Illinois carries the lowest bond ratings of any state.

CHICAGO – The Fitch shoe dropped for Illinois Wednesday, in the form of a long-threatened downgrade.

Fitch Ratings dropped the state's issuer rating one notch to BBB from BBB-plus, and kept the state on Negative Rating Watch.

Fitch had long warned the state that it planned to act on its earlier rating watch placement by the end of January and that a downgrade loomed unless progress was made in tackling the state's fiscal woes.

Despite bipartisan efforts promoting a "Grand Bargain" package of bills to get the state on track, January came and went without action.

The downgrade "reflects the unprecedented failure of the state to enact a full budget for two consecutive years and the financial implications of spending far in excess of available revenues, which has resulted in increased accumulated liabilities and reduced financial flexibility," Fitch's lead Illinois analyst Karen Krop wrote.

"As a result, the state finds itself with a current operating deficit, structural budget deficit, cash crunch, and accumulation of accounts payable that will surpass its highest level at the depth of the recession," Fitch wrote. "Even if the current attempts at a resolution to the extended impasse prove successful, Fitch believes that the failure to act to date has fundamentally weakened the state's financial profile."

The downgrade impacts $25.9 billion of general obligation bonds.

Fitch also lowered $431 million of state supported bonds issuer through the Illinois Sports Facilities Authority; $2.6 billion of Metropolitan Pier and Exposition Authority McCormick Place expansion project bonds; and $267.8 million of Chicago motor fuel bonds. All were downgraded to BBB-minus from BBB.

All require a state appropriation and so are notched off the state's GO rating.

The continuation of Rating Watch Negative status "reflects Fitch's expectation that the state's implementation of a solution, whether temporary or permanent, will be a challenge in the current political environment and that in the interim the state will continue to delay and defer payments in lieu of balancing the budget."

Fitch acknowledged that the "Grand Bargain" offers a path forward but warns too much remains unknown given the prolonged impasse.

"Its passage is uncertain and the timing of implementing solutions is unknown," analysts wrote. A Senate vote is expected next week but its fate in the House is unclear.

Fitch is giving the state another six months to break the logjam and then it will resolve its watch placement.

"Failure to enact a balanced budget for fiscal 2018 would result in a further downgrade. Successful implementation of measures to enact a structurally balanced budget and reduce accumulated budget liabilities would stabilize the credit," the report read.

Fitch lays out the state's mess taking it to task for allowing the 2011 temporary income tax hike to partially expire without then aligning its expenses with expected revenues.

"Once again, the state has displayed an unwillingness to utilize its extensive control over revenues and spending to address numerous fiscal challenges," the report said.

The rating is sensitive to the state's continued success in meeting its statutorily required debt service transfers as scheduled, 12 months in advance on a rolling basis. Any change "would result in an immediate downgrade of the rating to below investment grade because it would suggest that the state's liquidity pressures are presenting a risk to bondholder interests that has not been evidenced to date," Fitch said.

The state has a nearly $11 billion bill backlog, compared to the $7.6 billion at the close of fiscal 2016 June 30.

The "Grand Bargain" would authorize $7 billion in borrowing to pay down the backlog. "If the Senate proposal to issue bonds to reduce or eliminate this budgetary liability proceeds, Illinois' debt levels would be further elevated but would remain within the moderate range," Fitch wrote.

The state is facing a roughly $5 billion budget gap as 90% of spending of spending continues without a budget in place due to continuing appropriations, consent decrees, and some legislatively approved authorizations. It has about $126 billion in unfunded pension liabilities. The bipartisan Senate plan would raise more than $6 billion in taxes, authorize short term borrowing for the bill backlog, fund government for the remainder of the fiscal year, offer pension reforms; expand gambling; pave the way for local government consolidation; implement procurement and worker's compensation reforms; and create a local property tax freeze. It would also provide teachers' pension funding help for the Chicago Public Schools.

"These proposals, if they proceed through the full legislature and are signed by the governor, have the potential to meet the requirements to stabilize the Illinois IDR and related ratings," Fitch wrote.

Besides the political challenges of its own making, Illinois faces strains from potential Medicaid changes at the federal level under the Trump administration and Republican Congress.

"As one of the largest parts of state budgets and by far the biggest source of federal funding to the states, federal decisions could have significant implications for states' ability to manage this key budget item," Fitch wrote.

Moody's Investors Service rates Illinois general obligation bonds Baa2 and S&P Global Ratings assigns them its BBB rating. Both assign a negative outlook. Illinois is the lowest rated state by all three.

"Fitch's action further demonstrates the importance of reaching bipartisan agreement on a truly balanced budget and changes that will grow our economy and bring new jobs to our state," said Gov. Bruce Rauner's spokeswoman, Catherine Kelly.

The gridlock has been driven by the first-term Republican governor's demand that the Democratic legislative majorities approve various governance and policy reforms – some of which are in the Senate package – in exchange for tax increases.

Senate President John Cullerton, D-Chicago, a co-sponsor of the Senate plan, had warned of the urgency to act with a fresh downgrade looming.

"While unfortunate, this was expected," said Cullerton spokesman John Patterson. "The looming threat was among the many reasons why the Senate is working on a comprehensive budget and reform plan. The goal is to end the nearly two-year impasse and restore financial stability. If there's a silver lining, it would be that hopefully this action adds to the growing urgency to pass the Senate's plan and get a comprehensive budget for the state."

Illinois' 10-year paper was trading in recent days in the secondary market at a roughly 225 basis point spread to the Municipal Market Data's top-rated benchmark, according to data provided by Thomson Reuters MMD. The 10-year started out January at a spread of about 235 bp then narrowed slightly and ranged between 222 bp to 228 bp through the month.

"Even though the 'Land of Lincoln' has the highest spreads among the fifty states paradoxically about three weeks ago we saw evidence of some spread tightening" although it was relatively minor, said MMD's Daniel Berger said.

Over the last year, the spread hit a high of 238 bp on Dec. 22, after widening from a low of 162 basis points in late September. Spreads jumped in mid-October from that low to about 200 basis points and have been on the rise since late October. The 12 month average spread is at 185 bp.

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