Daley-Era Interest Rate Swaps Could Blow Up City Budget

By Chuck Sudo in News on Jun 18, 2014 8:35PM

Whether it’s dealing with underfunded pensions, re-working the parking meter privatization contract or coming up with ways to balance a city budget that always seems like it’s an Act of God away from becoming insolvent, Rahm Emanuel has spent much of his mayoralty dealing with the unsolved problems and other messes facing Chicago left behind by his predecessor Richard M. Daley. The cover story in Wednesday’s Sun-Times centers on a problem most Chicagoans may not have been aware of until now.

The Daley administration entered into a series of interest rate swaps with banks based on Chicago’s ability to maintain a certain favorable credit rating. Before we delve into how the credit ratings and the interest rate swaps are related, let's explain how an interest rate swap works, in language that everyone here can easily understand.

Now that we have that out of the way, here’s what the Sun-Times’ Dan Mihalopoulos writes about the city’s interest rate swaps.

The financial institutions involved could terminate the deals and demand immediate payment if the ratings agency Moody’s Investor Service drops the city’s credit rating again — which it has warned it will do unless Chicago’s underfunded pensions are dramatically reformed.

Taxpayers could end up owing bankers and other financial institutions, including Wells Fargo and Loop Capital Markets, $110.4 million if Moody’s drops its rating for Chicago by one notch, according to documents reviewed by the Chicago Sun-Times. Falling two more levels could cost the city another $88.5 million.

Moody’s dropped the city’s bond rating three notches last July. Then it lowered the rating again in March by another notch to the current Baa1 status.

Most of the swap agreements — which date as far back as 1999 — peg the termination threshold to any drop below Baa1.

Moody’s has warned that only cutting costs and finding new revenue streams would stave off another drop in the city’s credit rating. To see why this is important to monitor, we need only look to our bankrupt neighbor two states to the east. Former Detroit Mayor Kwame Kilpatrick gambled that $1.44 billion in interest rate swaps in 2005 would fill that city’s unfunded pension liability, a deal Detroit emergency manager Kevyn Orr said may have been illegal. The gamble failed, Detroit plunged into bankruptcy and Orr brokered a deal in March to settle with creditors UBS and Bank of America Merrill Lynch for $85 million. That was negotiated down from an estimated $350 million in liabilities to the banks.

Detroit isn’t the only American city to enter into interest rate swaps. The city of Philadelphia, Penn. and its school district lost an estimated $331 million on interest rate swaps. Oakland, Calif., which entered into a swap agreement with Goldman Sachs in 1997, has tried to walk away from the deal without paying a $14.8 million termination fee. Goldman Sachs has rejected the request.

Chicago isn’t in the dire straits Detroit faces … yet. Mihalopoulos notes the city is sitting on nearly $600 million in cash reserves and (still) has the ability to borrow money. But the possibility of seeing an extra $200 million added to Chicago’s current backlog of unpaid bills could have the banks making a run for what they feel is theirs. Deputy Mayor Steve Koch told Mihalopoulos the Emanuel administration has not continued the credit swap practice and has been in negotiations with three of the banks involved in the swaps to lower the threshold needed for the city to enact termination procedures on the deals.

And some friends of Emanuel stand to make some money if the banks demand payment with another bond rating downgrade. Jim Reynolds heads Loop Capital Markets and works at Wells Fargo, which stands to receive $34.3 million and $40.9 million if the banks decide to demand payment from the city. Reynolds is an Emanuel appointee to the Illinois Sports Facilities Authority and World Business Chicago.

As for whether the credit swaps were a good idea, Koch tried not to blame his boss’ predecessor.

“I’m not here to argue with whether that was good, bad or indifferent. What I can tell you is we don’t do it, and we basically stopped doing it when the mayor took office.”