Municipal Bankruptcy and Chicago
A chat with Prof. David Schleicher on fiscal crises and some reforms to avoid them
If you’ve read most of my prior posts, at this point you should be well acquainted with the idea that Chicago’s primary challenge going forward is dealing with our debt and pension issues. While I’m mostly focused on how we can do that, I also think it’s pretty important to think about what happens if we can’t.
David Schleicher is a professor at Yale Law School and is an expert on state and local finance. His book, In a Bad State: Responding to State and Local Budget Crises, provides a great overview of the history of state and local fiscal crises in the U.S. from Alexander Hamilton’s plan1 to assume state debts after the Revolutionary War all the way through the Great Recession and into municipal challenges during COVID. He also outlines a variety of reforms - both to make bankruptcy less painful and to avoid it altogether - and discusses the kind of tradeoffs governments have to face in a bankruptcy scenario. I thought it was a really good read and would recommend it for anybody interested in municipal finance. I invited Professor Schleicher for a quick chat on how some of the reforms and issues he discusses might apply as it relates to Chicago.
CD: Thanks for taking the time - I wanted to start with your take on how you see things for municipalities coming out of COVID and Chicago/Chicago-related entities in particular.
DS: To start with disclaimers: I’m not a credit analyst. I’m not really in the business of specifically analyzing any jurisdictions’ budgets. That said, there are some broad trends of which Chicago is a really prominent example. The broad trend coming out of the post-pandemic era is that state budgets were generally in pretty good shape. They got a lot of federal money, and the economy’s pretty good, and so those have both left states in a better shape than you might otherwise imagine.
Now, Chicago - and Illinois more broadly - entered the pandemic in the worst shape of any major city and state. If you count pensions and OPEBs, Chicago is the most indebted city in one of the most indebted counties with one of the most indebted school districts in the most indebted state (relative to revenues). Its challenges weren’t fixed [coming out of COVID], but they were buoyed the same way everyone else’s were buoyed during this period. The thing that’s going to reveal itself over the next couple of years is what jurisdictions did with those good times and whether they prepared themselves for the bad times, which inevitably come.
You’ve seen across the country a real variation. Connecticut, for example, was one of the ‘basket case’ states. After Illinois, Connecticut - along with New Jersey and Kentucky - were the states with the worst pension problems. Connecticut really committed itself to fiscal responsibility during the pandemic. It used some interesting legal tools, which I can talk about if you’re interested, but really has made a real effort. New York State and City, on the other hand, have mostly… well this might be a bit cruel, but it was like Brewster’s Millions. They got the money and they had to spend it within a week. In this they created some long-term obligations for themselves that are going to be very difficult for them to deal with. It’s not all bad - they saved some money in the rainy day fund too - but it’s not a picture of fiscal responsibility.
Chicago is a complicated problem. First of all, both Chicago and the state just come into the period with very, very, very severe fiscal problems, and then it has an election where they elect a candidate who is very committed to spending a lot of money - so we’ll see what happens.
CD: Sure, makes sense. I know we do have some pretty large budget gaps projected going forward with a lot of that ARP money rolling off - with that in mind, I’d love to know more about those Connecticut reforms you referred to, in terms of how they addressed things going forward and any lessons there for Chicago.
DS: Connecticut is a fascinating example. In 2017, Connecticut passed a set of statutory budget requirements. Connecticut, like all other states, has state constitutional limits on its budgeting, and they then passed a bunch of limits on top of that. They also then put covenants in all of their bonds to say they were going to follow these fiscal rules, which theoretically gave every bondholder the power to sue them if they didn’t. These rules included something called a volatility rule, which said that if revenues come in above expected, money has to immediately go first into the rainy day fund and then to pay back pensions.
So when revenues came in during the pandemic at much higher than expectations, the money immediately went into savings and the legislature had no choice about whether to spend it. That was under the last governor, though the current governor and legislature then renewed these fiscal limits and put the covenants into what’s called ‘bond lock.’ This was a different mechanism for achieving limits on state budgeting, and it particularly had the effect of forcing money to be saved for pensions, which traditional state constitutional limits don’t do (as everyone in Chicago knows).
CD: Interesting. Were there any other key reforms or was removing that flexibility from themselves really the big thing?
DS: Often it’s very hard to know whether (1) legal limits themselves or (2) the politicians willing to enact those legal limits are the driving force, but the current governor has been very committed - in the face of lots and lots of pressure to spend money and to cut taxes - to saying no. So it’s really a combination of a political choice and these legal limits. It’s a really interesting story, because again Connecticut traditionally had been in that class of states with Illinois and New Jersey, and then it goes in a different direction.
