Standard & Poor’s: Illinois Remains At BBB-, Will Not Descend To Junk

government budget, BBB-, Standard & PoorsSan Francisco, CA-(ENEWSPF)- The good news is, Illinois retains a BBB- rating after the legislature overturned vetoes from Governor Bruce Rauner, passing a budget. But there is still work to be done.

Speaker Michael J. Madigan issued the following statement Wednesday after Standard & Poor’s reacted positively to passage of a bipartisan balanced budget:

“S&P’s action today is a strong signal that the balanced budget enacted by Republicans and Democrats is an important step in the right direction. At the end of June, I wrote to the rating agencies and asked that they temporarily withhold judgment and give legislators more time to enact a budget, and I’m grateful for the legislators on both sides of the aisle who used this time to work together and make the difficult decisions needed to start getting Illinois back on track.

“There is more work to be done, and it’s clear from S&P’s statement that rating agencies, like all Illinois residents, are hoping Governor Rauner will work in good faith with legislators to address these challenges rather than rejecting compromise by turning further to the extreme right.”

Standard & Poor’s detailed analysis and reasoning for not rating the state of Illinois as ‘Junk’ follows:

S&P Global Ratings affirmed its ‘BBB-‘ rating on Illinois’ general obligation (GO) bonds. We also affirmed our ‘BB+’ ratings on the state’s appropriation-backed debt, which includes Chicago’s outstanding motor fuel tax (MFT) revenue bonds. Finally, we affirmed our ‘BB-‘ ratings on the state’s moral obligation-backed debt. At the same time, we removed the ratings from CreditWatch, where they had been placed with negative implications on June 1. The outlook on all the debt ratings is stable. We have removed the ratings from CreditWatch because we no longer believe the state is at risk of experiencing a liquidity crisis in the near term as it was before.

The rating affirmations and stable outlook reflect that following Illinois’ enactment of a fiscal 2018 budget, which required a bipartisan vote of the General Assembly to override the governor’s veto, the odds of its GO credit rating falling to below investment grade within the next year has substantially diminished. As it is a U.S. state imbued with extensive and constitutionally protected sovereignty over its fiscal policy, its protracted budget impasse came to represent an extraordinary threat to its credit quality. Through a combination of spending cuts and tax increases, the budget package brings the state’s revenue and expenditure base much closer to structural alignment and reduces the near-term uncertainty that had come to characterize its financial operations. Crucially, budget enactment also reasserts state authority over its finances while simultaneously helping preserve and strengthen the adequacy of its resources to reliably cover its priority obligations.

On its own, the passage of a budget—among the most basic of lawmakers’ governing responsibilities—does not alleviate the pressure on Illinois’ credit quality related to its weak liability profile. Furthermore, the state will almost certainly suffer an extended fiscal hangover from the impasse, not least from its record level of unpaid bills, which will be a drain on its future resources. Revenue spent on servicing and retiring the roughly $15 billion in unpaid bills is unavailable for contribution to the state’s severely underfunded pension systems or to fund state services. It also crowds out fiscal capacity the state might otherwise use to accommodate a reduction in tax rates. Similarly, the state has incurred an immeasurable but undoubtedly steep opportunity cost throughout the impasse in terms of foregone pension reforms or investment in its higher education institutions. From a credit perspective, there is also a disconcerting lack of consensus among state officials on the way forward. Nevertheless, despite being fractured and delayed, passage of the budget represents an affirmation of lawmakers’ collective willingness to prioritize the state’s fundamental claims-paying ability at an investment-grade level.

While the budget does not comprehensively address the state’s burdensome pension liabilities—no individual budget could—it does move the state’s annual revenue and expenditure baselines toward alignment. And in our view, balanced fiscal operations are for Illinois a necessary precondition to improving its prospects for longer term solvency. Still, it is largely because of the bill backlog, poorly funded pension systems, and ongoing political dysfunction that the state’s rating is well below that of peer-comparison states with similar economic profiles.

The ‘BBB-‘ GO rating reflects our view of the state’s:

  • Depleted budget reserves and generally weakened financial condition that—as a direct consequence of intransigent political leadership—has left Illinois susceptible to experiencing liquidity stress;
  • Backlog of unpaid bills that has mushroomed to more than 40% of annual general funds’ expenditures;
  • Distressed pension funding levels that will require substantial contribution increases in the coming years; and,
  • Inability throughout the past two years to deliver adequate and timely funding for a range of important public services and institutions.

Partially offsetting these weaknesses is our view of the state’s:

  • Statutorily-based monthly transfers for semi-annual debt service;
  • Well-established record of treating transfers for GO debt service as priority payments;
  • Deep economic base anchored by the Chicago metropolitan statistical area, muted to a degree by a growth outlook that is expected to trail the nation through the next five years;
  • Above-average income levels; and
  • Sovereign authority to adjust tax revenues, expenditures, and—to a point—the timing of disbursements.

