Fitch Rates $1.8 Billion Illinois GOs 'BBB+; Remains on Rating Watch Negative

NEW YORK--()--Fitch Ratings has assigned a 'BBB+' rating with a Negative Rating Watch to the following general obligation (GO) bonds of the state of Illinois:

--$1.349 billion GO refunding bonds, series of October 2016;

--$483.045 million GO bonds, series of November 2016.

The October refunding bonds are expected to sell via negotiation on or about Oct. 13, 2016 and the November bonds are expected to sell via competitive bid the week of Oct. 17, 2016.

Fitch has also maintained the Rating Watch Negative on the following ratings:

--Issuer Default Rating (IDR) 'BBB+;

--$25.9 billion in outstanding GO bonds 'BBB+';

--$431 million Illinois Sports Facilities Authority sports facilities bonds (state tax supported) 'BBB';

--$2.6 billion Metropolitan Pier and Exposition Authority McCormick Place expansion project bonds 'BBB';

--$267.8 million city of Chicago motor fuel tax revenue bonds 'BBB'.

Fitch expects to resolve the Rating Watch by the end of January based on the progress of the fiscal 2017 budget. Fitch expects to resolve the Rating Watch by the end of January following an assessment of the state's financial condition if and when it enacts a full budget for the fiscal year that began July 1, 2016. At that time, Fitch will assess state action to address the chronic and growing financial imbalance that has resulted from an unwillingness to make use of the significant gap-closing tools available to the state.

SECURITY

The bonds are general obligations, full faith and credit of the state of Illinois.

State statutory mechanisms include an irrevocable and continuing appropriation for all GO debt service, and continuing authority and direction to the state treasurer and comptroller to make all necessary transfers from any and all revenues and funds of the state. The state funds debt service in advance by setting aside 1/12 of principal and 1/6 of interest every month for payments due in the ensuing 12 months.

KEY RATING DRIVERS

The Rating Watch Negative reflects the financial implications of the state's extended budget stalemate, which, as anticipated by Fitch, has continued into a second fiscal year. Illinois has failed to capitalize on economic growth to bolster its financial position. Rather, the decision to allow temporary tax increases to expire and the subsequent failure to develop a budget that aligns revenues with expenditures have resulted in a marked deterioration in the state's finances during this time of recovery. Once again, the state has displayed an unwillingness to utilize its extensive control over revenues and spending to address numerous fiscal challenges.

The 'BBB+' rating continues to reflect the strengths inherent in a state's independent ability to control its budget, which remain substantial in Illinois despite policy decisions over a long period that have reduced expenditure flexibility. The rating also incorporates the state's elevated but still moderate liability burden. These factors are offset by a history of notable fiscal management weakness that manifests itself in weak operating performance throughout the economic cycle.

Economic Resource Base

The state benefits from a large, diverse economy centered on the Chicago metropolitan area, which is the nation's third largest and is a nationally important business and transportation center. Economic growth through the current expansion has lagged that of the U.S. as a whole.

Revenue Framework: 'aa' factor assessment

Illinois' broad revenue base, primarily income and sales taxes, captures the diversity in its economy and has shown modest growth since the end of the recession. Fitch expects revenue performance to continue to track slow economic growth. The state has unlimited legal ability to raise revenues.

Expenditure Framework: 'a' factor assessment

Illinois has adequate expenditure flexibility despite elevated carrying costs for debt service and retiree benefits, with much of the broad expense-cutting ability common to most U.S. states. However, it is unlikely that reductions in state spending alone would be sufficient to achieve budgetary balance given the magnitude of the current budget gap. Funding demands associated with retiree benefits will continue to be a pressure as these benefits are constitutionally protected.

Long-Term Liability Burden: 'a' factor assessment

Liabilities are an elevated but still moderate burden on Illinois' resource base, even when considering the large and growing accounts payable backlog that the state has accumulated. The state has limited flexibility with regard to pension obligations following a May 2015 Illinois Supreme Court decision that found 2013 pension reform unconstitutional.

Operating Performance: 'bbb' factor assessment

Illinois's operating performance, both during the most recent recession and in this subsequent period of economic growth, has been very weak. The failure to address a long-standing structural budget gap with permanent and comprehensive solutions, whether revenue or expenditure, has left the state with an gaping hole in its operating budget and increasing budgetary liabilities. The failure to enact a budget for the whole of fiscal 2016, followed by passage of a partial budget for fiscal 2017, reflects an unprecedented level of political discord and dysfunction.

RATING SENSITIVITIES

FISCAL 2017 BUDGET: Failure to enact measures that lead to ongoing budget balance would trigger a downgrade. Successful implementation of measures to enact a structurally balanced budget and reduce accumulated budget liabilities would place the credit on a positive trajectory.

CREDIT PROFILE

Illinois is a large, wealthy state at the center of the Great Lakes region. It benefits from a diverse economy centered on the Chicago metropolitan area. Illinois' economy has gradually shifted, similarly to the U.S. in general, away from manufacturing to professional business services. The remaining manufacturing sector does include more resilient non-durables, and is less concentrated in the auto sector than surrounding states, but remains vulnerable to cyclical downturn. By most measures the economy has grown slower than the nation for many years and population levels have been stagnant.

Revenue Framework

Illinois has a reasonably diversified revenue base. It relies most heavily on personal income taxes (close to half of general fund revenues) and sales tax. The balance consists of corporate income tax, lottery and gaming revenues, and a variety of other smaller taxes and transfers. The state has a flat personal income tax rate of 3.75%, which was temporarily increased to 5% between 2011 and 2015 from the prior flat rate of 3% to close post-recession budget gaps and reduce accumulated liabilities.

