CHICAGO — Illinois Gov. Pat Quinn’s administration started the week bracing for further credit deterioration in response to lawmakers’ adjournment of their regular session without solving the state’s pension crisis and Fitch Ratings Monday came through delivering the first blow by lowering the state’s general obligation rating down one notch.

The impasse on pension reforms overshadowed accomplishments that included passage of a fiscal 2014 budget, Medicaid expansion, a public-private partnership to develop a third Chicago area airport, and $2.7 billion in bonding for the state’s ongoing capital program.

Lawmakers adjourned Friday after failing to overhaul four of the state’s five pension funds. Quinn, investors, and rating agencies have warned action was needed to fix the system in order to stabilize the state’s fiscal foundation and its already blemished general obligation rating, which is the lowest among states by Moody’s Investors Service and Standard & Poor’s. Fitch’s action pushing Illinois’ rating on $27 billion of general obligation debt down to A-minus from A and warning of further action by assigning a negative outlook puts Illinois at the bottom along with California but the latter carries a positive outlook.

“I have made pension reform the top priority for the state of Illinois for more than a year….but as I said in my budget address, I cannot act alone,” Quinn said. “Downgrades hurt our economy, waste taxpayer money and shortchange the education of our children.” He intends to call the legislative leaders together in the coming week to work on a reform agreement.

Past meetings have not resulted in much success, and passage of reforms that take effect immediately now becomes harder in the near term as a three-fifths majority would be needed during a special session of the legislature through December.

Illinois holds the distinction among states of having the weakest pension system with $95 billion of unfunded liabilities for a funded ratio of just 40%. Payments will rise by almost $1 billion in fiscal 2014 to consume $6 billion of the state’s newly passed $35.4 billion general fund budget. Annual increases are  squeezing out funding for education, human services and public safety.

House and Senate Democratic leaders pushed through rival plans in recent weeks, but neither chamber was willing to budge on their philosophical differences over how to tackle the problem. Similar efforts failed last year and again during a lame-duck session in January.

Standard & Poor’s rates the state’s $27 billion of GOs A-minus and assigns a negative outlook, making it the lowest-rated state. Fitch assigns an A to the state’s $27 billion of GO debt and has the credit on negative watch. Moody’s rates Illinois GOs A2 with a negative outlook, its lowest rated state. The state has suffered a dozen downgrades over the last five years.

Investors demand steep penalties on state GO paper with 10-year bonds trading at about 140 basis points over the Municipal Market Data benchmark on top-rated paper.

Investors on Monday said they expected volatility on trading levels as some disappointed traders shed Illinois paper. The impact after the market digests the news remains to be seen. Some believe that the state’s prices have already hit bottom and reflect a rating more in line with a triple-B credit, even though several investors polled don’t believe that state ratings will sink that low. Thirst for yield has also helped stabilize the state’s credit spreads despite it’s ongoing financial turmoil.

The lack of action on pensions, a looming expiration of the 2011 income tax increase and liquidity struggles are also offset by a law that gives state GOs a strong claim on revenues. The legal structure requires that sufficient cash be set aside each month to cover debt service payments, and it cannot be tapped for other purposes.

“I think it’s going to be bumpy over the short term, but the fact that the GO bonds have unusually strong protections and state is at least talking about pension reform are positives,” said Eric Friedland of Schroders Investment Management. “Underlying support will come from those who say you don’t need dramatic change” to improve the state’s situation.

“The inability to address the most visible and concerning long-term threat to its financial position will likely lead to negative rating actions and potentially wider spreads,” Municipal Market Advisors Matt Fabian wrote in the firm’s weekly outlook published Monday. Wider spreads would “represent a good opportunity for incremental yield for buy and hold investors” although MMA cautions that “future valuations will likely be subject to above average volatility.”

MMA also pays strong heed to the state’s GO legal structure, which mitigates the impact of “years of failing to address the growing liability” and “incurring additional debt to make contributions.”

The state has been at most risk for discipline from Moody’s and Fitch. S&P said it factored into its downgrade early this year the difficulty that lay ahead in passing reforms and the likely legal challenge.

“When we took action in January it reflected the fact that pension reform didn’t appear imminent,” Standard & Poor’s analyst Robin Prunty said Monday. The next budget cycle will prove '”pretty pivotal” in averting a downgrade given rising pension costs and the partial expiration of the income tax hike.

Fitch had the state’s GO and appropriation ratings on negative watch in anticipation of the results of the spring session. Lead analyst Karen Krop put the blame for Monday’s downgrade squarely on the failed efforts during the session.

“Fitch believes that the burden of large unfunded pension liabilities and growing annual pension expenses is unsustainable, and that failure to achieve reform measures despite the substantial focus on this topic exacerbates concern about management’s willingness and ability to address the state’s numerous fiscal challenges,” lead analyst Karen Krop wrote.

The state is planning a $1 billion GO sale in the coming months although it has not settled on the timing. The state withdrew a GO sale early this year after investors were poised to demand steeper penalties because of the Standard & Poor’s downgrade and difficult market conditions. A $600 million highly rated sales tax backed refunding is planned for next week.

Senate President John Cullerton pressed for a plan that asked employees and retirees to accept benefit cuts in exchange for preserving their retiree healthcare subsidies. House Speaker Michael Madigan’s package enacted direct cuts to cost-of-living increases and raised the retirement age and employee contributions. Both men are Chicago Democrats. Quinn is also a Democrat.

Cullerton and his caucus believe their plan — negotiated with the support of state unions — has the best shot at surviving an expected legal challenge, because employees would make the choice to switch plans. The Illinois constitution prohibits impairing or diminishing pension benefits. Madigan counters that the their plan, which offers double the savings, stands a good chance of passing constitutional muster based on the current system’s insolvency and lack of state assets to cure it.

The House plan would trim about $187 billion off total payments owed over the next three decades to bring the system to a fully funded level. The Senate plan would achieve $57 billion in savings to bring the system to a 90% funded ratio. The House plan would trim the unfunded liabilities by $21 billion and the Senate plan $9 billion. The House plan failed in the Senate last week but the Senate plan was never called up for a vote in the House. q

Quinn expressed frustration with legislative leaders while Republicans put the blame on Quinn’s leadership along with House and Senate Democrats. Quinn faces re-election next year. 

“It is a massive failure despite their substantial numbers.  The failure of reform will have a devastating effect on the state and will almost surely result in yet another credit rating downgrade,” said Senate Minority Leader Christine Radogno, R-Lemont.

In other developments, an expansion of gambling that included five new casinos including one in Chicago also stalled. Legislation that would have extended the Chicago Public Schools pension holiday which expires in fiscal 2014 stalled, as did a measure to require state community colleges and university to begin funding their teacher pension payments. The state currently makes those payments. The cash-strapped CPS faces a $338 million increase in its next budget, contributing to a looming $1 billion deficit. 

Lawmakers did pass a $35.4 billion general fund budget and Quinn’s proposed expansion of Medicaid under federal healthcare reform, and they authorized $2.7 billion in additional bonding authority for the final phase of the state’s ongoing $31 billion capital program.

Lawmakers also authorized the use of a public-private partnership to develop a long stalled third Chicago regional airport about 40 miles southwest of the city.  Lawmakers also smoothed the way for the Metropolitan Pier and Exposition Authority to help finance a new arena that would house convention, trade show, and private events along with serving as home the DePaul University of Chicago’s basketball team.

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