CHICAGO – Political gridlock in Illinois spurred a new round of downgrades to the state's already tarnished bond ratings as its bill backlog balloons and red ink swells with no end in sight to a year-old budget stalemate.
Moody's Investors Service dropped the state one notch to Baa2, two notches above junk, ahead of a $550 million general obligation sale pricing next week. S&P Global Ratings followed, lowering the state one notch to BBB-plus from A-minus. Both assign negative outlooks.
Fitch Ratings affirmed its BBB-plus rating Thursday but placed it on negative watch. Fitch previously assigned a stable outlook after downgrading Illinois to BBB-plus from A-minus in October. Analysts expect to resolve the watch status in the next six months depending on budget progress.
The deal comes against the backdrop of a prolonged budget impasse as the state careens toward fiscal 2017 on July 1 without a fiscal 2016 or 2017 budget in place.
Deep rancor between Republican Gov. Bruce Rauner and the General Assembly's majority Democrats has prevented a compromise, prompting one high-profile investor to suggest a buyer boycott. The downgrade heightens swap termination risks for Illinois and will fuel political sniping and negative headlines likely to add to the state's borrowing costs.
Moody's action late Wednesday affects $26 billion of state GOs and $2.7 billion of sales-tax backed Build Illinois bonds, which were also dropped one notch to Baa2 from Baa1.
Moody's last downgraded the state in October, to Baa1 from A3.
In connection with the GO bond downgrade, S&P also lowered the state's appropriation debt to BBB from BBB-plus and junked its moral obligation backed bonds, dropping them to BB-plus from BBB-minus.
Both put the downgrades squarely at the feet of state leaders over their inaction.
"The rating downgrade reflects continuing budget imbalance due to political gridlock that for more than a year has kept Illinois from addressing revenue lost due to income tax cuts that took effect in January 2015," Moody's wrote.
"The state's challenges are largely political. With a consensus in place, Illinois could quickly provide for fiscal balance in the coming fiscal year, given the breadth of its economic base," Moody's added.
The downgrade reflects the state's weakened financial management and fiscal position due to the delay in tackling its fiscal woes, said S&P analyst John Sugden.
"The duration of this mismanagement has undermined Illinois' credit profile and impeded its ability to address its long-term liabilities," he said.
S&P had rated Illinois A-minus since downgrading it from A in January 2013.
S&P said the state could stabilize its credit should "elected leaders demonstrate the ability to negotiate and agree on a revenue and spending package that makes significant and long-lasting improvements to the state's structural budget alignment."
The state's deficit and rising bill backlog is due in large part to the partial expiration of a 2011 income tax hike that raised the individual rate to 5% from 3% and the corporate rate to 7% from 4.8%. Last year they rolled down to 3.75% and 5.25%, respectively.
Illinois was already the lowest rated state. Moody's records date back to 1970 and the only state at the same level since then has been Massachusetts which from 1990 to 1992 was rated Baa, in a period when Moody's did not assign 1, 2, or 3 modifiers, said spokesman David Jacobson.
Rauner wants Democratic support for worker's compensation and tort reforms and local government union curbs in exchange for tax increases to supplement $32 billion in revenues and help close a $4 billion to $5 billion deficit.
Democrats consider his policy wish list too business-friendly and want the budget tackled separately. Rauner is now pushing a stopgap spending plan that would get the state through the November election and into January, buying time to reach a long term agreement.
Moody's also lowered the Metropolitan Pier and Exposition Authority's $2.7 billion of debt to Baa3 from Baa2 to reflect the risk on the state appropriation needed to allocate its tax revenue for debt payments.
The state has $113 billion of unfunded pension obligations in a system just 41% funded.
Contributions of $7.8 billion will consume a good chunk of $33 billion in expected general fund revenues in fiscal 2017.
The state's backlog of unpaid bills could top a record $10 billion by the fiscal year's end June 30.
"The potential for economic underperformance or unplanned liquidity demands heightens the risk of further financial weakening," Moody's analysts wrote.
Illinois benefits from a large and diverse economic base, legal provisions that ensure continued payment of debt even with no enacted budget, and sovereign powers to increase revenues or constrain spending. While its general fund faces a bill backlog, the state enjoys a cash balance of $9.75 billion in an array of special non-general fund accounts.
The prolonged budget gridlock leaves the state vulnerable to adverse revenue trends, unplanned liquidity demands, and increasingly underfunded retiree benefit plans which could further erode its rating, Moody's said.
TERMINATION RISKS
The Moody's cut puts Illinois one downgrade away from triggering termination events on five interest-rate swap agreements tied to $600 million of variable-rate debt from 2003. Moody's said the negative valuation on the swap was $155 million at the end of April. Termination events are triggered if the state's GO rating falls to Baa3 from Moody's or BBB-minus by S&P.
