CHICAGO - The fiscal costs of the political turmoil resulting from Illinois Gov. Rod Blagojevich's arrest last week on federal corruption charges continued to mount this week as Fitch Ratings downgraded the state, in part due to concerns the scandal might impede its ability to resolve a $2 billion deficit.

Fitch released its report downgrading Illinois' general obligation debt to AA-minus from AA late Monday as the state prepared to sell $1.4 billion of GO certificates Tuesday, although Fitch was not asked to issue a short-term rating on the sale.

Standard & Poor's rated the notes SP-1-plus, while putting the state's AA long-term rating on negative CreditWatch and Moody's Investors Service assigned a MIG-2, down from the MIG-1 rating on the state's last note issue in April. Moody's rates the state's GOs Aa3.

The ratings - most notably Moody's decision to assign a MIG-2 - and concerns over the corruption scandal helped sour broker-dealer interest in the note sale yesterday. JPMorgan - the sole bidder on two of three maturities - won the deal offering a 4.5% coupon on the three maturities due in April, May, and June with an average yield to the state of 3.99%, including issuance costs.

Goldman, Sachs & Co. submitted the next best bid of a nearly 5% yield on one $400 million tranche. The state also received an 8% bid on that piece, but no other bids were received on the other $400 million and the $600 million maturities. The numbers mark a significant jump from the yields of 1.94 % and 2.1% paid by the state on its $1.2 billion note sale last spring.

Illinois faced a significantly tougher market this time around due to the credit squeeze and the fact that many investors are winding down their books on the year. But market participants also directly attributed the lack of interest to the MIG-2 rating and corruption scandal.

The primary buyers - money market funds - were spooked when they saw the Moody's rating yesterday morning because it's not consistent with an Aa3 credit, which typically receives top short-term marks. It's also the lowest short-term rating money market fund holdings can carry.

"That shocked the short-term market. No one wants to be that close to the edge and folks wondered what Moody's might know," said one market source. "That in conjunction with the governor's scandal raised concerns over event risk."

With few orders from funds ahead of the 11 A.M. Central Time bidding, broker-dealers held back, according to market participants. Sources said some broker-dealers were soliciting fund interest for yields as high as 6 to 7%.

JPMorgan's James Lansing, a managing director in the tax-exempt capital markets group, said the firm submitted its bid without any orders in hand, a move he hopes sends a message of the underwriter's capital commitment to issuers.

"This is an example of JPMorgan's ability to provide liquidity to municipal issuers during this period of market dislocation," he said. The firm has placed most of the securities at a profit, although he declined to provide more information.

Illinois Treasurer Alexi Giannoulias estimated that the downgrades would cost the state about $20 million in added interests based on a comparison to short-term index rates.

"We received the best rate possible given the credit market and the economic crisis currently plaguing every state in the nation," the governor's spokeswoman Katie Ridgway said. "I would like to emphasize that our focus in doing the short-term borrowing is to ensure that organizations who have provided services to the people of Illinois are getting paid as quickly as possible.

The impact on the bids of the political pounding Illinois has taken in the national media is difficult to gage, market participants said, but some premium was likely paid for the negative credit actions. At the root of those moves is the state's fiscal struggles, but analysts fear the state faces a difficult road resolving its crisis given the corruption scandal.

The Illinois House yesterday morning convened a special investigative committee on inquiry, the first step in the impeachment process, and Attorney General Lisa Madigan has asked the state Supreme Court to temporarily remove the governor or strip him of his duties due to his failure to resign.

Blagojevich was arrested along with his chief of staff, John Harris, last week on federal charges accusing the governor of pay-to-play schemes and seeking to profit from his sole authority to name President-elect Barack Obama's Senate replacement.

"Given the controversy and uncertainty surrounding the governor's situation, as well as the inability last fiscal year, and so far this year, to achieve consensus on corrective measures, it is unclear at this time how budgetary solutions will move forward and be implemented," Fitch wrote.

"The governor's arrest on charges of conspiring to use his office for personal gain, leading to calls for his resignation or impeachment, may impede or at least delay the legislature's action on fiscal issues in the near term," Moody's wrote in its report assigning a lower short-term rating. "While state officials believe the matter will not affect cash flows or ability to pay debt service, the controversy creates additional uncertainty around the state's ability to address substantial revenue shortfalls in a timely manner."

In putting the state's AA-rated, $25.5 billion of GO debt on negative watch last week, Standard & Poor's analyst John Kenward was more even more pointed in respect to the impact of the scandal on the agency's action.

"The CreditWatch placement reflects our opinion of the state's growing budgetary shortfall, now projected at $2 billion for the current fiscal year, and our concern that the legal charges now facing the governor and his chief of staff may challenge the state to respond to this fiscal situation on a timely basis," he wrote.

Illinois entered the current fiscal year with problems. Amid a strained relationship between the governor and lawmakers, the General Assembly adopted a $59 billion operating budget for fiscal 2009 that was more than $2 billion in the red. Blagojevich vetoed $1.4 billion in spending, leaving a $700 shortfall.

The latest revenue estimates show increased expenses and a drop in anticipated tax collections will add another $1.3 billion of red ink. When combined with the $700 million in unfunded spending, the state now faces a roughly $2 billion deficit.

The governor announced a plan last month to withhold 8% of general fund spending and plans to seek an additional $1 billion annually over the next three years in federal aid for various programs. The 8% withholding proposal would need state legislative approval.

Illinois could draw on more than $6 billion in surpluses in about 400 other non-general fund accounts, but such action would also require legislative approval. Though lawmakers have approved transfers in the past to support the budget, they have been critical of the practice. Moody's noted that the state's non-general fund resources give substantial strength to its short-term rating.

The state is further pressured over the long term by its mammoth $54.4 billion unfunded pension liability. As of June 30, the pension system was at just a 54.4% funded ratio, down from 62.6% a year earlier.

In addition to the looming budget deficit, state Comptroller Dan Hynes reported last month that Illinois faces a record $4 billion backlog in unpaid bills that is hurting health care and social service providers. While the note issue will speed up bill payments, it will provide just a temporary salve as the state must repay the debt in the coming months as more bills will come due.

The state issued the notes yesterday, five days after its original sale date. It was postponed after the attorney general raised questions over her ability to sign off on a certification that's among the documents required by bond counsel regarding litigation facing the governor. The issue was resolved by amending the language.

The notes mature in three tranches in 2009: $400 million due April 24, $600 million due May 25, and the remaining $400 million due June 24. Ice Miller LLP was bond counsel.

Illinois issued several addendums to the offering statement, first disclosing last week that the governor had been arrested and then that the sale was being postponed. The state yesterday issued another notice notifying potential bidders of the Fitch downgrade and assignment of short-term ratings.

On the legislative front, the Illinois House on Monday unanimously approved the creation of the impeachment committee, and yesterday the panel held its first meeting in its effort to determine whether the governor's alleged misconduct warrants impeachment.

Committee chairwoman and House Majority Leader Barbara Flynn Currie, D-Chicago, said it was expected that Blagojevich attorney Ed Genson would appear before the panel at its hearing today.

Separately, House Democrats this week held up a vote on a measure that would set a special election for Obama's Senate seat.

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