies of Detroit, Vallejo, Stockton and San Bernardino, bondholders have faced losses of up to 99% of their holdings, according to a Moody’s report dated May 18. Meanwhile all three California cities chose to preserve full pensions for their employees, while Detroit only cut pensions by approximately 18%.

As the following chart shows, bond values have taken haircuts that far exceeded those of pension benefits:

Part of the reason bondholders have been taking it on the chin is the process of so-called “Chapter 9 bankruptcies.” A Chapter 9 is the type of bankruptcy in the Federal bankruptcy code regulating the bankruptcy of cities and other municipal governments.

The way Chapter 9 works, a city has to present an outline of its assets and liabilities to a bankruptcy court and propose a plan, known as a “plan of debt adjustment,” essentially saying how much it will pay each creditor, such as bondholders, pensioners and employees.

But unlike other bankruptcies, where creditors can also put forward plans — including the proposal to liquidate assets — in a Chapter 9 bankruptcy, the city council is in control of the process and the judge can only determine whether the plan is “fair and equitable,” explains Ty Schoback, a municipal bond analyst at Columbia Threadneedle Investments.

This practically means that once the bankruptcy begins, creditors find themselves “at the mercy of the city’s proposed treatment,” Schoback added.

Pension supremacy

Though some have pointed to political ties between unions and governing officials for the favorable treatment of pensions, the legal reality may be far more complex.

In many states, public pensions are protected by state constitutions or statutory law, and as a result are afforded many privileges, according to a Center for Retirement Research report.

In legal circles, this has come to be known as “pension supremacy” and it is a real headache for bond investors.

In Chicago, the state’s constitution dictates that pension benefits for current workers “shall not be diminished or impaired.” New York carries a similar clause, while Hawaii, Louisiana, and Michigan have constitutional provisions that have been interpreted as protecting all pension benefits earned to date.

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