Moody's Revises State of Illinois' Rating Outlook to Negative from Stable

Moody's Investors Service has revised the State of Illinois' credit outlook to negative from stable, while affirming the state's general obligation debt rating at A2. The state has about $28 billion of G.O. bonds outstanding. We have also affirmed related ratings assigned to state borrowings, including about $2.6 billion of debt issued by the Metropolitan Pier & Exposition Authority, rated A3, and the state's Build Illinois sales tax revenue bonds, rated A2, of which $2.7 billion are currently outstanding. The negative outlook is linked to ratings on the G.O. as well as the related credits.

The negative outlook reflects our view that the state's pension funding pressures are likely to persist and perhaps worsen in the near term. Moreover, fiscal 2014 marks the last year before Illinois' 2011 income tax increases are partly unwound, putting the state on track to deal with simultaneous growth in pension funding needs and loss of revenue. If the legislature in coming weeks or months enacts significant pension reforms, they are almost certain to be challenged, given the state's constitutional protection of retiree benefits. Political pressures, coupled with the threat of litigation, may mean that any reforms enacted have only a marginal effect on liabilities. Despite a diverse economy with above-average wealth, lackluster demographic and economic characteristics indicate that, even with continued US economic improvement, the state's existing tax structure will not provide enough revenue to address the rising cost of pension benefits and other state expenses. In addition, the state's payment backlog remains high.

STRENGTHS

-- Sovereign powers over revenue and spending

-- Statutory provisions giving priority to debt service over other state expenditures

-- Large, diverse, and wealthy economy

CHALLENGES

-- Severe pension funding shortfall

-- Chronic use of payment deferrals to manage operating fund cash

-- Long-term weak management practices reflected in pension under-funding and bill payment delays

DETAILED CREDIT DISCUSSION

STATE'S ABILITY TO MANAGE CONTINUING ASCENT OF PENSION FUNDING REQUIREMENTS REMAINS UNCLEAR

Governor Quinn is pushing lawmakers to pass reforms to pensions during the "lame-duck" sessions at the beginning of next month, before the formal start of the General Assembly's new term, on January 9. This year, the state legislature repeatedly failed to act on pension reform -- during the regular session that ended May 31, during a one-day special session convened by the governor on August 17, and again during the state's "veto sessions" in November and December. When we lowered the state's rating in January, we noted that the state might be unable to muster the political will to address its pension liabilities this year. As the year draws to a close, prospects for significant reforms remain unclear. A sense of urgency is growing and the governor is exhorting action within four weeks, but neither the governor nor legislative leaders have articulated a preferred course of action. Political pressures against action remain strong, as does the threat of litigation against any meaningful pension reforms enacted. We therefore see substantial risk of outcomes other than successful pension reform, suggesting that the steady growth in pension funding pressure will continue. The scheduled partial sunset, in 2015, of the state's 2011 income tax increases would leave the state grappling to cope with increased pension funding costs at a time when its revenues are dropping significantly. The tax-increase legislation (which raised corporate and personal income tax rates as of January 1, 2011) includes provisions to reduce tax rates on January 1, 2015.

ILLINOIS REMAINS OUTLIER AMONG STATES BASED ON SIZE OF PENSION LIABILITIES

Illinois remains an outlier among states for the size of its unfunded pension liabilities. Its five major plans had an actuarial accrued liability (AAL) of $158.6 billion as of June 30, 2012, up from $146.5 billion a year earlier. Assets of the plans on that date amounted to $62 billion, resulting in an unfunded actuarial accrued liability (UAAL) of $97 billion (as reported in the retirement plan valuations, without asset smoothing). Contribution shortfalls have been the main cause of the mounting UAAL since 1996. In fiscal 2011, for example, the employer contributions to the state's pensions amounted to almost $4.3 billion. While this amount satisfied Illinois' statutory contribution requirement, it was only about 73% of the annual required contribution (ARC) -- the actuarially determined amount needed to provide both for current-year accrued benefits and for UAAL amortization. Under current Illinois pension funding law, state contributions will account for increasing shares of resources in coming years without substantially boosting the pensions' funded status; state figures indicate a combined funded ratio (actuarial assets to liabilities) of less than 50% even in 2020. Some past legislative pension reforms have placed a higher priority on near-term fiscal relief, allowing pension challenges to worsen. We would view such actions next year as evidence that the state - for either political or legal reasons - is unable to effect pension reforms that prevent further, substantial credit deterioration.

