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Chicago downgrades: the takeaways for investors

Moody's recently downgraded Chicago's general obligation bonds to Ba1 from Baa2. Standard & Poor's and Fitch followed with their own less severe rating downgrades. The revisions reflect concerns among the rating agencies that burdensome pension liabilities will strain the city's finances.

They also cited cash-flow challenges facing Chicago in light of the rating triggers associated with various interest-rate swaps, lines of credit, and standby bond purchase agreements. The downgrade has complicated the management of those contracts, which present a much more significant near-term risk.

Chicago, Illiinois.
Adam Jones | Getty Images
Chicago, Illiinois.

Widespread concern regarding the management and operation of public pension programs is not a new phenomenon. In fact, the Illinois General Assembly commissioned a report in 1916 to assess the affordability of the state's defined benefit programs. The results were not encouraging. The commission's report concluded that the pension plans then in existence "with perhaps a single minor exception … are financially unsound and moving toward a crisis."

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Those conclusions sound awfully familiar and beg the question: If state legislators were so concerned about the solvency of public pension plans 100 years ago, and if those programs have survived to the present day, are we exaggerating the current credit risks posed by unfunded pension liabilities?

We don't think so. We readily concede that the credit risks are unevenly distributed among city governments. Most cities have either recovered completely from the lingering effects of the Great Recession or have made great strides towards financial stability. Their pension liabilities pose an obstacle but one that can be surmounted through higher contributions and incremental changes to benefit programs. However, a smaller number have made little progress in restoring structural balance to their financial operations.

Let us first acknowledge some good news. In a recent report, Fitch reported that the ratio of upgrades-to-downgrades across all public finance sectors in 2014 was positive. For the first time since 2008, the agency upgraded more municipal credits than it downgraded. Upon closer inspection, however, a more troubling trend is evident. In its recent report on state and local pension funding, Loop Capital Markets found that the weighted average pension funding ratio for 22 of America's largest cities had fallen to 65.3 percent in 2013 from 65.6 percent a year earlier.

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The decline might well be considered incidental except that it occurred in the midst of a huge equity-market rally. And given the disproportionate concentration of public pension fund assets in the equity market, one might have expected the funding ratio to increase. We attribute the absence of any improvement to a number of factors, chief among them the failure of employers and plan beneficiaries to make sufficient contributions. As recent research from the Center for Retirement Research at Boston College will attest, public sector employers have only been paying 80 percent of the annually required contribution on average.

The introduction of new public pension accounting standards by the Governmental Accounting Standards Board (GASB) only compounds the challenge by requiring all public pension plans to report their liabilities in a standardized manner. The net effect is a sharp reduction in the reported pension funding ratio. The State of New Jersey was among the first to implement the new accounting rule and its funding ratio plummeted from 54.2 percent to 32.6 percent overnight.

Critics of the new accounting rule argue that it makes pension plans appear weaker despite the absence of any fundamental changes in asset values. The counterargument, and one to which we subscribe, is that the old rules were far too permissive and malleable to accurately reflect the onerous financial burden posed by pension liabilities.

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The term "cash is king" has been overused in recent years, but the sentiment is accurate. When the economy loses steam and contracts, as it inevitably will, tax revenue will decline again. And when that happens, cities flush with cash are more likely to ride out the storm. Those without adequate reserves will be the first to face rating agency downgrades, see wider credit spreads for outstanding bonds and, in limited instances, struggle with insolvency.

Commentary by Thomas McLoughlin, head of municipal fixed income at UBS Wealth Management Americas, which oversees $1.1 trillion in invested assets. Follow UBS on Twitter @UBS.