With its weak investment-grade ratings hanging in the balance, Illinois begins its 2018 legislative session with municipal bond market participants watching to see if the state can solve a budget gap and manage its pension quagmire without again driving up its bill backlog to record levels.
Political dysfunction left the state without a budget for two years before this year's spending plan passed in July.
The stakes are high with two of the state’s general obligation ratings only one notch above speculative grade. Deep political divisions between Gov. Bruce Rauner, a Republican, and the General Assembly’s Democratic majorities are only amplified by the looming March primary and November general election.
“The upcoming governor's race is likely to complicate the political landscape, making the most difficult issues, such as pensions and budget standoffs, hard to achieve agreement,” said Richard Ciccarone, president of Merritt Research Services LLC. “Expect higher taxes to be on the priority list for Democrats relative to budget issues and spending cuts to be favored from the Republicans.”
The state’s bill backlog will remain front and center. The issuance of $6 billion in general obligation bonds authorized in the budget package brought the backlog down from a peak of $16 billion to about $8.4 billion. Comptroller Susana Mendoza recently said interest on the backlog totaled $1 billion during the impasse.
“The backlog won't be entirely closed and current projected shortfalls still have to be closed and realized, such as selling the state building in Chicago,” Ciccarone added.
The state has a $1.5 billion gap to fill in the current $36 billion fiscal 2018 budget. A handful of Republicans broke with Rauner to override his vetoes of the budget, which brings in $5 billion in new revenue mostly from an income tax hike.
Agreement on a spending plan for fiscal 2019, which begins July 1, appears to be a longshot based on Rauner's comments that he will push to roll back the tax hike. The budget debate could crowd out any action on pensions or infrastructure.
Rauner and lawmakers all talk about the need to take action on pensions to rein in the annual contributions – about $8 billion this year -- and growth in unfunded liabilities, now at $128.9 billion with a funded ratio of just 39.9%.
A House committee kicked off talks on pension measures Tuesday with a hearing on a proposal to borrow more than $100 billion to pay down the debt. That proposal is unlikely to fly, and politics could get in the way of any action as both sides dig in to avoid the perception of handing the other a victory.
Local governments and transportation planners are clamoring for a capital plan now that a $31 billion, 2009 infrastructure plan has expired, but there’s been little talk over where new revenue will come from to support one.
The state’s bond market spreads have widened slightly this month to about 185 basis points above the Municipal Market Data’s top benchmark after seeing a big drop after the budget’s passage in July before settling around 175 bp late last year.
Passage of the budget staved off a cut to junk.
Moody’s Investors Service has the state at the lowest investment grade level of Baa3 with a negative outlook. S&P Global Ratings has it at the lowest investment grade level of BBB-minus but assigns a stable outlook. The state has more breathing room from Fitch Ratings at BBB, with a negative outlook.
Failure to close the current year deficit or the lack of a fiscal 2019 budget alone may not spur a cut to junk by Moody’s. But it's watching the bill backlog.
“The current rating does already acknowledge a long history and tendency toward structural imbalance” and “we are not saying the state has to create a perfectly balanced budget immediately in order to avoid a downgrade,” Moody’s lead Illinois analyst Ted Hampton said in an interview Monday.
“The question is whether the state can contain the backlog,” he said, after borrowing $6 billion last year to shrink it.
“I think the current imbalance is a concern or a potential threat to the rating in that it could drive the backlog back up,” Hampton said.
The state can maintain its credit position if it can contain the backlog through some form of spending restraint or other positive action even if a balanced budget isn’t achieved, he added.
With the state’s massive pension burden weighing heavily on the state’s credit quality, another potential rating trigger is action that “dramatically eases pension funding requirements just to relieve budget pressure,” Hampton said.
Moody's viewed negatively pension changes in this year's budget that included a smoothing of the impact of actuarial changes such as investment returns because they eased near-term contributions at the expense of the system’s long term health. But the package also created a less-generous tier 3 pension benefit plan for future hires of longer term benefits once established.
“We are looking at these tell-tale indicators….including the backlog and how they approach pension payments,” Hampton said.
Rauner is expected to outline his agenda during his State of the State speech Wednesday. The budget will be unveiled on Feb. 15.
“I will be introducing another balanced budget three weeks from now and that will include a tax cut. I will propose reforms so we can run a small surplus and begin to cut back every year Madigan’s income tax hike that he passed over my veto,” Rauner said during an appearance Monday before the Chicago Tribune’s editorial board with his Republican primary rival Rep. Jeanne Ives.
Rauner has sought to lay blame for the tax hike on House Speaker Michael Madigan, D-Chicago. Democrats will argue the state can’t afford to roll back the 32% hike in rates.
Chicago Civic Federation president Laurence Msall called on the governor and legislature to meet their “primary responsibility” which is passage of a balanced budget.
With the potential to drive back up the bill backlog, the state can’t afford to wait for the election results and can't afford a “vacation from stabilizing state finances,” he said. Not having a budget for two years was a “very expensive experiment.”
The Civic Federation in its 2018 legislative agenda will press the state to adopt other sound budget practices such as building a rainy day fund equal to 10% of general fund revenues and establishing a revenue forecast procedure.
A myriad of ideas are being pitched to rein in the state’s pension mess, but the options are severely restricted by the Illinois Supreme Court’s 2015 ruling that found any benefit cuts violate the state constitution’s pension clause.
The House’s Personnel and Pension Committee launched debate on the subject with a hearing late Tuesday on a proposal pitched by the State Universities Annuitants Association to issue $107 billion of pension obligation bonds to pay down the unfunded liabilities. The plan was developed by University of Illinois professor Runhuan Feng.
Municipal market participants have already cautioned such a move would likely sink the state’s ratings to junk and there’s little chance the market would absorb that level of borrowing, which would quintuple the state's bond debt.
Committee chairman Rep. Robert Martwick, D-Chicago, called the Tuesday hearing for Feng to outline his proposal and said in an interview he expects to call subsequent hearings seeking input from market professionals and plans to weigh other proposals.
“I’m not taking a position on the proposal but I want to put all the options on the table and explore those options,” Martwick said.
Other proposals include one that asks employees to accept cost of living adjustment cuts in exchange for preserving the ability to have future pay increases count toward pensionable salaries. Unions have threatened a constitutional challenge. Another promotes a re-amortization of the backloaded 50-year pension payment schedule reducing the funded ratio goal to around 80% from 90%.
The Civic Federation in its legislative agenda wants lawmakers to put a constitutional amendment on the ballot that would limit the future impact of the constitution’s pension clause by protecting only accrued benefits. The organization also will press for the consolidation of downstate police and firefighter funds and merging the Chicago teachers system into the state fund.
Local and state infrastructure work is languishing in the absence of a capital plan. Transit agencies have warned they can afford to spend only $1.2 billion this year, far short of the $2 billion to $3 billion needed annually to meet maintenance and fund priority projects.
The state has “reached a crisis in transportation funding that threatens to stunt our economic growth and negatively impact our resident’s quality of life. To simply operate and maintain our aging system in its current condition through 2050—not including any required modernization or expansion—we face a shortfall of $24 billion of reasonably expected revenues,” Chicago Metropolitan Agency for Planning executive director Joseph Szabo told lawmakers at a recent hearing.
“If the state is to go forward with a capital plan, it must identify a stable revenue source on its own,” The Civic Federation wrote last week in a blog post.