How did Illinois get into its financial mess, and what can be done about it?

Posted from: Outlook for Financial Markets BMO Wealth Management August 2017

Illinois is trying to avoid becoming the first “junk“ rated state. It already has the lowest credit quality rating among all 50 states. S&P Global Rating service warned Illinois legislators that without a viable budget for fiscal 2018, its third straight year without a budget, Illinois’ credit rating would fall below investment grade, forcing many municipal bond holders, most notably mutual funds, to disgorge their holdings or simply not buy. Illinois carries massive pension debt, a backlog of $15 billion of unpaid bills and a revenue shortfall as a result of the expiration of a temporary income tax rate increase.

As demand for Illinois’ shaky credit shrinks, the state’s financing costs are already on the rise. The state’s 10-year notes trade at a 4.8% tax-exempt yield; that’s 2.2 percentage points higher than what most other states pay. The higher interest expense costs Illinois taxpayers millions of dollars, funneling funds away from government services. Falling into junk status would exacerbate the trend. In the meantime, a handful of local issuers that rely on the state funding have been downgraded to junk, including the entities that run Navy Pier, McCormick Place convention center and Guaranteed Rate Field, home of the White Sox. Five publicly funded universities populate the high-yield universe too. Enrollment, not surprisingly, has plunged.

On paper, Illinois and Chicago are situated to succeed. The centrally located state is a logistics goldmine, set at the crossroads of rail, air and Mississippi river traffic. Chicago is thriving. The economically diversified city supports a multiplicity of industries, where no single sector accounts for more than 20% of the total. New construction in America’s Second City is on the rise too. There are currently 52 high rises under construction in Chicago’s downtown metropolitan area. Thirty-one Fortune 500 companies make their home in Illinois, including Boeing, McDonald’s and Walgreens. So why is Illinois in such a dubiously distinctive financial position? For decades, the Democratically controlled legislature engaged the state’s more than 300,000 public sector employees in a duplicitous back-scratching scheme. Union leaders marshalled votes for incumbent lawmakers in exchange for member perks. The perks were, not in pay hikes, since wages would be reflected in current budgets, but in the form of lavish retirement benefits that are not required to be disclosed. Thanks to a unique feature of municipal accounting, accruals for future liabilities do not show up on statements and local financial states, allowing lawmakers to purchase votes today and pay for them on someone else’s watch in the future. That future is today.

Michael Madigan, Speaker of the Illinois House, facilitated the pension-benefits-for-votes trade. Elected in the early 1980s, Madigan has outlasted seven governors, four of whom spent time behind bars. Republican businessman Bruce Rauner, the current governor, is the eighth. Elevated into office on a platform of reform, Governor Rauner, a private equity investor, has failed to enact one piece of legislation aimed at turning the state’s fiscal fortunes around. Early in his career, Madigan supported legislation that compounded retirement benefits at 3% annually, allowing benefits to effectively double during the course of retirees’ golden years.

Fiscal mismanagement also contributed to Illinois’ ills. Chicago, in particular, has had a poor record in that regard. Continually behind budget, Chicago, under the leadership of Richard M. Daley, in 2008 leased its parking meters to a consortium for 75 years for $1.2 billion. The price was determined to be nearly $1 billion too low, according to independent analysis. Subsequent parking fee hikes prompted a public backlash, but the city was powerless to react. Worst of all, the mayor squandered the proceeds of the sale on short-term funding gaps, essentially burning the furniture to heat the house.

Illinois’ pension system, serving more than 800,000 retirees, is among the lowest funded, at 37%, among all 50 states. Unfunded liabilities stand at roughly $130 billion, nearly double the value of the debt that forced Puerto Rico into bankruptcy. Pension contributions consume roughly a quarter of the state’s budget. Governor Rauner’s administration predicts unpaid bills could reach nearly $50 billion by 2022. Bankruptcy is not an option under current law. States aren’t allowed to seek bankruptcy protection. Time is not a friend. The state has hemorrhaged taxpayers every year for the last three years. Short of a federally appointed administrator directing the state’s finances, a permanent solution must include taxpayers, bond holders and pension beneficiaries. Constitutional precedents argue in favor of pension beneficiaries. That means that bond holders and tax payers will likely be left holding the bag.

Illinois’ pension system, serving more than 800,000 retirees, is among the lowest funded, at 37%, among all 50 states. Unfunded liabilities stand at roughly $130 billion, nearly double the value of the debt that forced Puerto Rico into bankruptcy. Pension contributions consume roughly a quarter of the state’s budget. Governor Rauner’s administration predicts unpaid bills could reach nearly $50 billion by 2022. Bankruptcy is not an option under current law. States aren’t allowed to seek bankruptcy protection. Time is not a friend. The state has hemorrhaged taxpayers every year for the last three years. Short of a federally appointed administrator directing the state’s finances, a permanent solution must include taxpayers, bond holders and pension beneficiaries. Constitutional precedents argue in favor of pension beneficiaries. That means that bond holders and tax payers will likely be left holding the bag.