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Illinois remains on brink of becoming first state rated junk, but does pass a budget

SPRINGFIELD (Heartland Newsfeed/MarketWatch.com) — Illinois, which currently has the lowest-rated bond rating of any U.S. state, took another step Tuesday to ward off a deepening budget crisis and an imminent risk of becoming the first state ever branded with a junk bond rating.

Fog surrounds the Sears Tower in Chicago. (Getty Images)

The state entered an unprecedented third straight fiscal year without a budget on Saturday and the process has been crippled by the partisan impasse between Republican governor Bruce Rauner and Democrats who control the legislature. However, the Illinois Senate, who worked over Independence Day, passed a major permanent income tax hike amounting to $5.4 billion but the Illinois Senate as part of a $36 billion budget plan, following the House approving their version on Sunday, which required several Republicans to break ranks with Rauner for passage.

Rauner, as pledged, promptly vetoed the measures. The Illinois Senate already voted to override the veto and the House is expected to follow suit this week.

This action MIGHT hold the credit rating agencies at bay – for now – but the risk of being downgraded to a junk rating can still happen this year, and the consequences could severely harm the state, the fifth largest in the nation.

Illinois currently has a $15 billion backlog of unpaid bills, roughly 40% of the state’s operating budget. A junk rating could hit investors too, although the state’s pledge to keep up with bond payments has preserved bond values so far.

The fiscal-year deadline caught up with other states as well. Maine and New Jersey announced Saturday that their respective government operations would have to shut down after lawmakers failed to reach budget deals before Friday’s midnight deadline. Both states came to a budget agreement early this week.

Rauner, who likely faces a tough re-election battle in 2018, had sought a temporary tax hike and a property tax freeze.“Under Speaker [Michael] Madigan’s direction, legislators chose to double down on higher taxes while protecting their special interests and refusing to reform the status quo. It’s a repeat of the failed policies that created this financial crisis and caused jobs and taxpayers to flee” the governor, who was elected on his pledge to reform pensions and break union power, said earlier in the process.

For his part, Madigan, the Chicago Democrat who is House Speaker, has been insistent on linking non-budget demands to the budget discussion, including an education funding overall. Illinois is one of only a handful of other states that rely on property taxes to fund schools.

Past-due bills are a big strike against Illinois’s credit standing, but Standard & Poor’s, which rates the state BBB-minus or one step away from the “junk” rating that would be the first for any state, has warned about a chronic structural deficit. S&P has Illinois on warning for a downgrade to BB-plus. The state is rated Baa2 by Moody’s Investors Service and BBB by Fitch Ratings, both with negative outlooks.

Standard & Poor’s responded to the House passage by calling that action a “meaningful step.”

”Even with a budget, however, it’s likely that Illinois’ finances would remain strained and vulnerable to unanticipated economic stress. In addition to having accumulated record amounts of payables, the state’s university system has been deprived of state funding since January,” S&P analysts said. “If a budget is enacted, the degree to which it closes the state’s structural deficit, provides a pathway for addressing the backlog of unpaid bills and its impact on cash flows will be important factors in our review of its effect on Illinois’ credit quality.”

Spillover effect?

The state’s uninsured general obligation debt traded this week as high as 95 cents on the dollar, well above junk equivalents. Much of Illinois’s $25 billion in outstanding general obligation debt is held by individual investors. Money management giant Vanguard Group has $1.2 billion of the state’s bonds spread across seven mutual funds. It is the biggest holder among all mutual fund firms that own a total of $4.5 billion in Illinois bonds, according to research firm Morningstar.

Most mutual funds have rules limiting their investment in junk-rated debt, although rules typically do not force them to sell debt that has fallen into junk. At Vanguard, mutual funds are allowed to hold a “modest allocation” of junk bonds, a spokesman told The Wall Street Journal.

Analysts predict investors could demand an additional half-percent to a percent in interest as compensation for the perceived risk that comes with a junk rating. That will tack on an additional $5 million to $10 million for every $1 billion the state borrows. Illinois already pays a premium. When it last sold tax-exempt debt in November 2016, the state paid yields of 4.4% for 20-year bonds. In contrast, 20-year bonds issued by the state of Wisconsin around the same time yielded 2.8%, The Wall Street Journal reported.