Throughout the budget impasse, our view of Illinois’ weakened financial position remained balanced by the presence of its continuing appropriation providing legal authority for monthly transfers from its general funds to the general obligation bond retirement and interest (GOBRI) fund. The state has a history of treating cash on deposit in the GOBRI fund as restricted for debt service. One exception to this was in 2009, when lawmakers approved a temporary loan from the GOBRI fund to finance start-up costs of the state’s Hospital Provider Assessment program. We view statutes governing Illinois’ debt service transfers as providing a strong–though as illustrated by the 2009 episode, not immutable–level of protection to its bond holders.

BUDGET OVERVIEW

The state’s fiscal 2018 general funds budget provides $36.6 billion in estimated expenditures funded by $36.3 billion in anticipated revenue, leaving a modest operating deficit of $289 million. Key provisions of the fiscal 2018 budget include a permanent increase in the individual income tax rate to 4.95% from 3.75% and an increase in the corporate income tax rate to 7.0% from 5.25%. Preliminarily, the state Department of Revenue estimates that the higher taxes will generate approximately $5.0 billion in additional tax revenue. Considering that recent collections performance has lagged earlier projections, it’s possible, however, that the DOR’s estimate may be revised lower. Various other smaller revenue-side policy changes bring the total expected increase in revenue for fiscal 2018 to $5.4 billion.

On the spending side, the budget contains about $2.5 billion in various spending adjustments that lower the general funds’ expenditures compared with the prior fiscal 2018 “autopilot” spending trajectory. Specific reductions include 5% across-the-board cutbacks to the operating budgets of most state agencies relative to their fiscal 2015 appropriations levels, except the state’s higher education system, which is reduced by 10%. Expenditures in the budget may be understated, however. For example, although the budget provides over $1 billion in supplemental appropriations for fiscal 2017, there is still roughly $1.3 billion in agency costs from 2017 that did not receive an appropriation. Instead, the legislation allows the state to fund bills from fiscal 2017 with fiscal 2018 appropriations. This may effectively result in the carryforward of a residual deficit attributable to fiscal 2017. Nevertheless, the budget eliminates much of the state’s structural budget gap going forward, in our view.

Compared with the prior “autopilot” spending estimate, the enacted budget recognizes $1.4 billion in lower expected pension contribution costs for fiscal 2018. A portion of the projected savings comes from a change that allows the state to smooth, over a five-year period, contribution increases related to actuarial assumption changes by the pension plans. In our view, this change represents a cost deferral more than a genuine expenditure reduction. More favorably from a credit perspective, the legislation limits end-of-career pay increases (pension spiking). The budget legislation also creates a Tier 3 pension benefit option for newly hired employees. Pension costs for the new Tier 3 plan, which entails both defined contribution and defined benefit components, would be funded by the universities and school districts (outside of Chicago). It’s likely the new plan will produce savings for the state by reducing the growth of its future pension liabilities. However, the budget assumes savings to the state of $500 million in fiscal 2018, which may prove premature.

The budget includes appropriations totaling $8.2 billion for preschool-through-grade-12 education, an increase of $730 million from fiscal 2017. Release of the budgeted education funds is contingent on the implementation of a new education funding formula detailed in legislation that the governor has threatened to veto. A sticking point on the funding formula is that it would provide a larger increase in aid to Chicago Public Schools, including for its pension costs, than the governor supports.

Regarding the state’s nearly $15 billion in unpaid bills, the budget legislation establishes a plan for paying down approximately $8 billion of them. Central to the strategy is the authority for the state to issue up to $6 billion in GO bonds though the plan contemplates a $3 billion issuance. If proceeds from the bonds, which would mature in 12 years, paid Medicaid obligations, they could help generate an additional $2 billion in federal matching funds. Bonding to pay down the bill backlog is tantamount to the state financing its operating costs with debt. While this practice would be inconsistent with a higher rating, we believe that it is encompassed in our ‘BBB-‘ rating. Furthermore, given that the state pays elevated annualized interest rates of 9% or 12% on much of its unpaid bills, a debt financing does offers the potential for fiscal savings. Budget legislation also provides $1.2 billion in inter-fund loan authority and identifies up to around $2.1 billion in non-general funds-funding sources to reduce the bill backlog.

Various provisions included in the budget legislation should alleviate Illinois’ near-term liquidity pressure and ensure its ability to fund its core priority payments in the coming weeks. Beginning in August, the income tax rate increase should generate somewhere in the range of $200 million to $250 million in increased cash receipts. In addition, the budget allows the comptroller to reallocate up to $292 million from other funds and provides the aforementioned inter-fund borrowing authority. These cash management tools offer a potential liquidity bridge to the general funds until higher cash inflows materialize and the state implements its larger backlog borrowing.

