The Chicago Federal Reserve weighs in on Illinois’ finances in a Letter authored by economist Thomas Walstrum.

CHICAGO – Illinois' fiscal reckoning arrived after disguising its structural budget woes for years in large part by shortchanging its pension system.

That's the conclusion offered in a new Chicago Federal Reserve Letter authored by business economist Thomas Walstrum.

The review, "The Illinois Budget Crisis in Context: A History of Poor Fiscal Performance," asks how Illinois arrived in its current financial mess, which has worsened as lawmakers remain locked in a partisan divide over policy, spending, and tax issues that has prevented passage of fiscal 2016 and 2017 budgets.

The state's current troubles are underscored by at least a $5.5 billion operating deficit, $7.7 billion of unpaid bills, and $111 billion of unfunded pension liabilities.

Illinois has long spent more than it took in but was able to mask the structural mismatch despite rules that require a balanced budget by using "a variety of techniques to put off paying the bills, including underpaying into the pension systems," Walstrum writes. "Such techniques can work for only so long, and Illinois is now coming to terms with over 20 years of poor fiscal performance.

"The crisis has also led credit rating agencies to give Illinois the lowest ratings of any state—which has pushed up borrowing costs," the letter notes.

Illinois was once a low-expenditure, low revenue state but spending more than it took in has persisted since the late 1980s. While shared by some other states, Illinois took it too greater extremes outpacing the national average since the mid-1990s.

Illinois overspending became markedly higher than that of the typical U.S. state in fiscal 1994. The report tracked the average of annual expenditures as a percentage of total revenues through 2011 when Illinois raised taxes, finding Illinois's spending averaged 115.9% of its revenues. That compares to 105.7% for the typical U.S. state.

"Thus, while spending outstripped revenues for both Illinois and the typical state during this span, Illinois overspent by much more," Walstrum writes.

The top two categories consuming more of Illinois dollars were pension liabilities and employee retirement expenses. "Pension-related spending, then, makes up almost three-quarters of the difference between Illinois's spending and that of the typical state," he wrote.

Illinois also spent 1.3 percentage points more of its revenues on general debt interest than the average state—a sign that Illinois was accumulating debt outside of its pension system as well, the report notes.

The report distributed this week followed another from S&P Global Ratings that looked at revenues and expenditures from another perspective, assessing how the state might fare in a future economic downturn. The state is S&P's lowest rated at BBB-plus and it carries a negative outlook.

"Illinois' revenue and expenditure volatility is moderate relative to other states in our sample; however, the state's weakened fiscal position, limited financial flexibility, and political gridlock leave it susceptible to the most severe fiscal stress in the event of a recession," S&P wrote in its report that looked at the fiscal resilience among U.S. states after seven years of economic expansion.

The state's political gridlock over a budget solution "adds to existing fiscal pressures at a time when the state is at risk of approaching service level insolvency, which could more fundamentally jeopardize its creditworthiness," the report says. The backlog is expected to hit a high of $10 billion in the coming months. The state's lean reserve account of $275 million is being tapped to help fund a partial, stopgap budget.

S&P estimates the state could see a 3.4% decline in its key revenue sources -- income, corporate and sales taxes--in the first year of a recession which would translate into a roughly $1.29 billion hit. At the same time, the state would face greater pressure on its already overstrained social support network. Unemployment, already well above the national average, could also rise.

"Given the current structural imbalance, tax increases or spending reductions would have to be more draconian to cover the current budget gap plus the newly opened recessionary one," S&P warned. The state also faces rising fixed costs to cover debt and pensions, narrowing its flexibility to trim.

Politically, the state has traditionally been slow to act to shift spending or raise taxes and that was before Gov. Bruce Rauner, a Republican, took office last year and began feuding with the Democrats who control the General Assembly.

The state discloses its fiscal woes for investors in its new offering statement and investor presentation posted Thursday on a $573 million junior lien sales-tax issue.

"The state's financial condition has been materially adversely affected by this budget impasse," the state tells potential investors. "There have been delays in the payments of bills and the state estimates that the backlog of bills will continue to grow until the impasse is resolved."

The sale is set for Thursday, Aug. 25 and the state will host one-on-one investor calls on Monday and Tuesday of that week. Columbia Capital Management LLC is advising the state.

The state is highlighting the strong AA-plus and AAA ratings assigned, respectively, by Fitch Ratings and S&P. The latter assigns a negative outlook.

The Build Illinois bonds are characterized by "strong security and repayment sources, an irrevocable continuing debt appropriation, high debt service coverage of over 25 times, a limiting additional bonds test and the bonds are highly rated," state debt manager Kelly Hutchinson says in the investor presentation. The state has $2.5 billion outstanding under the program set up in 1985.

Despite the strong security, S&P worries that the credit becomes more vulnerable as the state's budget strains worsen.

"The negative outlook reflects our view that more severe budget and liquidity challenges at the state level could arise as the state continues to operate without a structurally balanced budget and could test the ability of Build Illinois bonds to remain insulated from the state," said analyst John Sugden.

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