Long time readers of this blog know that I reside in the Land of Lincoln. Illinois now has the distinction of perhaps being in the worst fiscal mess of any state in the Union, as this recent article by Josh Barro for Real Clear Markets indictates:
If you go to Sacramento this week, don’t be surprised to hear champagne corks popping and chants of “We’re #2! We’re #2!” The cause for celebration? Illinois has overtaken California as the worst credit risk among American states.
As of Monday, the credit default swap spread for Illinois general obligation bonds climbed to 313 basis points for a five-year contract — meaning a bondholder must pay over 3% of the bond’s face value per year to be insured against default.
That’s a higher price than for all but seven sovereign entities tracked by CMA, and slightly higher than California, whose five-year CDS spread sits at 293. Investors rate Illinois’s debt as slightly riskier than Iceland’s or Latvia’s, but not quite as big a gamble as Iraq’s.
Despite this environment, Illinois chose to issue an additional $300 million in taxable Build America Bonds last week. Unsurprisingly, the markets were not keen and demanded a high price: the new 25-year bonds were sold with a yield of 7.1%, a spread of 297 basis points over 30-year treasuries. Illinois’ last long term issues, in April, had spreads of 205 and 210 basis points, meaning investors were already nervous about Illinois and are growing moreso.
This issuance provides further evidence that the ratings agencies haven’t fully appreciated the dire nature of state finances, at least in states like California and Illinois. While Illinois carries a Moody’s rating of A1, six notches above junk status, the markets put Illinois’s debt close to the borderline between junk and investment grade.
As my colleague Nicole Gelinas points out, bonds due in 2036 from Anandarko Petroleum (BP’s 25% partner in the Deepwater Horizon rig) were yielding 7.3% at the time of the Illinois issue. That’s only a bit richer than Illinois’s bonds maturing in 2035, yet Anandarko is rated Baa3, five notches below Illinois. Jeffries and Hartford Financial, rated Baa2 and Baa3 respectively, both have issuances due in 2036 that were yielding 7.1%.
What is Illinois doing that has the markets so nervous? A few months back, I explored the issue, noting that Illinois doesn’t face many of the challenges that typify “states in peril.” Unlike California, Illinois cannot blame its budget woes on a particularly volatile revenue system or on outsize exposure to the housing bubble. Illinois’s crisis is unique in that it is purely a creature of mismanagement by elected officials.
Like California, Illinois hasn’t balanced a budget in nearly a decade, and instead uses gimmicks and borrowing to close gaps. Like California, Illinois regularly issues bonds to pay for current government operations. But unlike California, Illinois has some of the country’s least-funded public employee pension plans.
Public employee pensions plans create fiscal challenges for all states, but it’s hard to find one that is coping more poorly than Illinois. Legislators have routinely closed budget gaps by deferring pension payments. (Or sometimes they make the payments by issuing Pension Obligation Bonds, over $13 billion in the last 10 years). In a recent study that I co-authored looking at the funding status of teacher pension plans in the states, Illinois was the second-worst performer; only West Virginia’s pension fund has a lower funding ratio.
Illinois’s pension funding irresponsibility may come home to roost soon. Joshua Rauh, a professor at Northwestern University, estimates that the state’s pension funds will run out of money in 2018 at the current funding pace. He estimates the plans’ total funding gap at $219 billion — a liability that dwarfs the $117 billion in bonds outstanding from the state and localities within it.
Once the reserves run out, Illinois won’t be able to defer its pension costs any longer. Unless it wants to default on pension promises made to retirees over decades (which it is barred from doing by the state constitution) it will have to draw on current tax revenues to pay out current-year benefits — and that need will compete with other state spending and with debt service.
Illinois did enact a pension reform this year, but the reform only applies to newly-hired employees, so it generates only minimal savings in the near-term. Worse, it keeps those new employees on a defined benefit system, only with reduced benefits — leaving open the possibility that legislators will go back and sweeten benefits when the economy looks stronger. (This is a cycle that New York State has been through more than once.) Instead, Illinois should shift to a defined-contribution system for future retirement benefits, at least for new hires.
Recent actions in non-pension areas are even less inspiring. The state legislature recently passed a provisional budget designed to “close” the state’s budget gap, though it does nothing to resolve $6 billion in accrued but unpaid bills to state service providers, like doctors and hospitals providing Medicaid services. Legislators currently have no plan to make the $4 billion payment due into the state’s employee pension funds this year.
The bond markets are screaming that Illinois needs real fiscal reform, and they didn’t find the pension reform to be satisfactory. To calm the bond markets, Illinois must stop using its pension funds as a venue for backdoor borrowing, stop borrowing to pay for current operations, and stop spending more money than it takes in.
The Illinois Policy Institute has been advancing a creative solution to the state’s budget woes. They have proposed a constitutional spending cap, similar to one enacted in Colorado in 1992, that would limit state spending growth to population plus inflation growth.
Go here to read the rest. How out of touch the powers that be in Illinois are about the fiscal hole that we are in was underlined by the endorsement of Governor Pat Quinn, the Lieutenant Governor who took over from Blagojevich who was too much of a crook even by Illinois standards, by the teacher’s union, the Illinois Education Association, yesterday. The teacher’s union blasted Republican nominee for governor Bill Brady for having the audacity for proposing that new teacher hires pay for their own retirement! Quinn has been handing out with a free hand raises to his stop staff while Illinois careens to fiscal disaster. The message really hasn’t sunk through yet that the State of Illinois is just as broke as anyone who cannot make even the minimum payments on his credit cards and has debt collectors calling at all hours. Brady has an 11 point lead over Quinn in the latest Rasmussen poll, and I think Brady will probably be the next governor of Illinois. I do not envy him his task. The Illinois is Broke website here says it all.