Illinois Governor-elect Bruce Rauner

CHICAGO - The Illinois governor-elect, Bruce Rauner, will take the helm of a state struggling with battered credit ratings threatened with further deterioration, massive unfunded pension obligations, and an out-of-balance budget.

Rauner, a Republican, beat incumbent Gov. Pat Quinn, a Democrat, in Tuesday's contest by a 50% to 46% margin. Quinn conceded defeat Wednesday. Democrats appeared to have retained veto-proof majorities in the General Assembly.

At stake in the election was the fate of a 2011 income tax hike that partially expires Jan. 1, resulting in the expected loss of nearly $2 billion in revenue in fiscal 2015 and $4 billion in fiscal 2016.

Quinn was expected to press the Democratic controlled General Assembly to make permanent the current rates possibly in an upcoming veto session or a later lame-duck legislative session. Rauner wants to phase them out although he's acknowledged the difficulty of letting the Jan. 1 rollback occur as planned due to the strain on the fiscal 2015 budget.

Near-term decisions will influence both investor appetite for state debt and rating agency opinions with the state potentially facing further credit deterioration as a negative outlook is assigned to its general obligation ratings -- already the lowest among states at the A-minus level.

"Governor-elect Rauner has little time to celebrate his election; the work of governing the state's pressured finances will demand state leaders' immediate and full attention," Nuveen Asset Management wrote in a report Wednesday.

"The state's sagging credit ratings, anemic economic recovery, accumulated fiscal deficits, backlogged bills and unfunded pension liability pressures at both the state and local level will demand the governor's attention when he takes office on January 12," said the report by analysts Molly Shellhorn and Kristen DeJong.

The current personal income tax rate of 5% will fall to 3.75% and the corporate rate will drop to 5.25% from 7% Jan. 1, midway through fiscal 2015. Quinn initially proposed a fiscal 2015 budget that relied on making the 2011 temporary increases permanent.

With many lawmakers facing re-election, they refused to tackle the sensitive issue and instead passed a $36 billion budget that relied on one-time revenue sources like interfund borrowing to avoid deep cuts. Quinn called the budget incomplete and legislative leaders agreed, saying they expected to revisit the tax issue and spending levels after the election. A veto session begins later this month.

Rating agencies and investors are watching closely and some have warned steep mid-year budget cuts alone could hinder the state's economic recovery. The state's credit deterioration has been driven by its structural budget woes and $100.5 billion of unfunded pension obligations in a system that is just 39.3% funded.

Lawmakers overhauled the pension system last December but the changes face a legal challenge by unions that will eventually be decided by the Illinois Supreme Court. The state has cut its unpaid bill backlog in half in recent years, but the roughly $5 billion owed will rise again if new revenue is not found or deep spending cuts made.

Fitch Ratings wrote in a report Monday that near-term management decisions in Illinois, as well as California and New Jersey, will prove critical to credit quality in those states.

"Taking steps to address the longstanding structural mismatch between revenues and spending would put the state on more solid financial footing, while failure to take action would be a return to past practices and leave the state particularly poorly positioned to confront future downturns," analyst Laura Porter wrote of Illinois.

For investors, the risk is that the state's paper could lose value due to investor jitters or further credit hits. General obligation debt service enjoys top priority by statute and the state is not overburdened by its GO obligations, with debt service representing 5.6% of noncapital expenditures, according to Nuveen.

Nuveen warned investors to be concerned about the growing likelihood of downgrades, the liquidity and price volatility of Illinois bonds, and negative impact on underlying local governments and school districts statewide. Local governments pay what's widely referred to in the market as the "Illinois penalty" when they borrow and the state's public universities have been downgraded for ties to the state.

Rauner has "been opposed to extending the personal income tax surcharges that many credit analysts assume are critical revenue inputs," Municipal Market Advisors wrote in a commentary Wednesday. "Near term prices in IL paper could fall, however, a potential change of top level strategy in Illinois with respect to pension and the budget in general is welcome."

Several market participants said they did not see an immediate jump in secondary trading of Illinois' GOs or notable spread changes. Janney Capital Markets tracked state spreads over the last decade, noting in a recent report deterioration in the last four years. September spreads between the state's 10 year debt and the Municipal Market Data benchmark were 155 basis points. Before the pension overhaul passed, spreads had at times exceeded 200 basis points.

Rauner released a 10-point fiscal blueprint during the campaign, but Democrats criticized him for refusing to provide specifics. Rauner said he would trim $1 billion in spending, cut state purchasing and crack down on Medicaid eligibility, among other promises.

Rauner said he would eliminate state shuttles for lawmakers and the governor and sell the existing state planes, cut lawmakers and state constitutional officers' pay, and merge the state comptroller and treasurers' offices. He said he would not take any pay or a pension as governor.

Rauner, a political novice, wants to overhaul the state's tax system. He would expand the sales tax to cover some services which would raise $600 million, and freeze property taxes. The changes are needed to improve the state's economic and business prospects, he said. Under his plan, any future property tax hikes at the local level would require voter approval.

Rauner will face veto-proof majorities in the General Assembly controlled by House Speaker Michael Madigan and Senate President John Cullerton, both Chicago Democrats who Rauner accused in advertisements of being part of the state's corrupt political system.

"I said to them this is an opportunity for us to work together, this is an opportunity for us to come together on a bipartisan basis," Rauner said during his acceptance speech.

Rauner runs an equity investment firm and used some of his own wealth to fund his campaign. Quinn, long considered an outsider in Illinois political circles, was the state's lieutenant governor in 2009 when he took office after lawmakers stripped Gov. Rod Blagojevich of power following his arrest on corruption charges. Quinn won a full term in 2010.

During a brief news conference Wednesday, Quinn said it was important to let all provisional and other ballots be counted "but it's clear we do not have enough votes to win the election and therefore we respect the vote. We respect what the voters did yesterday and I look forward to working with the new administration" on the transition.

Quinn said it would be important for the new governor to work with lawmakers on the budget and he would work to raise the minimum wage before he leaves office. "I'm going to fight for that," Quinn said. He did not take questions after his statement.

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