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Rating Update:

MOODY'S AFFIRMS ILLINOIS' NEGATIVE OUTLOOK AND A1 GENERAL OBLIGATION DEBT RATING

24 Jan 2011

OUTLOOK APPLIES TO APPROXIMATELY $30 BILLION OF OUTSTANDING G.O. AND RELATED DEBT

State
IL

Opinion

NEW YORK, Jan 24, 2011 -- Moody's Investors Service has affirmed the A1 rating and negative outlook assigned to the state of Illinois' general obligation bonds. This action follows the state's enactment of fiscal measures including authorization of debt for pension contributions, increases in corporate and personal income taxes, and expenditure caps.

Rating Rationale

Recent fiscal actions constitute a major step toward beginning to address Illinois' chronic budget imbalances. They alleviate immediate downward rating pressure and will have a positive effect on state operating fund liquidity, while also resolving current-year pension funding questions. The outlook nevertheless remains negative, signaling that significant challenges persist. Plans to address an accounts payable backlog are not yet approved and entail execution risk, given reliance on borrowing. Any financings to create a long-term amortization schedule for the state's payables would crystallize the increase in debt levels, although the operating budget impact would be limited by dedication of incremental tax revenue through maturity. Debt burden growth, also reflecting about $7.5 billion of pension notes needed for the current and prior fiscal year contributions, will constrain financial flexibility in coming years. Resolution of the accounts-payable issue, action on a proposed cigarette tax increase and legislative adoption of the budget for fiscal 2012 will be important considerations for the rating and outlook in coming months.

Credit Strengths:

-- Sovereign powers over revenue and spending, as demonstrated by recent fiscal measures

-- Statutory prioritization of debt service payment from state revenues

-- Diverse economy with above-average wealth levels

Credit Challenges:

-- Negative year-end fund balance reflecting systematic payment deferrals, structural imbalance

-- Very large unfunded pension liabilities

-- Growth in debt burden associated with deficit financings

Detailed Credit Discussion:

FISCAL MEASURES ENACTED BY 96TH LEGISLATURE PREVENTED IMMEDIATE CREDIT DETERIORATION

The 96th General Assembly in its final days enacted large tax increases, in conjunction with spending caps to ensure that new revenues are not used for increased spending. The state's individual income tax rate rose to 5% from 3% effective January 1, and the corporate income tax rate rose to 7% from 4.8%. Together with other increases (including suspension of provisions for corporate net operating loss carry-forwards and reinstatement of the estate tax), these measures are projected to generate about $7.5 billion annually in fiscal years 2012 through 2014. In the current year, the increases are projected to generate almost $2.9 billion, or 8.1% of spending. The laws do not fully achieve the state's goal of long-term structural balance; the individual income tax is set to decline to 3.75% and the corporate tax rate to 5.25% on January 1, 2015. Notwithstanding these sunset dates, the tax rate increases are an important first step in restoring fiscal stability, creating a window of several fiscal years in which the state can address structural challenges, such as rising pension expense. The next milestones will include the Governor's budget proposal, expected February 16, and resolution of proposed measures to address an approximately $8 billion backlog of payables in coming months.

SPENDING CAPS EXPECTED TO PREVENT NEW REVENUE USE FOR SPENDING INCREASES

Caps on expenditure increases were an important part of legislation enacted by the 96th General Assembly. These caps - $36.8 billion in fiscal 2012 and increasing by about 2% per year through 2015 - are intended to keep the state from using recent tax increase revenues simply to allow spending growth. The 2012 base level incorporates all appropriated expenditures, including pension funding, employee healthcare, and Medicaid. The bulk of the annual 2% increases will be mostly accounted for by growing pension and Medicaid funding obligations, requiring cuts in discretionary programs. The spending law gives the governor the ability to hold back reserves from appropriations. Any new expenditures enacted by the legislature must be reviewed by the state's Auditor General for compliance with the cap, no later than 60 days after the effective date. The law lays out a procedure for corrective action, as well as a threat that recently amended taxes revert to 2010 levels if no action is taken. The law, scheduled to remain in effect through fiscal 2015, therefore provides strong incentive for compliance. In addition, any modification of the caps would require a legislative super-majority. The governor may request spending in excess of the caps in the event of an emergency, subject to approval from both the state's comptroller and treasurer, who are independently elected.

