CHICAGO - The financial stakes for Illinois as Gov. Pat Quinn and lawmakers work to close a $12 billion budget gap rose yesterday when Fitch Ratings placed the state's AA-minus credit on negative watch ahead of today's $150 million general obligation bond sale.

Standard & Poor's yesterday affirmed the state's AA-minus and Moody's Investors Service on Friday downgraded the credit to A1 from Aa3. Illinois has $19.3 billion of GO debt and will take competitive bids this morning on the new-money issue. The only states rated below the double-A category by Fitch are California, at A, and Louisiana, at A-plus.

The proposed budget relies on several one-time measures to erase the red ink, including the deferral of debt service through the restructuring of $2.2 billion of debt and the deferral of $2.85 billion in scheduled pension payments. To bring down a current-year deficit while paying off a backlog of bills, the state wants to borrow $2.3 billion by issuing notes in the current fiscal year and repaying them in the next.

Fitch analysts said such measures are generally viewed as negative credit factors, but could be acceptable at the state's current rating level as part of a larger, overall package to balance the budget that includes an income tax increase and pension funding reforms that will cut future costs.

"There are some good things in the budget that will improve the structural balance and some bad. If all of these proposals happen they will be better off," said analyst Karen Krop. "The economic assumptions underlying the projected base revenues appear reasonable. The negative watch will be resolved following the sale of the GO notes, the enactment of the budget, and an assessment of the extent to which the final budget addresses the funding imbalances."

While the note issue represents what amounts to deficit borrowing, it will help ease Illinois' near-term liquidity and avoid a large end of the year cash deficit. Oficials defend the move as part of a multi-year approach to shoring up the budget that will allow the state in the near-term to clear a backlog of bills owed to Medicaid and other struggling nonprofit vendors until additional revenue from the proposed income tax hike are collected in the next fiscal year.

Fitch is also watching to see whether the state can complete the note issue that would sell in two separate tranches later this spring. Illinois received little interest in its $1.4 billion cash-flow issue last December after Moody's stripped it of its top short-term credit marks, putting the rating at the lowest level allowed for money market funds to hold the securities.

Investors were also spooked at the time by the political turmoil stemming from the arrest a week earlier of then-Gov. Rod Blagojevich on corruption charges. The federal government last week unveiled a sweeping, 19-count indictment against Blagojevich and five associates alleging they sought to leverage the governor's influence on legislation, jobs and contracts for personal profit.

Fitch was not asked to rate the December note issue but did at the time downgrade the state's long-term general obligation rating to its current level of AA-minus. Standard & Poor's downgraded the state one notch to its current level of AA-minus last month.

In its ratings report yesterday, Fitch noted that Illinois' political landscape and potential to resolve budget issues has improved since Quinn took over as governor following the General Assembly's removal of Blagojevich early this year. However, the state's "financial situation has continued to deteriorate" because of dwindling revenues.

The state benefits from a diverse and wealthy economy, but was poorly positioned going into the current recession because of its late recovery from the last recession, failure to build reserves, and growing unfunded pension liabilities that were $74 billion at the end of 2008.

Standard & Poor's analyst Robin Prunty wrote in that agency's report issued yesterday that its stable outlook on the credit "reflects that, despite what we view as an extremely high budget gap for fiscal 2010 and limited general fund financial reserves, we believe that Illinois has capacity to restore budget balance."

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