Illinois paying for its big debt

Costs for Illinois borrowing continue to rise because of the state's dire financial situation

Wednesday, July 14, 2010

While Illinois continues its biggest borrowing spree in recent years, it is paying a steep premium for loans because of its failure to significantly address its financial crisis, observers say.

In peddling another $900 million in Build America capital projects bonds on Wednesday, Illinois could face interest costs of about $9 million a year more than if the state were in better financial shape. The extra costs would total about $225 million over the life of the bonds.

The annual hit may not seem like a huge sum compared with the state's $25 billion budget. But it's more than Gov. Pat Quinn's $8 million in cuts to the Department of Natural Resources, for example, or his $8 million in cuts for veterans programs.

And the additional borrowing costs are expected to keep on rising. Factors include recent downgrades in the state's credit ratings and the huge amount of borrowing the state is undertaking.

The latest bond issue is only a fraction of what could add up to $9.3 billion in long-term borrowing this fiscal year, on top of $8.9 billion in such borrowing last year. Those sums are topped only by borrowing in fiscal 2003, when then- Gov. Rod Blagojevich pushed through a record $10 billion bond sale to prop up the state employee pension funds.

"Every time Illinois comes to market, the premium they have to pay gets higher because the market experiences Illinois debt fatigue," said Brian Battle, a director at Performance Trust Capital Partners LLC, a Chicago-based fixed-income investment adviser.

"These are costs Illinois will be paying for decades to come," said Josh Barro, a senior fellow at the Manhattan Institute, a free-market think tank.

John Sinsheimer, the state's director of capital markets, said there is no question Illinois is paying more to borrow than states with better credit ratings. But net borrowing costs to the state remain "very attractive," he said, because interest rates remain at historically low levels and because the federal government will pay 35 percent of the state's interest costs on Build America bonds, the taxable bonds the state is using to fund its capital program.

"It still makes sense to strategically borrow," Sinsheimer said.

The state has not had a capital program for a decade, he said, "so there are a lot of roads, bridges, schools and infrastructure that need improvement. Equally important, we want to put people to work, and every $1 billion in Build America bonds adds 20,000 to 25,000 direct new jobs to the Illinois economy."

Still, the state's escalating borrowing, not only for capital projects but to make the state's annual payment to employee pension systems and to meet other operating expenses, is raising red flags among government watchdogs, investment firms and credit rating agencies. They see a state unwilling to address its growing operating deficit and its accumulating pension and retiree health care obligations with anything more than stop-gap measures.

The state had $4.7 billion in unpaid bills in the fiscal year ended June 30, and its pension system is the worst funded among the states, according to one recent study.

"The financial uncertainty of the state and the continued failure of the General Assembly and the governor to address the problem are having very negative consequences for the business climate," said Laurence Msall, president of the nonpartisan Civic Federation. "Businesses are not willing to invest in a state when they cannot predict the long-term tax policy and fiscal conditions."

Last month, Fitch Ratings and Moody's Investors Service each took Illinois' debt rating down a notch, which can lead to higher borrowing costs. The Moody's downgrade to a fifth-rung A1 brought Illinois into a tie with California as the worst-rated state by that agency. The state remains a notch above California in ratings by Fitch and Standard & Poor's Ratings Services.

The state's status is reflected in how much interest investors are demanding. Ten-year Build America bonds issued earlier by Illinois were yielding 5.62 percent on the secondary market Friday, while Build America bonds from higher-rated Ohio were yielding 4.44 percent.

The secondary market, where previously issued bonds are bought and sold, provides a clue of what investors think bonds are worth at that moment, Battle said.

If that proves to be the case, Illinois may have to pay a 1 percentage point premium to move its $900 million in bonds Wednesday, which would translate into another $10,000 a year for every $1 million in bonds issued.

Battle declined to estimate a total extra cost, noting the 25-year issue is a collection of bonds with varying maturities. But a ballpark estimate, arrived through simple multiplication, reveals an annual premium of about $9 million.

The growing risk associated with debt issued by recession-battered states and cities was underscored last month when Warren Buffett, head of Berkshire Hathaway Inc., and Thomas Wilson, chief executive of Allstate Corp., said their companies had trimmed inestments in such debt.

Illinois is the only U.S. state listed among 10 government entities most likely to default, coming as No. 8, right after Iraq, according to CMA DataVision. The rankings are based on the cost of insuring a state's debt against default.

Yet, observers caution that fears of default are overblown.
Illinois' situation "is not good, but it's not a Third World country, either," said Tom Doe, chief executive of Municipal Market Ad.

In Illinois, the payment of debt service effectively comes ahead of any other obligation of the state, according to a report this week by the firm.

The state can still borrow, Battle said, "but it's paying more because it's a compromised borrower."