Illinois: Driving into a ditch
The state of Illinois, which joined the union in 1818, has a state motto: “State Sovereignty, National Union.” The website Netstate says this about the motto:
Two months after Illinois entered the Union, the new Illinois General Assembly decreed, on February 19, 1819, that a permanent state seal should be obtained for use on the official documents of the state. A seal, modeled after the Great Seal of the United States, was created with some differences appropriate to Illinois as a state. Importantly, the ribbon held in the eagle’s beak was changed from E Pluribus Unum to State Sovereignty – National Union.
Now, almost 200 years later, with the state in wretched fiscal condition, chatter among municipal traders concerns the possibility of a federal bailout or a state bankruptcy for Illinois within five years. The medium-term fiscal situation is that bleak. Long-term fiscal balance is not achievable without substantial changes to the state’s pension system, which the state has struggled with since 2009. The latest effort to reform the pension system ended last Friday when no agreement was reached in the State General Assembly.
The whip snapped quickly yesterday as Fitch Ratings downgraded Illinois one notch. One rating notch is not that significant, but the speed of the rating adjustment was, coming just one work day after the General Assembly failed to agree on pension reform. Market and credit raters had been led to believe that the pieces were in place for an agreement on pension reform. But the leaders of the General Assembly disagreed for so long, that agreement seemed unlikely. State Senate President John Cullerton had presented a weak version of pension reform, endorsed by the public unions. House Leader Michael Madigan endorsed tougher reform that many said would not pass constitutional muster. And the governor, Pat Quinn, seemed mainly content to sit on the sidelines of the debate. It was first class political gridlock.
As part of its downgrade, Fitch laid out the details of the pension problems:
Illinois’s long-term liabilities, particularly pension liabilities, are very high for a U.S. state. As of the most recent actuarial valuation, dated June 30, 2012, the unfunded actuarial accrued liability was reported at $94.6 billion, resulting in a 40.4 percent reported funded ratio. This large unfunded pension liability is despite the issuance of pension obligation bonds and passage of bipartisan comprehensive pension reform affecting new employees in March 2010.
Translation: The state has not made about $95 billion in payments to the state’s pension plan (investment losses may have caused some of the shortfall). This is about three times the amount of Illinois’ annual general budget. The state has the most under-funded pension plan of all 50 states. Here is the damage that the weak pension system causes (Fitch again):
Annual pension funding requirements have been increasing significantly and growing pension payments are crowding out other expenditure growth and absorbing revenue growth. Pension payments from the general fund increased $965 million to $5.1 billion in 2013, an increase of 23 percent, reflecting in part the use of more conservative investment return assumptions. Pension payments will increase a further 18.2 percent to $6 billion in fiscal 2014. Fitch notes that even these large payments, which consume a well-above-average percentage of the state’s general fund budget, are based on statutory formula and are below the ARC.
The Illinois state budget has about $34 billion in general fund revenues. Of those revenues, the state paid $5 billion in 2013 and expects to pay $6 billion in 2014 for pension costs. But that is not covering the full amount owed. Approximately 15 percent of general fund monies now go to pensions, and next year that will rise to 17 percent. This is a crushing expense for any government.
Then there are the revenue and cash flow problems. Fitch again:
The Negative Outlook reflects the challenges faced by the state in finding comprehensive solutions not only to reducing its unfunded pension liabilities, but also to maintaining budgetary balance in light of the temporary nature of the tax increases and the large accounts payable backlog.
Translation: Unstable cash flows continue. Here is why:
The temporary increase in tax revenue, in conjunction with enacted hard spending limits, moved the state closer to budgetary balance for fiscal years 2011 through 2014. Medicaid reforms implemented in the fiscal 2013 budget also made significant progress toward alleviating some pressure on the general fund. However, the tax increases will begin to phase out in 2015; thus, even if the state maintains budget balance to that point, it will once again be faced with a significant budget balancing decision to make permanent the tax increases, make severe expense reductions, or identify new revenues.
How long can Illinois stagger along under these massive liabilities? Actually, quite some time, if the bond market keeps lending to the state. In a chat with Adam Buchanan, Vice President for Municipal Investments at Chicago-based Ziegler and Company, he said the immediate concern is the possibility of Illinois being downgraded by one of the raters to BBB. This could preclude a number of investors from holding the paper and contract the buying pool, while their cost of funding would go up.
Muniland has a constitutional guarantee of debt repayment from Illinois. But Greece had the same provision in its constitution, and it was changed when economic conditions became horrific. Maybe we should never say never.
Fitch has given Illinois a kick to spur better governance. It probably didn’t hurt too much for politicians. Bond markets have not yet punished the state, but when interest rates go up, Illinois will likely suffer more than fiscally healthy states. Will Illinois’ leaders make the painful choices, or will they stumble along for several more years? Stay tuned.