The high cost of borrowing for Illinois

June 27, 2013

Illinois, the state with the lowest credit in the United States, had to pay up this week to bring a $1.3 billion general obligation bond offering to market. Reuters reported that the general obligation bonds due in 25 years were priced at 5.65 percent on Wednesday. This was approximately 180 basis points (1.80 percent) over Thomson Reuters MMD AAA, compared to a spread of 138 basis points on Tuesday. In other words, Illinois got spanked hard.

Illinois has massively unfunded public pensions and a huge stack of unpaid bills that make the state less creditworthy and force it to pay higher interest rates when it borrows. But a new study by the Mercatus Center suggests that, since the risk of default for Illinois is very small, the state is overpaying for its bond offerings. The study’s author, Marc Joffe, formerly a Senior Director at Moody’s Analytics, developed a fiscal simulation model that takes into account pension, education and health care payments over time in addition to debt service:

The model results suggest that Illinois state bonds carry very little credit risk and that Indiana’s obligations are even less risky. While Illinois’s fiscal policies are likely to have negative effects on future state residents and implications for other public policies, they are not sufficiently dangerous to worry bondholders.

To establish some history for the state, Joffe looks back to a time when it did default on bond payments in January, 1842:

Illinois took on substantial debt in 1836 and 1837 to finance the construction of a canal connecting the Illinois River to Lake Michigan, and to capitalize two state banks. Illinois bonds all carried interest rates of 6 percent. The high rate (by contemporary standards) reflected the speculative nature of these bonds. When the bonds were issued, the state did not generate sufficient tax revenue to service them. Buyers were effectively relying on the canal project to raise property values and thereby generate enough property-tax revenue for the state to make interest and principal payments.

A severe financial panic in 1837 was followed by a nationwide economic downturn in the late 1830s and early 1840s. Illinois continued issuing bonds to finance the canal, cover the state’s operating expenses, and even fund interest payments on previously issued debt. By September 1841, the state had $13.6 million in bonds outstanding, all carrying a rate of 6 percent (US Congress, 1843). The approximately $800,000 in interest costs exceeded state revenues in 1841 by a factor of more than four (Krenkel, 1958). In December 1841, Illinois bonds were trading at less than 30 cents on the dollar. Lacking a market for new bonds and the revenue to service existing issues, the state defaulted in January 1842 (United States Magazine and Democratic Review, 1842).

Tax revenues eventually increased, especially after the opening of the canal in 1848. In 1857, the state fully emerged from default, and by 1880 Illinois’s state debt was fully repaid (Moody’s, 1934).

To set a default threshold for Illinois bonds, Joffe looks at state and sovereign defaults:

Over the last 140 years, the Arkansas situation is the only case in which a state defaulted on interest payments owed to individual investors as a result of a fiscal crisis. It is thus the most relevant default case available, and it merits further study. On the eve of the Arkansas default, interest costs accounted for roughly 30 percent of state revenues—far above the level for any other state. Other Depression-era government-bond defaults in the Anglophone world—including those of Australia, New Zealand, New South Wales (an Australian state) and Alberta (Canada)—were also accompanied by interest-to-revenue ratios of 30 percent or more (Joffe, 2012b).

Today other fiscal commitments compete with bondholders for payment:

It is thus possible that the default threshold today is lower than it was during the Depression because of changes in attitudes toward the sanctity of debt obligations and the political power of constituencies that receive income from the government.

This is the most important element of Joffe’s model:

Given the protection now accorded pension benefits, I treat them as pari passu—legally equivalent—to debt service in the state’s priority of payments. The default threshold I use is thus a 30 percent ratio of interest and pension expenses to total revenue. Other post-employment benefits (OPEB) such as retiree health care do not enjoy the same level of legal protection, so I have not added them to the numerator of the threshold equation.

The Joffe model concludes:

In 2012, Illinois’s ratio of interest and pension expenses to revenues was 9.8 percent—well below the 30 percent threshold assumed to be the default point. Even under very bad economic conditions, it would take several years for Illinois to reach this default threshold. Consequently, in the near to intermediate term, Illinois’s modeled annual default probability would be zero under any plausible budget scenario.

A nice final summary:

In general, US states are much safer than corporations and should enjoy higher credit ratings than most private debt issuers. Illinois last defaulted in 1842, and it cured its insolvency in 1857. It has been either debt free or a timely payer for 155 years. Few corporations can claim such a long record of good credit. Even the best-managed companies face the risk that their offerings will lose popularity or become obsolete. If this happens, their revenue and debt servicing capacity can quickly decline. A government presiding over a large, diversified economy does not face such a problem. Through taxation, it extracts economic rents from citizens and businesses that choose to remain within its borders.

Joffe’s study sets a high benchmark for municipal bond research. It argues for lower interest on Illinois’ debt. Here is what Illinois Governor Pat Quinn said about Wednesday’s bond sale:

Today’s bond sale ensures that the work continues on much-needed improvements to roads, bridges and other infrastructure projects across Illinois. But legislative inertia has a price, and today the price for taxpayers was an extra $130 million.

Joffe’s work argues that this penalty is unnecessary. Then there is the important matter that holders of Illinois debt are constitutionally required to be paid ahead of everyone else. It really is risk free.

Sidenote: After I wrote about the U.S. Treasury awarding a no-bid contract to Municipal Market Advisors for research to be used by the Office of the Comptroller of the Currency, Joffe contacted the buying agent. He requested that the agency consider his platform to judge risk of default for local debt in California. He was flatly rebuffed for consideration. The OCC would be wise to hire Joffe to lead its oversight of bank holdings of municipal bonds.

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