Historical revenue growth, adjusted for the estimated impact of policy changes, has been slightly above the inflation rate over the 10 years through 2014 but has somewhat lagged national economic growth. With Illinois' economic performance also lagging national growth, Fitch expects a continuation of this trend of flat to modest real revenue growth.

Illinois has no legal limitations on its ability to raise revenues through base broadenings, rate increases, or the assessment of new taxes or fees.

Expenditure Framework

As with most states, Illinois' spending is largely for social services and education, although its carrying costs for debt service and pension payments are comparatively high.

Spending growth, absent policy actions, is likely to be higher than revenue growth, driven mainly by increasing pension costs. Illinois has chronically underfunded its pension system based on a statutory formula that permitted a slow incremental build-up to higher pension funding and targeting only 90% of full actuarial funding. Pension costs are unusually large and continuing to grow, crowding out other spending. As with most states, other spending drivers include Medicaid and education. The fiscal challenge of Medicaid is common to all U.S. states and Illinois has taken action to control costs, including shifting clients into managed care and tightening eligibility.

Despite carrying costs that are among the highest of the states, Fitch believes that Illinois retains adequate expenditure flexibility that could be used in the budget process. Illinois funds a broad range of services for its citizens and did not significantly reduce spending during the recession. This leaves the state with ongoing capacity to make spending reductions if needed. However, Illinois has no ability to unilaterally modify retiree benefits following the May 2015 Illinois Supreme Court decision that found a 2013 pension reform unconstitutional.

During the current budget impasse, almost 90% of spending continued to be funded in fiscal 2016 at the 2015 rate, based on continuing appropriations, consent decrees, and court orders, as well as the enacted education budget. A similar partial budget was enacted for fiscal 2017. There is little flexibility to control spending outside of the budget process in part because the governor cannot unilaterally make changes without legislative participation.

Long-Term Liability Burden

Illinois' long-term liabilities, particularly pension liabilities, are very high for a U.S. state. Illinois is the weakest of the states in terms of its ratio of debt and unfunded pension liabilities to personal income, at 25% as of 2015, well above the 5.8% median for states. The state's three largest pension systems, covering teachers, universities, and state employees, have low funded ratios driven by a history of weak contribution practices.

Short-term borrowing is allowed, subject to a limitation of 5% of appropriations for revenue anticipation purposes, which must be repaid by the close of the fiscal year, and 15% to meet revenue failure, which must be repaid within one year. The state has no short-term borrowing currently outstanding or planned, although notes were issued during the downturn.

Operating Performance

Illinois is poorly positioned to address a future economic downturn. While it has substantial theoretical capacity to weather a downturn, both in terms of revenue raising potential and spending flexibility, it has not demonstrated the political capacity to achieve a long-term solution to its chronic budget deficits. During the recession, the state largely maintained spending but delayed payments to address lower revenues. It accrued, as a result, an accounts payable balance that at its peak, reached 20% of the operating budget. In the absence of a change in management's approach to state finances, it is Fitch's expectation that future deficits would also be addressed by deferring state payments and increasing accumulated liabilities.

Illinois' budget management during the current period of expansion also has been especially weak. Temporary increases in personal and corporate income tax rates in place for four years, from Jan. 1, 2011 through Dec. 31, 2014, closed or partially closed the budget gap across five fiscal years. However, with their expiration, and the failure to enact a spending plan within expected revenues, the budget gap has ballooned. As a result, the state finds itself with a current operating deficit, structural budget deficit, cash crunch, and accumulation of accounts payable that will surpass its highest level at the depth of the recession.

The governor and state legislature could not come to agreement on a realistic spending and revenue plan for either the fiscal year that ended June 30, 2016 or the current fiscal year. With spending that far exceeded available revenues in fiscal 2016, the state's accounts payable balance ballooned to an estimated $7.9 billion at year-end, a significant portion of which was for the state employee health insurance plan. Similarly unable to enact a full-year balanced budget for fiscal 2017, the governor proposed, and the legislature enacted, a partial or bridge budget to fund operations while continuing negotiations over the budget and the governor's proposed reform agenda, which addresses issues in addition to the budget. If spending continues in the current year without approval of new revenues or the enacting of severe budget reductions, which seem unlikely, the state would once again run a sizeable deficit that would flow through to the accounts payable bottom line.

The state has a history of enacting important legislation in what is termed the "lame duck" session, after an election. The legislature has raised revenues and passed pension reform legislation during these non-regular legislative sessions. To stabilize the rating, the state will need to address the fiscal 2017 budget following the election in November or at the latest during a January legislative session. While it is unlikely that any actions taken would fully address the fiscal 2017 budget gap, Fitch will be looking for a solution that is comprehensive in its approach, addressing structural budget balance and including a plan to address accumulated liabilities. Failure to do so would result in a rating downgrade.

Additional information is available at 'www.fitchratings.com'.

In addition to the sources of information identified in the applicable criteria specified below, this action was informed by information from Lumesis and InvestorTools.

Applicable Criteria

U.S. Tax-Supported Rating Criteria (pub. 18 Apr 2016)

https://www.fitchratings.com/site/re/879478

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Fitch Ratings
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Karen Krop
Senior Director
+1-212-908-0661
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eric Kim
Director
+1-212-908--0241
or
Committee Chairperson
Marcy Block
Senior Director
+1-212-908-0239
or
Media Relations
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elizabeth.fogerty@fitchratings.com

Contacts

Fitch Ratings
Primary Analyst
Karen Krop
Senior Director
+1-212-908-0661
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
or
Secondary Analyst
Eric Kim
Director
+1-212-908--0241
or
Committee Chairperson
Marcy Block
Senior Director
+1-212-908-0239
or
Media Relations
Elizabeth Fogerty, New York, +1-212-908-0526
elizabeth.fogerty@fitchratings.com