CD: Getting a bit more into your book, you talk about a variety of reforms - both those to help when you get to a point of fiscal crisis and also those in advance to avoid a crisis. Those both strike me as relevant for the Chicago case. What sorts of pressures do you think either at the federal or state level really make sense to pass?
DS: So those are two very different sets of reforms. With respect to the federal responses - which would be both to Illinois’s and to Chicago’s problems - I argue for some general policies that the federal government could apply which would have particular effect in Illinois and Chicago. For instances, conditioning the ability to issue tax exempt bonds on following accrual accounting rather than cash accounting for your budgeting process. That can also be a bond condition.
Chicago, interestingly, during its high periods of fiscal irresponsibility, issued a lot of non-tax exempt bonds, because it was scoop-and-tossing for the second or third time, which is particularly bad. The federal government could make something like that harder, but there’s limits on what they can do given that states are sovereign.
What Springfield can do with respect to Chicago is a much more complicated problem. Springfield gives a lot of money to Chicago, and Springfield also has huge fiscal problems of its own. American history is full of examples of states and local governments fighting over revenues in down periods. This is a real problem if there’s ever a really, really big recession at some point and revenues really fall in Illinois and Chicago. State politicians’ incentives are to reduce local fiscal aid and pull back on giving money to local jurisdictions, because that’s what’s necessary to balance the state’s budget, but that very thing could be the thing that pushes the city over into real crisis. But no one’s going to blame a legislator from downstate for a fiscal crisis in Chicago. The conflict between state and city - and there are dozens and dozens of examples of this over American history - in a down period can be a really nasty, messy thing.
I have lots of other reform proposals in the book, but one is very relevant to the Chicago case in particular, if a crisis ever hits Chicago. One of the problems that Chicago’s governmental structure creates is that you have so many local governments that are all independent. I think your average taxpayer in Cook County is paying to somewhere between seven and ten local governments, all or many of which have real fiscal problems. In a real down cycle, every jurisdiction tries to fend for itself. This can create real inequities. For example, when Detroit went bankrupt, the state decided to bail out the Detroit school system - which was a separate entity, although the boundaries of the City of Detroit and the school system of Detroit are exactly the same. That ended up in a situation where police pensions were written down and lenders to the city faced losses, but teachers’ pensions and lenders to the school district didn’t lose anything. And that’s not a good thing - first of all, it’s much worse to lose a lot than to lose a little; it’s increasingly worse. It would be far better if we had legal tools to allow multiple jurisdictions to go bankrupt at the same time, and that’s particularly true in the Chicago case, because it would allow for small hits to be taken across multiple features in Chicago and to have a mechanism for coordinating their fiscal problems.
There’s an interesting question about why Chicago has so many local governments in the first place, and why it doesn’t have any tools for coordinating them, and this is a broader story where I think about the decline of the Daley Machine. Under Daley, it didn’t really matter in the end that the county and the CTA and the park district and the school district were distinct entities, since they were all effectively controlled by one person, so you could coordinate their behavior. In the absence of that, and especially in a crisis, it can be a real problem.
CD: And that sort of reform would have to take place at the federal level?
DS: That would require both changes at the federal and state level.
CD: Got it. Let’s talk a bit more about a bankruptcy scenario. In terms of other bankruptcy-related concerns, Chicago has a lot of odd nuances to a lot of our debt - as an example, with our Sales Tax Securitization bonds. Are there any implications for how those would work in bankruptcy scenarios?
DS: It’s a really open legal question. The Sales Tax Securitization bonds are modeled on what New York City did in the fiscal crisis in the 1970s - similar to what Puerto Rico did with its COFINA bonds. The basic idea is that the government has several streams of revenue, it’s heavily indebted and it has trouble borrowing, or it’s borrowing at high rates, and what it does - or what the state does on its behalf - is it dedicates one of those revenues to another set of bondholders who would theoretically be bankruptcy-remote. The idea here is that regardless of what happens to Chicago, the people who own the sales tax bonds are going to be protected because they have priority access to the sales tax revenue.
This was challenged and never made it past the District Court level in New York in the 70s. The structure of the challenge was that it is a violation of the Contracts Clause of the US Constitution - the contract that the bondholders has with the city to rededicate resources to some other set of bondholders.
We’ve never had a resolution with this question. There are some cases from the 1880s and 1890s that say if you remove all of the revenue from all of the taxing powers of a city, it can violate the Contracts Clause. There’s this wonderful set of cases called ‘corporate suicide’ cases, the most famous of which is a case called Port of Mobile. The city of Mobile, Alabama went bankrupt, and the state created a new city called Port of Mobile, and then reassigned the taxing authority to tax everything - mostly property - to this new government. The new government bought assets from the old city, and then bondholders were left recovering the old city of Mobile, which had no taxing authority and no assets. The Supreme Court said you absolutely can’t do that.
