Chicago finances are even worse than I thought which is saying quite a bit because I have written about the sorry state of Chicago finances on numerous occasions.
Kristi Culpepper, a bond guru, has gone over Chicago’s annual financial report, bond documents, investor presentations, and CAFRs. She has uncovered things the City of Chicago does not want anyone to understand.Â
For example, Culpepper reports Chicago general obligation bond deals have been used by the city as a means to avoid servicing short-term debt. Says Culpepper, “These bonds have received extraordinarily aggressive tax opinions . If the Internal Revenue Service ever gets around to scrutinizing them, your bonds probably won’t be tax exempt for long. Many of these uses of bond proceeds are not eligible for tax-exempt financing under the federal tax code.”
That is just the tip of the iceberg as to what Culpepper has discovered.
Who Is Kristi Culpepper?Â
Intrigued? You should be.
First let’s go over Culpepper’s background. Kristi Culpepper is a state government official with the Commonwealth of Kentucky. Among other things, she handles the structuring and sale of bonds for schools across the state. Previously, she worked for the Kentucky General Assembly analyzing state and local government bond issues and tracking the state’s capital construction programs. She has also worked at Merrill Lynch.
“Bond Girl”
Culpepper built up a huge following as “Bond Girl”. Bloomberg explains Twitter’s ‘Bond Girl’ Outs Herself as Kentucky Official. (TWTR)
 Bond Girl, using the Twitter handle @munilass, had been posting commentary about state and city borrowing and issues beyond public finance since April 2011. Her sometimes-pointed posts attracted the attention of municipal-bond investors, bankers and analysts. Using her nom de Twitter, Culpepper sparred with other users, criticized public officials and vented about her life.
Culpepper “is regarded as an authority on capital projects and debt by the Legislative body,†according to a Kentucky Education Department website posted in November that announced her appointment. “She has worked with legislators, lobbyists, and attorneys to draft legislation and effect policy changes related to the state’s bonded indebtedness.â€Â
Buyers and traders in the $3.7 trillion muni market had puzzled at the true identity of Bond Girl, Hector Negroni, co-founder of New York-based investing firm Fundamental Credit Opportunities, said in a telephone interview.
“For any bond geek like myself, she’s fascinating, well-informed and entertaining,†Negroni said.
On Oct. 28, as Bond Girl, she wrote a 1,650-word blog post for the Financial Times’ Alphaville on a proposed debtor-in-possession financing for bankrupt Detroit.
Guest Post
I mention the above to prove Culpepper is highly regarded in the industry. She knows what she is talking about. Â Â
The following guest post by Culpepper first appeared on Tumblr as How Chicago has used financial engineering to paper over its massive budget gap.
For those who want to follow Culpepper, her Twitter handle is @munilass.
I dispense with my usual blockquotes for ease in reading. What follows is a guest post by Kristi Culpepper.
Emphasis in Italics is Mine – My Comments and Recommendations follow Culpepper.Â
How Chicago Used Financial Engineering to Paper Over its Massive Budget GapÂ
Chicago made headlines at the end of February after Moody’s downgraded the city’s general obligation bond rating to Baa2. Moody’s has cut Chicago’s rating five notches in less than two years. This downgrade, however, placed the city’s credit below the termination triggers on some of its outstanding interest rate swaps. The city has been working to renegotiate the terms of those contracts with its counterparties.
If Chicago’s general obligation rating falls below investment grade, the city’s credit deterioration will become a self-fulfilling prophesy. The city risks nearly $400 million of swap termination payments and the acceleration of its $294 million of outstanding short-term debt.
Unsurprisingly, some of Chicago’s bonds are already trading at junk levels. Chicago CUSIPs are listed here.
That said, the rating agencies and most other market participants still appear to be light years away from understanding the true scope of Chicago’s financial problems. The city has a very — well, let’s just call it unconventional — approach to borrowing money and probably should not be considered investment grade.
Some Budget HistoryÂ
In order for you to follow my discussion of Chicago’s borrowing shenanigans, it is necessary to understand the fiscal machinery behind its bond issues. Please be patient with me here. This story will blow your mind shortly.
Chicago’s budget is divided into seven different fund classifications, but only three funds are relevant to our narrative: the Corporate Fund, Property Tax Fund, and Reserve Funds.
The Corporate Fund is Chicago’s general operating fund. This fund is used to pay for essential government services and activities (e.g. public safety and trash collection). Corporate Fund revenues are derived from a wide variety of sources, including: (1) local tax revenue from utility, transaction, transportation, recreation, and business taxes; (2) intergovernmental tax revenue, which represents the city’s share of the state’s sales and use taxes, income tax, and personal property replacement tax; and (3) non-tax revenue from fees, fines, asset sales, and leases.
Chicago’s property tax revenues do not go into its general operating fund. These revenues go into a Property Tax Fund, which is used to make debt service payments on the city’s general obligation bonds; make required employee pension contributions; and (to a minor extent) fund the library system. The fund also includes tax increment financing revenues that flow to projects in designated TIF districts.
The city used some of the proceeds from long-term leases of city assets to establish Reserve Funds. The Chicago Skyway reserve funds were established in 2005 in the amount of $975 million. The Metered Parking System reserve funds were established in 2009 in the amount of $1.15 billion. Of these funds, $475 million of the Skyway reserves were designated for budgetary uses. What remained was $500 million for the Skyway; $400 million for the Metered Parking System; and $326 million for a budget stabilization fund.
There has been a structural gap in Chicago’s Corporate Fund budget since at least 2003. Although most governments are required to balance their budgets on a cash flow basis each fiscal year, a structural budget gap can arise when recurring expenditures are greater than recurring revenues. Some of the city’s offering documents suggest that this gap is a legacy of the last economic downturn, but in reality the gap pre-dates the economic downturn by several years. The impact of economic downturns on tax collections tends to have a considerable lag anyway.
So, Chicago’s structural budget gap is a political, not economic, creature. Rather than cut expenditures to a level that could be supported by recurring revenues, the city mostly used non-recurring resources to fill the gap from one fiscal year to the next. This is not surprising. Most of Chicago’s Corporate Fund budget goes to salaries and benefits for its employees, and 90% of the city’s employees belong to around 40 different unions. Attempts to adjust expenditures tend to have well organized opposition.
Between fund transfers and drawing down its reserves, the city blew through its financial cushioning quickly. The $326 million budget stabilization fund was exhausted by 2010. From 2009 to 2011, the city used $320 million from the Metered Parking Reserves. The city’s budget gap was at its widest in the wake of the last economic downturn, at over $600 million.
Chicago’s Dysfunctional Debt ProgramÂ
Now things start to get interesting. Transfers from reserves and other funds have not been the only means Chicago officials (across administrations) have devised to subsidize the city’s Corporate Fund. The city has effectively been using its general obligation bond offerings and interest rate derivatives to accomplish the same thing.
State and local governments typically use the proceeds from their bond offerings to construct or renovate public buildings and infrastructure. These are projects that have long useful lives and will benefit residents for generations.
Dating back to at least 2003, however, Chicago has been issuing long-term tax-exempt and taxable bonds to:
(1) Roll over short-term debt used as working capital;
(2) Pay for maintenance activities that would otherwise be paid from the Corporate Fund;
(3) Pay for judgments and settlements that would otherwise be paid from the Corporate Fund, including wage increases and retroactive pension contributions for its employees; and
(4) Provide discretionary funds to each of the city’s 50 aldermen to pay for activities in their own districts.
The magnitude of tax-exempt bond proceeds used for judgments and settlements over this period is staggering. The Chicago Tribune estimated it at approximately $400 million:
