Is Illinois the New California?
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.
But unlike Colorado's cap, which was designed to finance tax rebates, the Illinois proposal would direct that the state to fully fund its pension contributions each year. It would also require the state to pay off the billions in deferred payments to providers, and to maintain a rainy day fund equal to 8% of state spending. Only once the state had achieved these measures to put its fiscal house in order would taxpayers start seeing rebates.
Illinois legislators should seriously consider the cap or other measures to ensure that Illinois sees real budget balance. They would also do well to take a page from New Jersey Governor Chris Christie, who has been focusing on reining in the cost of local government, which can then reduce the need for budget-busting rises in local aid.
In 2008, Illinois had the country's lowest level of voluntary turnover in state employment, under 2% per year. Translation: public workers aren't giving up their jobs unless they're fired or retiring on pension. Near-zero turnover is a sign that Illinois could achieve significant savings on employee compensation while continuing to retain a quality workforce. Since payroll costs are roughly half the total cost of state and local government in America, this is an avenue for real savings.
This spring, Tina Fey -- a sometime-Chicagoan of Greek descent -- admonished Greece to get its fiscal house in order. "You're embarrassing us in front of Turkey!" she proclaimed, in perhaps Saturday Night Live's first analysis of sovereign debt crises.
Now, Illinois legislators are embarrassing the state in front of California (and Turkey, which has a CDS spread below 200). If Illinois doesn't take steps to get its fiscal house in order, it will face a vicious cycle -- rising borrowing costs that eat up more of the state's budget, which will grow the state's budget deficit and make it an even worse credit risk. And we will all have evidence that, yes, you can do worse than California.