Fitch Places State of Illinois on Negative Watch; Rates $550MM GO Bonds ‘BBB+’
By Business Wire News
By Business Wire News
Fitch Ratings has assigned a ‘BBB+’ rating to the following general obligation (GO) bonds of the state of Illinois:
–$550 million GO bonds, series of June 2016.
The bonds are expected to sell competitively on June 16, 2016.
In addition, the state’s Issuer Default Rating (IDR), $25.8 billion in outstanding GO bonds of the state, and the current issuance of series of June 2016 have all been placed on Rating Watch Negative. Fitch expects to resolve the Rating Watch within the next six months based on the progress of the fiscal 2017 budget. Fitch will assess state action to address the chronic and growing financial imbalance that has resulted from management’s unwillingness to make use of the significant gap-closing tools available
In conjunction with this rating action, Fitch also placed on Rating Watch Negative the following ratings, which are linked to the state’s IDR, all rated ‘BBB’:
–$431 million Illinois Sports Facilities Authority sports facilities bonds (state tax supported);
–$2.6 billion Metropolitan Pier and Exposition Authority McCormick Place expansion project bonds;
–$267.8 million city of Chicago motor fuel tax revenue bonds.
The bonds are general obligations, full faith and credit of the state of Illinois.
State statutory mechanisms include an irrevocable and continuing appropriation for all GO debt service, and continuing authority and direction to the state treasurer and comptroller to make all necessary transfers from any and all revenues and funds of the state. The state funds debt service in advance by setting aside 1/12 of principal and 1/6 of interest every month for payments due in the ensuing 12 months.
KEY RATING DRIVERS
The Rating Watch Negative reflects the financial implications of the state’s extended budget stalemate, which seems likely to continue into a second fiscal year. Illinois has failed to capitalize on economic growth to bolster its financial position. Rather, the decision to allow temporary tax increases to expire and the subsequent failure to develop a budget that aligns revenues with expenditures have resulted in a marked deterioration in the state’s finances during this time of recovery. Once again, the state has displayed an unwillingness to utilize its extensive control over revenues and spending to address numerous fiscal challenges. Fitch expects to resolve the Rating Watch within the next six months following an assessment of whether or not an enacted fiscal 2017 budget addresses the structural budget imbalance and, if a budget is not enacted, the resulting effect on financial condition of the state.
The ‘BBB+’ rating continues to reflect the strengths inherent in a state’s independent ability to control its budget, which remain substantial in Illinois despite policy decisions over a long period that have reduced expenditure flexibility. The rating also incorporates the state’s elevated but still moderate liability burden. These factors are offset by a history of notable fiscal management weakness that manifests itself in weak operating performance throughout the economic cycle.
Economic Resource Base
The state benefits from a large, diverse economy centered on the Chicago metropolitan area, which is the nation’s third largest and is a nationally important business and transportation center. Economic growth through the current expansion has lagged that of the U.S. as a whole.
Revenue Framework: ‘aa’ factor assessment
Illinois’ broad revenue base, primarily income and sales taxes, captures the diversity in its economy and has shown modest growth since the end of the recession. Fitch expects revenue performance to continue to track slow economic growth. The state has unlimited legal ability to raise revenues.
Expenditure Framework: ‘a’ factor assessment
Illinois has adequate expenditure flexibility despite elevated carrying costs for debt service and retiree benefits, with much of the broad expense-cutting ability common to most U.S. states. However, it is unlikely that reductions in state spending alone would be sufficient to achieve budgetary balance given the magnitude of the current budget gap. Funding demands associated with retiree benefits will continue to be a pressure as these benefits are constitutionally protected.
Long-Term Liability Burden: ‘a’ factor assessment
Liabilities are an elevated but still moderate burden on Illinois’ resource base, even when considering the large and growing accounts payable backlog that the state has accumulated. The state has limited flexibility with regard to pension obligations following a May 2015 Illinois Supreme Court decision that found 2013 pension reform unconstitutional.
Operating Performance: ‘bbb’ factor assessment
Illinois’s operating performance, both during the most recent recession and in this subsequent period of economic growth, has been very weak. The failure to address a long-standing structural budget gap with permanent and comprehensive solutions, whether revenue or expenditure, has left the state with a gaping hole in its operating budget and increasing budgetary liabilities. The failure to enact a budget for the whole of fiscal 2016, which may be repeated in fiscal 2017, reflects an unprecedented level of political discord and dysfunction.
FISCAL 2017 BUDGET: Failure to enact measures that lead to ongoing budget balance would trigger a downgrade. Successful implementation of measures to enact a structurally balanced budget and reduce accumulated budget liabilities would place the credit on a positive trajectory.
Illinois is a large, wealthy state at the center of the Great Lakes region. It benefits from a diverse economy centered on the Chicago metropolitan area. Illinois’ economy has gradually shifted, similarly to the U.S. in general, away from manufacturing to professional business services. The remaining manufacturing sector does include more resilient non-durables, and is less concentrated in the auto sector than surrounding states, but remains vulnerable to cyclical downturn. By most measures the economy has grown slower than the nation for many years and population levels have been stagnant.
