MuniLand

Illinois’ expensive retiree health care ruling

Illinois

Illinois suffered a blow when the State Supreme Court ruled that public employee retiree health benefits are enshrined in the state constitution and may not be adjusted via legislation. Illinois has lost an important tool for reducing $56 billion of unfunded retiree health care liabilities and $100 billion in unfunded pension liabilities. These unfunded retiree costs outstrip the state’s $33 billion of net tax supported debt.

The Chicago Tribune wrote:

The Illinois Supreme Court ruled today that subsidized health care premiums for retired state employees are protected under the Illinois Constitution, signaling potential trouble for an overhaul of pension benefits that’s also being challenged in court.

Today’s ruling also could affect the city of Chicago’s ongoing phase-out of retiree health insurance subsidies, a program Mayor Rahm Emanuel was counting on to save millions of dollars a year, as well as legislation recently approved to modify the pension plans of city workers and laborers.

The 6-1 decision centers around a 2012 law that allowed the state to charge retired workers for health care insurance premiums, which many did not have to pay depending on how long they worked for the state.

Crain’s Chicago Business identified the trouble for the state in the court ruling (emphasis mine):

Is Illinois getting weaker?

Illinois has queued up contestants for the governor’s race this fall. The New York Times reports:

Bruce Rauner, a multimillionaire businessman making his first run for political office, won the Republican nomination for governor of Illinois on Tuesday, setting up what is expected to be one of the nation’s most contested races for governor this fall.

Mr. Rauner, little known to Illinois voters before an intense run of television commercials, is expected to bring a serious challenge to Gov. Pat Quinn, a Democrat seeking a second full term in office. Although control of Springfield, the capital in President Obama’s home state, has been solely in the hands of Democrats for more than a decade, a fierce contest is anticipated, in part because of the economic picture in Illinois, given the state’s poor credit ratings and high unemployment rate compared to other states.

How effective was Illinois’ pension reform?

The state of Illinois had two milestone events recently. The legislature passed a long-awaited pension reform and the state treasurer issued $350 million of taxable general obligation (GO) bonds. The Bond Buyer reported on the GO offering:

The yields ranged from 0.75 percent on the short end to 5.65 percent on the long end. The two-year maturities priced at a yield of 1.28 percent, 95 basis points above a Treasury rate of .33 percent. The spread on the state’s final 2038 maturity was about 175 basis points more than the 30-year Treasury rate of 3.90 percent Thursday.

Thomson Reuters Municipal Market Monitor’s Dan Berger wrote in a December 10 commentary about Illinois GO bonds:

The high cost of borrowing for Illinois

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:

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.

Two massive pension reform struggles

After similar challenges fought in 42 other states, Muniland’s two weakest credits – Illinois and Puerto Rico – are fighting difficult battles over pension reform. The pension struggles will have enormous effects on their creditworthiness.

Puerto Rico’s pension fund, which is dangerously close to insolvency, figured prominently in credit rater Moody’s analysis when it downgraded the commonwealth last December to Baa3, its lowest investment grade rating:

- Economic growth prospects remain weak after six years of recession and could be further dampened by the commonwealth’s efforts to control spending and reform its retirement system, both of which are needed to stabilize the commonwealth’s financial results. The lack of significant economic growth drivers and the commonwealth’s declining population have also reduced prospects for a strong economic recovery.

Illinois, the sovereign entity, gets a slap on the wrist

Numerous public pension plans across America are in horrendous shape. The employee plan of the Commonwealth of Puerto Rico, funded at an alleged 7 percent of assets, is functionally broke. Other public plans, like that of Charleston, West Virginia, have 24 percent of the assets needed to meet future promises to retirees.

There is little to no regulatory oversight of public pensions. And what little there is comes in a roundabout way. For example, the sanction that the Securities and Exchange Commission administered to the state of Illinois for not adequately disclosing to bond investors that it was not properly funding its system.

The core of the SEC complaint says:

The state omitted to disclose in preliminary and final official statements material information regarding the structural underfunding of its pension systems and the resulting risks to the state’s financial condition.

Illinois on the downward slope

The state of Illinois was placed in the lower investment grade class last week when Standard & Poor’s downgraded the state to A- with a negative outlook.

Fitch

Moody’s

Standard & Poors

A  [negative watch]

A2  [Negative outlook]

A -  [Negative outlook]

On a market-based scale, the Fitch (A) and Moody’s (A2) ratings for Illinois are considered equivalent, while Standard & Poor’s is considered one notch lower. But more importantly, all the raters have a “negative watch or outlook” on the state. This means that it could be downgraded again. The ship is taking on water.

There are several reasons why raters view Illinois so negatively. The state’s spending is way out of line with its revenue and its deficit is about 25 percent of its annual budget. Unlike the federal government, Illinois cannot endlessly issue new bonds to cover annual shortfalls. Instead, the state simply delays paying its bills from year to year. From S&P’s rating action:

Do muniland’s flare-ups signal a bigger fire?

Now that three California towns have declared bankruptcy in the past few weeks, the mainstream media is abuzz with headlines of imminent doom for state and local governments. Adding fuel to the fire were Warren Buffett’s comments on Bloomberg TV about how cities may find it easier to declare bankruptcy after seeing others do it:

“The stigma has probably been reduced when you get very sizeable cities like Stockton or San Bernardino to do it,” Buffett, 81, said in an interview today on “In the Loop with Betty Liu” on Bloomberg Television. “The very fact they do it makes it more likely.”

He said the nation isn’t on the brink of hundreds of billions of dollars in defaults, as banking analyst Meredith Whitney predicted in 2010. “I don’t think we’re at the precipice,” Buffett said. “People will use the threat of bankruptcy to try and negotiate, particularly pension contracts, with their employees.”

Winners and losers in a hot municipal market

Like U.S. Treasury debt, muniland securities have been hot, hot, hot. Investors have been piling into municipal bonds for about 16 consecutive months. At first, demand was driven by investors who were attracted to the high yields in the wake of Meredith Whitney’s predictions of default, which scared retail investors out of the market between November 2010 and February 2011. Demand then accelerated as the Federal Reserve kept interest rates at artificially low levels, driving investors out of Treasuries and into riskier assets. Steady municipal bond mutual-fund flows, coupled with the reinvestment of muniland proceeds into new bond issues, has also helped keep demand elevated.

On the supply side, municipal bond issuance in 2011 slowed to $295 billion, down 32 percent from 2010 and the lowest level since 2001. This lack of supply, along with massive demand, has covered over a lot of issuer weaknesses that would normally drive yields higher. Bloomberg reports:

“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.

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