THREAT TO SOVEREIGNTY OVER CASH RESOURCES IMPERILED INVESTMENT-GRADE RATING

Already compromised liquidity and a pending loss of discretion over the allocation of its cash resources had introduced a potentially speculative element to the state’s credit profile, in our view. To a point, the state’s practice of deferring payment on some of its obligations represents an exercise of sovereign authority that insulated its ability to cash-fund what the comptroller deems its core priority commitments, such as its bond payments. However, we expect there is a threshold beyond which the state’s ability to triage its cash and various payment obligations in favor of its chosen priorities can become impaired. Given its status as a sovereign, the precise boundary of this limitation for Illinois is unspecified. But as it is a financing partner (along with the federal government) of the Medicaid program, we view the approximately $3.3 billion in delinquent payments owed to its Medicaid managed care organizations (MCOs) as testing one such limit.

A recent federal court ruling highlighted this risk, finding that Illinois was not compliant with prior consent decrees pertaining to the timeliness of payments to its Medicaid MCOs. The court’s decision, which effectively reiterated existing consent decrees, exerted additional legal pressure on the state to expand its definition of core priority expenditures to include more of the Medicaid payments. Beginning in July, the court ruling mandates the state to increase its monthly payments to the Medicaid MCOs by $583 million and to pay $2 billion toward its unpaid Medicaid bills during fiscal 2018. Federal matching funds will reduce by approximately half the net cost to the state. Even the $290 million this translates to, however, far exceeds the $75 million the comptroller said before the budget was passed that the state could accommodate.

In this way, the state’s cash management had become subject to material reprioritization by the courts, raising the specter of a near-term liquidity crunch. We saw the state as having begun to relinquish key aspects of its sovereignty to the courts as a direct consequence of the budget impasse. The comptroller had recently described the state’s finances as verging on “unmanageable” given the deficiency of cash inflows relative to funding obligations. Passage of the budget likely helps avert a scenario in which the state becomes unable to fund its core obligations, thus alleviating an acute source of pressure on the rating.

Still, having unfolded and even accelerated amid a broader economic expansion, Illinois’ fiscal deterioration stands in contrast to the experience of other states. Relative to the macroeconomic backdrop, U.S. states tend to exhibit pro-cyclical revenue performance and countercyclical demand for safety net social services, such as Medicaid. Illinois saw a widening structural budget deficit, depletion of its budget reserves, and dramatic growth in its budgetary debts and long-term liabilities during a period of economic growth. This leaves the state ill-prepared to weather the effects of a recession should one occur. And while our baseline forecast does not anticipate an economic downturn, we cannot rule one out given that in June, the current expansion surpassed its eighth anniversary, solidifying its status as one of the longest post-World War II periods of uninterrupted growth.

Prospects for a fuller recovery of Illinois’ creditworthiness will be impeded by the distressed funding condition of its pension systems and large unfunded retiree health benefits liabilities. Collectively, the ratio of plan fiduciary net position (GASB assets) to total pension liability fell to 35.6% as of fiscal 2016. State contributions to its pension systems are determined according to statute as a level percentage of payroll expense designed to achieve a 90% funded ratio by 2045. The amortization schedule is back-loaded and risks becoming untenable vis-à-vis Illinois’ capacity to provide funding for other public services, particularly if investment return or other actuarial assumptions don’t hold. At such a low funded level, we believe there is a nontrivial risk that one or more of the pension systems could enter insolvency in a sustained bear market.

OUTLOOK

The stable outlook reflects that with passage of its fiscal 2018 budget, the likelihood that Illinois will experience a liquidity crisis in the coming months has fallen markedly and therefore so have the odds of its rating falling to below investment-grade. Enactment of the budget is also favorable in that key fiscal adjustments on the revenue and spending side are permanent and thus shrink significantly the state’s structural deficit. Nevertheless, a backlog of approximately $15 billion in unpaid bills and severely underfunded pension systems contribute directly to the rating being ‘BBB-‘, currently the lowest among the states. We expect the magnitude of these liabilities relative to the state’s budget and tax base will continue to weigh on its credit rating for the foreseeable future. Along with its large balance of payables, the state depleted its budgetary reserves during fiscal 2017 leaving it vulnerable to additional fiscal stress in the event of weaker-than-anticipated economic performance. Depending on the severity of any such weakening and whether it translates to liquidity strain, the state’s rating could be subject to renewed downward pressure. The stable outlook assumes the state will implement key provisions of the budget legislation. Various tools provided in the budget to address the unpaid bills are particularly important to the condition of the state’s liquidity, in our view. Any indication that the state will opt against executing on the backlog-related provisions could result in short-lived outlook stability and an immediate renewal of negative pressure on the rating.

Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.globalcreditportal.com and at www.spcapitaliq.com. All ratings affected by this rating action can be found on the S&P Global Ratings’ public website at www.standardandpoors.com. Use the Ratings search box located in the left column.

Sources: Speaker Michael Madigan, Standard & Poor’s