The situation has prompted some comparisons with Puerto Rico, which earlier this year announced a historic restructuring of some of its $70 billion in debt through courts after negotiations with bondholders fizzled.

New Jersey and Connecticut, among the lowest-rated states after Illinois, face their own longer-term budget problems and mounting liabilities. But New Jersey and Connecticut still have a long way to go to match Illinois’s ratings risk; they are rated several notches higher by S&P and Moody’s Investors Service. Other than Illinois, New Jersey, and Connecticut, the lowest rating of any other state is AA-. There are nine states rated higher than the U.S. itself even, with full AAA ratings.

New Jersey Gov. Chris Christie was in the weekend spotlight after cameras captured the Republican leader enjoying the sand and surf at a waterfront Jersey Shore park that been closed to the public because of the state’s budget impasse.

Unlike city and county governments, states cannot legally declare bankruptcy, whereby they force creditors, bondholders and pensioners to absorb some of the loss, although a state could technically default on its bonds. The last time a state declared bankruptcy was Arkansas in 1933, in the throes of the Great Depression.

Bob DiMella, co-head of municipal managers at MacKay Shields, said at a Morningstar conference earlier this year that he found Illinois bonds more attractive than New Jersey equivalents in part because Illinois, for all the political pain of the budget process, was “trying to rectify” its situation while New Jersey appeared to be in denial over its falling revenues. Connecticut wasn’t far behind with its own revenue issues, he said. Even bigger, the municipal market had already somewhat discounted Illinois bonds, meaning they were better priced relative to risk than other muni bonds.

What’s next for Illinois?

For the first time ever, Illinois suspended sales of Powerball and Mega Millions lottery tickets if there is no budget. And out of Illinois’ 401 public school systems, 144 expect to have less than 90 days of operating cash at fiscal year-end, Robert Wolfe, chief financial officer for the Illinois State Board of Education, has said. Its state universities and social services agencies are also running very lean.

State government currently brings in just $32 billion, meaning $4.5 billion in new taxes would be needed to make the books balance, although the state also has a large backlog of unpaid bills. A Wall Street Journal editorial drubbed Rauner for saying he’ll accept a four-year increase in the state income tax and expand the sales tax, labeling such concessions “capitulation” and “a political defeat by any definition. Rauner wanted a property tax freeze in return for tax hikes, but Democrats rejected the idea, worried it would create deeper financial problems for schools and local governments.

“Tax hikes have been tried in Illinois before. They’ve inevitably failed because they don’t fix the core problems of too much debt and too much spending. In fact, they allow such reckless behavior to continue,” said Michael Lucci, vice president of policy at the right-leaning Illinois Policy Institute. “Taxpayers need to put Illinois’ government on a diet, not the other way around.”

The group leans on what it sees as a tax-hike spiral that has had little traction in growing the economy. The 2011-2014 Illinois income tax increase triggered a significant flight of income-earning power from the state. Illinois lost more than $14 billion of annual adjusted gross income during the four years of the tax increase, the IPI said. The average income of a taxpayer leaving Illinois rose to $77,000 a year, compared with an average income of $57,000 for taxpayers entering Illinois. This income-earning differential—people leaving making $20,000 more than people entering—is the largest of any state.

But there’s more than money management at issue, say observers. The political fighting extends to the future of pension reform, school funding and more. The unfunded pension liability for the state’s five major plans grew 25% alone in one year, reaching $251 billion, according to Moody’s.

But that resolution may have to wait. Major pension plan reform will require a change to the Illinois constitution. And for now, the state is just trying to keep the lights on.

Written by MarketWatch’s Rachel Koning Beals and edited for content by Jake Leonard.

About the Author

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- Jake Leonard is the editor-in-chief of Heartland Newsfeed and general manager of Heartland Internet Media Networks. He is an active contributor to the Nokomis Free Press-Progress in Nokomis, IL. He currently serves as chairman of Tri-Counties Libertarian Party, as deputy communications director for the Libertarian Party of Illinois and as chairman and co-founder of the Libertarian Party Millennial Caucus. He has also been politically active since 2015, having run for city council, state representative, school board and is currently running for state senator for the 2018 election season.

Illinois remains on brink of becoming first state rated junk, but does pass a budget