CHICAGO – Illinois lawmakers began a 10-day special session Wednesday that represents the state’s last chance to avert the possible loss of at least one of its investment grade ratings by ending a two-year-old budget stalemate.
Lawmakers returned to the capital amid deep acrimony and distrust that undercuts the chances of an agreement, though various legislative proposals passed by Senate Democrats and another package pitched by House and Senate Republicans could provide a roadmap if the two sides are willing to budge.
Gov. Bruce Rauner called the session and in a speech late Tuesday pressed for unity and compromise. He also pushed Democrats to sign on to the GOP-sponsored legislative package that includes a fiscal 2018 budget and various policy and governance reform proposals have driven the budget blockade.
“We must agree on a balanced budget plan, and get it to my desk before the end of the state’s fiscal year – one week from Friday,” Rauner said in the televised address. “If we can agree to pass it, we will stop this unnecessary crisis. Failure to act may cause permanent damage to our state that will take years to overcome.”
The legislature’s Democratic majority responded with criticism and skepticism.
“The budget supported by Gov. Rauner and legislative Republicans is not balanced. It’s clear that real negotiations and real compromise are needed,” said state Rep. Greg Harris, D-Chicago. Harris is House Speaker Michael Madigan’s lead budget negotiator.
Senate President John Cullerton, D-Chicago, called on Rauner and the House to get behind the Senate Democrats’ fiscal 2018 budget, tax hikes, and reform proposals already approved.
"Unity doesn't come from a speech and it certainly doesn't come from campaign attack ads aimed at your negotiating partners," Cullerton said in a statement. "It comes from a willingness for practical compromise with others and exerting the effort to round up the votes needed to make that compromise law.”
Moody’s Investors Service and S&P Global Ratings downgraded the state to the lowest investment grade level of Baa3/BBB-minus earlier this month. S&P made clear a drop to junk of the state’s $26 billion of general obligation likely looms absent a budget agreement by the start of the fiscal year July 1. Moody’s assigns a negative outlook.
Fitch Ratings has said it views the beginning of the new fiscal year as a key marker for a downgrade of the state’s BBB rating. It hasn't said whether it will drop the state one notch or two – into junk.
Consequences
Much more is at stake than the state’s ratings. Public universities and social services are clamoring for a deal. Both areas have been shortchanged over the last two years and have gone without any funding since the expiration of a six-month stopgap fiscal 2017 appropriation on Jan. 1.
More university and local government downgrades could come, further driving up their borrowing costs. Only two of the state’s nine public universities retain investment grade ratings.
Local governments in Illinois across the credit spectrum pay what’s known as the “Illinois penalty” or “Illinois effect” to borrow -- and that will rise. Nuveen estimated local governments pay $930 million in extra debt service annually as 25 basis points are tacked on to yields for high-grade credits and up to 150 basis points for low investment grade credits for being located in Illinois.
State construction on more than $2 billion worth of transportation projects could grind to a halt July 1.
The state’s largest district -- Chicago Public Schools -- has said it will open in the fall but others have warned they won’t be able to open on time.
The state also has been notified that it will be dropped from participation in the multi-state Powerball and Mega Millions lottery games due to state fiscal conditions.
The state’s delinquent bills, now at $15 billion, will mount, driving up a current interest tab of $800 million. State comptroller Susana Mendoza told lawmakers Tuesday that the state’s “dire fiscal straits” could soon impair payments on critical core responsibilities and legal consent decrees.
The office is in negotiations over how to speed up payment of a $2.8 billion Medicaid vendor backlog at the direction of a federal judge under previously entered consent decrees.
The state has been operating on piecemeal appropriations since July 2015. About 90% of spending flows from continuing appropriations and legal actions, at levels were based on the state's revenue before the partial expiration of an income tax hike in January 2015.