STATE ANTICIPATES MODEST IMPROVEMENTS ON ACCOUNTS PAYABLE IN CURRENT FISCAL YEAR

Deferred bill payments by the state have factored into Illinois downgrades during the past three years and remain a significant credit challenge, although state budget officials anticipate modest progress in reducing them in the current fiscal year. As of July 1, when the year began, the state had approximately $7.5 billion to $8 billion of unpaid obligations, according to the state comptroller. The payment backlog represented a slight improvement from the preceding two years, when the total was $8.5 billion. Amounts included in that estimate are not limited to general funds vouchers in the comptroller's office; they also contained Medicaid and state-employee health insurance bills not transmitted to the comptroller. Looking only at comptroller-held, unpaid general fund bills, the amount totaled $3.656 billion, compared with $3.798 billion a year earlier. More recently, the comptroller has voiced concern about the state's ability to reduce its accounts payable balance in the current fiscal year. In her November quarterly report, the comptroller noted that the state's general funds accounts payable had increased as of September 30, to $5.9 billion compared with $3.8 billion a year earlier. The outstanding unpaid bills included almost $1.4 billion attributable to year ended June 30, 2012. The state's delayed payments, according to the comptroller, meant it was likely to use $5 billion of fiscal 2013 revenue to pay fiscal 2012 liabilities. She also voiced concern over the possible need for supplemental appropriations to cover expected expenses in the year ending June 30, 2013.

The tax increases enacted in 2011 bolstered state revenues, but these revenues were allocated in large part to offsetting the loss of about $6.6 billion of prior-year non-recurring items, including federal stimulus dollars. In addition, the state had to adjust for the loss of proceeds of debt issued for operating purposes the prior year: $3.68 billion to finance pension contributions and $1.35 billion from tobacco-settlement revenue bonds. A law passed this year created a Backlog Payment Fund dedicated to paying outstanding non-Medicaid bills. In addition, a joint resolution of the General Assembly mandates that any surplus be used to reduce outstanding accounts payable. Current projections indicate an 18% to 20% decline in the general funds' accounts payables, based on an expected budgetary surplus of more than $1 billion.

NEGATIVE ENDING FUND BALANCE IMPROVES AS A SHARE OF REVENUES

Using deferrals to manage operating cash has worsened the state's year-end, negative fund balances over time. Illinois has reported negative available operating fund balances that are larger as a share of its budget than any other US state. In 2011, under the Governmental Accounting Standards Board's new fund balance reporting standard (Statement No. 54), Illinois had negative unassigned general fund balance of $9.28 billion, or about 38% of general fund revenue, adjusted for federal money. Although the dollar amount equaled the prior-year negative balance, the share of budget represented by this figure was less, because of the state's increased tax revenue in fiscal 2011 compared with 2010.

MEDICAID MEASURES WILL HELP ADDRESS PROVIDER PAYMENT BACKLOG

Payments owed to Medicaid providers have long been a component of the state's past-due bills, because the state tended to roll these payables from one fiscal year to the next. To address a $2.7 billion Medicaid deficit anticipated in the current fiscal year, the state enacted a $1-per-pack cigarette tax increase, bringing its total levy to $1.98. This measure is expected to raise $350 million of additional tax revenue, which will be expended on Medicaid services, leveraging additional federal reimbursements of $350 million. The state enacted $1.6 billion of Medicaid cost cuts, including provider rate reductions, tightening of eligibility requirements, termination of a prescription drug benefit program, elimination of optional services and enhanced fraud detection. Another $100 million of Medicaid funding is being provided through a new hospital assessment tax, and the state also allocated (but has yet to appropriate) $300 million of additional general fund revenues to the program.