Illinois has a reasonably diversified revenue base. It relies most heavily on personal income taxes (close to half of general fund revenues) and sales tax. The balance consists of corporate income tax, lottery and gaming revenues, and a variety of other smaller taxes and transfers. The state has a flat personal income tax rate of 3.75%, which was temporarily increased to 5% between 2011 and 2015 from the prior flat rate of 3% to close post-recession budget gaps and reduce accumulated liabilities.
Historical revenue growth, adjusted for the estimated impact of policy changes, has been slightly above the inflation rate over the 10 years through 2014 but has somewhat lagged national economic growth. With Illinois’ economic performance also lagging national growth, Fitch expects a continuation of this trend of flat to modest real revenue growth.
Illinois has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.
As with most states, Illinois’ spending is largely for social services and education, although its carrying costs for debt service and pension payments are comparatively high.
Spending growth, absent policy actions, is likely to be higher than revenue growth, driven mainly by increasing pension costs. Illinois has chronically underfunded its pension system based on a statutory formula that permitted a slow incremental build-up to higher pension funding and targeting only 90% of full actuarial funding. Pension costs are unusually large and continuing to grow, crowding out other spending. As with most states, other spending drivers include Medicaid and education. The fiscal challenge of Medicaid is common to all U.S. states and Illinois has taken action to control costs, including shifting clients into managed care and tightening eligibility.
Despite carrying costs that are among the highest of the states, Fitch believes that Illinois retains adequate expenditure flexibility that could be used in the budget process. Illinois funds a broad range of services for its citizens and did not significantly reduce spending during the recession. This leaves the state with ongoing capacity to make spending reductions if needed. However, Illinois has no ability to unilaterally modify retiree benefits following the May 2015 Illinois Supreme Court decision that found a 2013 pension reform unconstitutional.
During the current budget impasse, almost 90% of spending has continued to be funded at the 2015 rate, based on continuing appropriations, consent decrees, and court orders, as well as the enacted budgets for education and certain critical state operations. There is little flexibility to control spending outside of the budget process in part because the governor cannot unilaterally make changes without legislative participation.
Long-Term Liability Burden
Illinois’ long-term liabilities, particularly pension liabilities, are very high for a U.S. state. Illinois is the weakest of the states in terms of its ratio of debt and unfunded pension liabilities to personal income, at 25% as of 2015, well above the 5.8% median for states. All three of the state’s three pension systems, covering teachers, universities, and state employees, have low funded ratios driven by a history of weak contribution practices.
Short-term borrowing is allowed, subject to a limitation of 5% of appropriations for revenue anticipation purposes, which must be repaid by the close of the fiscal year, and 15% to meet revenue failure, which must be repaid within one year. The state has no short-term borrowing currently outstanding or planned, although notes were issued during the downturn.
Illinois is poorly positioned to address a future economic downturn. While it has substantial theoretical capacity to weather a downturn, both in terms of revenue raising potential and spending flexibility, it has not demonstrated the political capacity to achieve a long-term solution to its chronic budget deficits. During the recession, the state largely maintained spending but delayed payments to address lower revenues. It accrued, as a result, an accounts payable balance that at its peak, reached 20% of the operating budget. In the absence of a change in management’s approach to state finances, it is Fitch’s expectation that future deficits would also be addressed by deferring state payments and increasing accumulated liabilities.
Illinois’ budget management during the current period of expansion also has been especially weak. Temporary increases in personal and corporate income tax rates in place for four years, from Jan. 1, 2011 through Dec. 31, 2014, closed or partially closed the budget gap across five fiscal years. However, with their expiration, and the failure to enact a spending plan within expected revenues, the budget gap has ballooned. As a result, the state finds itself with a current operating deficit, structural budget deficit, cash crunch, and accumulation of accounts payable that approaches its highest level at the depth of the recession.
The governor and state legislature could not come to agreement on a spending and revenue plan for the current fiscal year, which ends June 30, 2016. As a result, there is a large projected deficit. Further, Fitch believes a significant portion of the remaining budget, which includes major funding items such as group health insurance and higher education, will ultimately have to be covered with state revenue. Based on currently expected revenues, this would lead to as much as a $3.4 billion to $4.3 billion operating deficit, or 10% to 14% of revenues.
The legislature ended its spring legislative session on May 31, 2016, without passing a budget for fiscal 2017, which begins July 1, 2016 and it appears unlikely that a budget will be enacted prior to the start of the fiscal year. The governor has proposed a partial year budget while continuing negotiations over the budget and his proposed reform agenda, which addresses issues separate from the budget. In the absence of an enacted appropriation, there will be no fiscal 2017 funding available to schools. In the past, the state has passed revenue-raising measures in the middle of the fiscal year.
Additional information is available at ‘www.fitchratings.com‘.
In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.
U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)
Dodd-Frank Rating Information Disclosure Form
Fitch Ratings, Inc.
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New York, NY 10004
Elizabeth Fogerty, New York, +1 212-908-0526