The $600 million is synthetically swapped to a fixed rate of 3.89%. The counterparties are AIG Financial Products Corp., Bank of America, Merrill Lynch Capital Markets, JPMorgan Chase Bank, and Loop Capital/Deutsche Bank AG.
The paper is supported by six direct pay letters of credit that expire Nov. 26 from JPMorgan Chase, PNC Bank, Wells Fargo Bank, State Street Bank & Trust Co., Royal Bank of Canada, and The Northern Trust Co.
The state recently hired Swap Financial Group and Katten Muchin Rosenman LLP to work on easing the liquidity risks. The contracts limit pay to $425,000 to Swap Financial Group and $100,000 to Katten.
Moody's says the swap and floating-rate risks represent a small piece for a $26 billion GO debt portfolio.
YIELDS
The state's 10-year GO paper has been trading at a 180 basis point spread to the Municipal Market Data's top-rated benchmark. While the state could see its penalty widen given the fresh downgrades and negative headlines, strong overall demand will limit the premium, some market participants said.
Blackrock strategists suggested that shouldn't be the case.
"We as municipal market participants should really be penalizing in some way, by almost not giving them any access to the market," said Peter Hayes, head of the municipal bonds group. "Think about it, they are a state without a budget, they refuse to pass a budget, they have the lowest funded ratio on their pension of any state, and yet they're going to come to market and borrow money."
Blackrock's Sean Carney, head of municipal strategy, said strong demand has reduced the penalty for fiscal problems. "There are a few ways to look at it. One way is that you see the spreads widening but another way to look at it is that with rates continuing to fall, even though they are coming in at wider spreads, the all-in interest cost is not that much greater then where they were, when they previously issued."
On its last sale in January, Illinois' 10-year maturity paid a yield of 3.33%, 155 basis points over the top-rated MMD benchmark and 61 basis points over the triple-B benchmark. The spreads were lower than the 170 to 180 basis points Illinois GO paper was trading at leading up to the transaction.
The spreads marked a sharp jump from 95 to 110 basis points on deals in 2014 before the Illinois Supreme Court overturned state pension reforms in May 2015 and the budget impasse took hold.
RHETORIC AND DISCLOSURE
The downgrades provided fresh fodder for political attacks.
Rauner put blame on Democrats. "Every rank-and-file Democrat who blindly followed the Speaker down this path is directly responsible for the downgrade," Rauner spokeswoman Catherine Kelly said in an email.
On Wednesday, the three key players in the state budget quagmire dug in. Rauner attacked House Speaker Michael Madigan, D-Chicago, for cancelling a Wednesday session as budget working groups continue discussions.
"Speaker Madigan and his supermajority are clearly working to create a crisis, clearly putting stress in the system, threatening our schools and threatening our essential government services….using it as leverage to force a bailout of the Chicago Public Schools and city of Chicago and to force a major tax hike after the general election in November….without reforms," Rauner said.
Democrats want to increase poverty grants to schools, which would benefit CPS, and to provide about $205 million for teacher pensions payments, mirroring what it does for other districts. Rauner wants to provide a slight education funding increase and keep lawmakers at work on a funding overhaul for future budgets.
Senate President John Cullerton, D-Chicago, at a later news conference, called on Rauner to put a halt to his "wild" campaign-like rhetoric and focus on stopgap budget negotiations.
"Right now we need a governor…..the over the top rhetoric is distracting at best, hurtful at worst," he said.
Madigan Thursday said the downgrades were "directly attributable to Governor Rauner's reckless decision to hold the state hostage for more than a year and to create the crisis he desired."
State comptroller Leslie Geissler Munger, a Republican appointed by Rauner to the post last year, called the Moody's downgrade a reflection of the "riskiness" in loaning money to the state. Her comments were made during a news conference called to warn of the dire impact on social service providers, educators, and others if a stopgap budget is not soon approved.
State Treasurer Michael Frerichs, a Democrat, said in a statement after the Moody's action that "Illinois remains a good investment, but the focus on non-budgetary items is driving up the cost of government. Higher interest rates when we borrow money mean fewer dollars for teachers, child care workers, and others who serve our most vulnerable."
Illinois' finance team sought to highlight the state's positives in an investor presentation that offered a measured tone in stark contrast to the political rhetoric.
Investment considerations begin on page 8 of the offering statement.
"The state's financial condition has been materially adversely affected by the budget impasse," it says.
Still, the state "has strong fundamentals with room for improvement," capital markets director Kelly Hutchinson told potential investors in a recorded presentation. She highlights the strong GO security features that give debt service a priority lien on state revenues and the pre-funding of debt service which is paid under a continuing appropriation without a budget in place.
"The budget impasse highlights the importance of these protections," she said.