FISCAL 2013 BUDGET ASSUMES FLAT REVENUE GROWTH TREND

The enacted budget assumes that growth in the state's top four tax sources (individual and corporate income taxes, sales and utilities taxes) will slow essentially to zero after surging 24% last year, because of the implementation of income tax increases. Total general fund operating sources are projected to increase 2%, reflecting a 15% jump in federal revenues. Total operating expenditures and transfers out decline by an estimated $896 million to $32.9 billion. Expenditures are reined in in many categories, including public school funding and higher education. However, these expenditures do not represent all the likely needed appropriations for the current year. The enacted budget provided for only six months of premiums for the state group health insurance program. Assuming the General Assembly eventually approves funding for the remainder of the year, the expenditures would increase by about $550 million. The precise extent of additional health insurance program costs is unclear, because of the recent implementation of a law allowing the state to charge retirees additional amounts for health insurance coverage. According to the state comptroller, the legislature also failed to provide sufficient appropriations for the Department of Human Services and possibly for the Department of Aging. Revenues for the fiscal year through October were on track with estimates. The state's four major tax sources had generated about $8.7 billion, 1.8% more than projected.

BUDGET ALSO AVOIDS RELIANCE ON NON-RECURRING MEASURES AND CASH-FLOW BORROWING

The enacted budget continues the state's avoidance of cash-flow borrowings and non-recurring funding measures for a second year. In fiscal years 2010 and 2011, the state issued a total of $7.2 billion of bonds to fund annual pension contributions. The governor's 2013 budget relies on continued strong revenue from the 2011 tax increases, but the state in future years will have to adjust to sunset provisions embedded in the tax-hike legislation. The tax increases generate new net revenues of more than $7 billion annually in fiscal years 2012 through 2014, according to a February 2012 projection by the state legislature's Commission on Government Forecasting and Accountability. The increases begin to sunset halfway through fiscal 2015, with the individual income tax rate falling to 3.75% from 5% and the corporate rate falling to 5.25% from 7%. The fiscal 2015 revenue reduction is projected at $2.2 billion. In fiscal 2016, when lower taxed rates will be in effect the full year, the loss versus 2014 is estimated at about $4.7 billion. The fiscal 2015 and 2016 revenue declines will coincide with rising pension contribution requirements.

POLITICALLY DIFFICULT DECISIONS WILL BE REQUIRED TO STABILIZE STATE FINANCES

Illinois' government has reached consensus on difficult decisions, such as last year's temporary tax increase legislation and this year's cigarette tax increase and related Medicaid measures, all of which stabilized state finances. Addressing the pension and payment backlog challenges in full, however, will require significant political will to combat conditions that have persisted and worsened over many years. Such solutions cannot be reached easily, as was demonstrated this year.

STATE CAN DRAW ON A LARGE AND DIVERSE ECONOMIC BASE

Illinois retains a strong economic base to draw on. Its personal income per capita is 105% of the nation's, and its 2011 GDP of $671 billion ranked fifth among states. As a Midwest state with exposure to manufacturing, Illinois participated in the sharp manufacturing declines of 2009, losing 12% of its employment in the sector that year. The state has benefited from manufacturing stabilization in the last two years, adding 2% to manufacturing employment in 2011 after a moderate decline (3%) in 2011. In the Rockford area, as many as 4,500 jobs are being regained at Chrysler's Belvidere plant to make the redesigned Dodge Dart.

OUTLOOK

The negative outlook reflects the possibility that the state will fail to make substantial progress addressing its credit challenges in the near term.

WHAT COULD MAKE THE RATING GO UP

- Implementation of a credible, comprehensive long-term pension funding plan

- Substantial progress in reducing payment backlog, with adoption of a legal framework or plan to prevent renewed buildup of bills

WHAT COULD MAKE THE RATING GO DOWN

- Early phase-out of 2011 tax increases without offsetting binding expenditure actions, increasing the structural gap

- Further deterioration in pension funded status or failure to make legally required pension contributions in full

- Failure to enact pension reforms, or passage of reforms that have limited impact on liabilities or are used to justify reductions in near-term pension contributions

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