The question that emerges from the New York MAC bonds and the Chicago Sales Tax Security bonds and the like is, is this like one of those corporate suicide cases, or is this a more ordinary state reassignment of revenue? It’s an open question. My belief is that they are constitutional and that anything short of a real corporate suicide would be constitutional, but it’s not obvious. There’s real interesting debates about this.
One other note - the Chicago structure for the Sales Tax Securitization bonds is also less abusive than the Puerto Rico COFINA bonds which were also upheld, because the Puerto Rico COFINA bonds didn’t involve any higher level of government. In Chicago, the state authorized the city to do this. In New York City, the state mandated it; they took the power away and created a new government that had the power to issue these bonds. In Puerto Rico, it was the government itself who issued the bonds - there’s a question of whether in a bankruptcy that would be what’s called a voidable transfer or a fraudulent transfer, where you effectively steal from one set of bondholders to pay another set of bondholders. I think the answer to that is also no, but it’s worse.
CD: A fair amount of Chicago’s debt also comes in the form of airport debt, where O’Hare and Midway (both city-owned enterprises) have their own revenue bonds which aren’t GO obligations of the city.2 How if at all would those be dealt with differently than regular debt?
DS: Municipal bankruptcy courts have been pretty protective of revenue bonds, even if they’re issued formally by the city. In the Detroit case, Detroit Water and Sewer got 100 cents on the dollar because revenue bonds were granted their fiscal protection.
We’ve actually seen a big move towards more revenue bond issuance - traditionally revenue bonds had weaknesses relative to GOs, in that they were only backed by the revenues of a specific project and you couldn’t call on the taxpayer, but in a bankruptcy context they’re much stronger because your interest in those revenues is secured.
I suspect that the [Chicago airport] bonds would be fine (depending on the revenues of the airports), but it’s also the case that - although the court can’t order it - you’d probably see the airports sold to a private actor. Under bankruptcy law, a court cannot order a city government to do anything; everything has to be something it opts to do, but I suspect what you’d see is the state/city getting rid of some assets.
CD: How about on pensions? Illinois, like a lot of other states, has the California Rule protecting any pension obligations as an irreversible commitment made preventing any reductions. My understanding is that that doesn’t always remain in bankruptcy - from a practical standpoint, what do those haircuts look like?
DS: Right. In the Detroit case, Detroit didn’t have the California Rule, so it doesn’t have the protections for workers on day one that their pensions can never be reduced, but all vested parts of pensions are protection as contract rights. When Detroit filed for bankruptcy, the AFL-CIO argued that the city couldn’t legally file for bankruptcy because it would imperil pensions. The court said no, contracts are legally protected constitutional rights, as are pensions; they can be impaired in bankruptcy even if they can’t be impaired in other contexts.
The interesting thing that’s happened, though, is that in most (although not all) municipal bankruptcies that have happened, pensioners did much better than GOs. The court said that while the state and constitutional clause does not stop pensions from being impaired, it does provide for some ability for a city in its plan of adjustment - that is, in its plan to get out of bankruptcy - to favor pensioners over other unsecured debtors. In Detroit, pensions took a haircut, but it’s pretty small relative to the haircuts that others had to take.
The one exception to this is in Rhode Island - in Central Falls, Rhode Island. In Rhode Island the state legislature passed a law that bondholders are understood as secured creditors; that is to say they have a first claim on assets in the context of a bankruptcy. As a result they had a lien on governmental tax assets and so in Central Falls the bondholders end up doing just fine while the pensioners take about a 45-50% haircut. In all other municipal bankruptcies - all of which said that pensions could theoretically be imperiled - pensioners are either held harmless or take a haircut, but a much smaller one than GOs.
The thing about it is that ultimately the city is in charge of writing its own plan of adjustment. To the extent you think the city, when it has the power to do writedowns, would write down pensions relative to writing down bondholders, your assessment of local politics should inform what you think the city is going to do.
CD: So it becomes a political question, not a legal one.
DS: Right - there was a big debate among lawyers as to whether this was legally acceptable, since they’re both unsecured creditors. But in practice it’s turned out that cities have a huge amount of power to make their determinations on who they pay. This is subject to some limits - the courts have to agree to it - but courts have given cities pretty wide berth to make those determinations.
CD: Makes sense - and seems like a good note to end on.
Yes, the one from The Room Where it Happens.
Conor note: both of our public utility enterprises - the water and sewer systems - also have reasonably significant amounts of Revenue Bonds as well (see the second chart here).