Mendoza stressed that debt service on Illinois bonds “will not be delayed or diminished” and her office will “use every statutory avenue or available resource to meet that commitment.” The state’s general obligation statutes allow for various non-general fund accounts that hold more than $10 billion to be tapped without legislative action.
“The comptroller’s commitment to debt service is supportive for bond holders but the overall tone and warning suggest that cash payments to other parties, some of which may hold municipal debt are threatening,” said Richard Ciccarone, president of Merritt Research Services.
Market
Market participants are skeptical that the state will resolve its budget mess in time to stave off further credit deterioration.
Illinois’ 10-year GOs were trading Wednesday at a spread of 273 basis points to the MMD’s top-rated benchmark. Rates have fluctuated from a low of 258 basis points early in the month to a high of 335 basis points after the adverse Medicaid ruling. They’ve come down from a level of 290 basis points in recent days, according to data from MMD strategist Daniel Berger. While they’ve come down, the spreads are still elevated and the highest among states.
The spreads reflect concerns that while states may not be able to file bankruptcy, they can miss a debt payment or two, although the market believes in such a scenario Illinois “would quickly come it its senses,” Berger said.
“Given its history of willingness to address politically unpopular and progressively complex fiscal choices, I believe the market has lost significant, though not all, confidence that the state will resolve by July 1,” said Hernando Montero-Salazar, director of credit analysis at Stoever Glass & Co.
The market does retain confidence that – at least for the time being – debt service remains safe.
“As Illinois moves down the rating scale, I believe appetite/demand for its bonds will shift from traditional investors to crossover investors, especially those seeking to purchase both insured and un-enhanced Illinois credits at a discount with the expectation of realizing quick gains as soon as the state legislature/governor solve their fiscal disagreements,” Montero-Salazar said in an e-mail.
If Illinois, which enjoys sweeping powers as a sovereign state, were to near default, Montero-Salazar said he believes the federal government would intervene because of the “unknown, potentially negative impact over this event's significant effect,” as it could damage the perception of US sovereign status and drive up costs for US Treasuries.
“Based on decades of history of states and cities stepping up to manage their challenges without resorting to default, MMA continues to expect that Illinois can and will do so as well,” said Matt Fabian, a partner at Municipal Market Analytics, in a recent outlook piece.
Fabian added that while he expects the state to “honor its debts as they come due, we would also need to acknowledge a rising risk of payment interruption that could and should sheer off some portion of current demand and make the state more reliant on hedge fund and speculative capital sources.”
While Illinois is acting recklessly, it's still a state with full control over its revenues and “with its GO bonds available at yields cheaper than much much riskier high yield credits like charter schools and hospitals, it should at a minimum be considered for purchase,” Fabian added.
Options
Senate Democrats have passed a $37 billion fiscal 2018 budget and other measures including a $5 billion tax hike package, pension changes, an education funding overhaul, $7 billion in cash flow borrowing, an expansion of gambling, cash flow borrowing, a two-year local government property tax freeze, local government consolidation, worker’s compensation and procurement reforms. The package initially was crafted with bipartisan input but Republicans pulled their support on all but a few items.
The GOP package offers a $36 budget with a hard cap on spending growth for four years, a four-year local property tax freeze, worker’s compensation reforms, local government consolidation, an overhaul of education funding formulas, term limits for leaders and constitutional officers, $4 billion in cash-flow borrowing, and pension changes. An income tax hike would sunset in four years.
Some are similar to what’s cleared the Senate, though budget cuts and a demand for a four-year property tax freeze veer from what Senate Democrats support.
The House didn't vote on the Senate Democratic budget and Democrats haven't offered a new version. The House did vote on few pieces of the package, previously referred to as the “grand bargain,” and have said they are reviewing all of the Senate package.
A bipartisan group of House members and Cullerton have said a stopgap budget is not on the table and Rauner also opposes it.
A stopgap wouldn't stave off downgrades, as ongoing spending without cuts or new revenue would only drive up the backlog. Some believe the budget’s mess will linger until the 2018 state elections.