PENSION BONDS AUTHORIZED FOR CURRENT YEAR CONTRIBUTION

The Senate's approval of as much as $4 billion of G.O. debt to provide for the current fiscal year's pension contribution will resolve near-term funding questions. Without those funds, the state would have to consider increasing its accounts payable balance to make its statutorily required contributions, or enacting legislation to waive the current-year requirement, exacerbating already weak pension funded status. The state's pension funding deteriorated further, as expected, in the year ended 6/30/2010. On an aggregate basis, the funded ratio of the five plans fell to 45% from 50%, as combined liabilities grew to $138 billion from $126 billion. Annual statutory pension requirements grow steadily in coming years. Illinois last year enacted certain reforms to improve the long-term outlook for its pensions, by raising the minimum retirement age and imposing certain other restrictions on incoming employees. The Securities and Exchange Commission in September began a non-public inquiry into the state's disclosure of potential savings from these reforms. The state is cooperating. The inquiry itself does not indicate that a violation of federal securities law has occurred, according to current state disclosure statements.

STATE PUBLISHES FIRST MULTI-YEAR FINANCIAL FORECAST

In connection with fiscal legislation enacted in May 2010, the state has published its first multi-year financial plan, including revenues and expenditure projections through fiscal 2014. This represents implementation of a governance practice that, over time, may help produce strong operating results. Illinois' projection shows the impact of the recent tax increases, as well as the potential impact of an as-yet unapproved increase in the state's tax on cigarettes (to $1.99 per pack from 98 cents). The projection shows the state making required pension contributions from operating revenues in fiscal years 2012 ($4.5 billion), 2013 ($4.9 billion) and 2014 ($5.2 billion).

ACCOUNTS PAYABLE BALANCE REMAINS UNRESOLVED

Legislation authorizing long-term debt to address past-due payments was not enacted at the end of the 96th General Assembly. Illinois' chronic failure to provide for structurally balanced operations over the years, and its reliance on payment deferral to manage operating fund cash, has fueled growth in past-due bills (those outstanding for more than 60 days). This practice has in turn hurt private providers of goods and services, as well as public-sector entities (such as transit agencies, universities and municipalities) that rely on state funding. In December, the state issued $1.5 billion of tobacco bonds to help pay residual vouchers from the fiscal year that ended June 30, 2010. A rolling balance of past-due amounts, however, remains and contributes to the large negative general fund balance.

PENDING MEASURE WOULD ADD $8.75 BILLION OF DEBT TO ADDRESS PAYMENT BACKLOG

The accounts-payable financing proposal, which has been reintroduced in the current legislative session, would alleviate pressure on entities awaiting payment. For the state, the plan entails potential market-access risk and an $8.75 billion increase in debt. The state would issue $5.75 billion of 14-year G.O. bonds this fiscal year under the proposal. Proceeds would be allocated primarily to payment of vouchers more than 60 days old ($4.75 billion), but would also provide corporate tax refunds and amounts owed under the state's employee health plan ($500 million each). Another $3 billion of bonds would be issued in fiscal 2012. Annual debt service paid from general revenue funds of the state would increase 33% to an estimated $3.85 billion in fiscal 2017 from $2.9 billion in fiscal 2011. Statutory dedication of half a percentage point of the recent individual income tax increase would mitigate impact on the state's financial operations, however. The dedicated amount is projected to raise $1.55 billion annually. Maximum annual debt service on the two accounts-payable issues is projected at just under $1.2 billion in fiscal 2016. Alternatives to this plan, in the event it fails to win legislative approval, may include using incremental revenues from the recent tax measures to reduce payables gradually.

Outlook

The outlook for the State of Illinois is negative, primarily reflecting uncertainty surrounding plans to address the state's large balance of accounts payable. Tax, spending and pension measures recently enacted constitute potential positives, provided that they perform as projected.

What Could Make The Rating Go Up

- Improving financial operations and prospects for structural balance

- Stronger budgetary reserve and fund balance levels

- Progress in addressing unfunded obligations for public employee pensions and other retiree benefits

- Substantial and recurring reduction in the amount of year-end unpaid bills (accounts payable)

What Could Make The Rating Go Down

- Increase in negative GAAP fund balance

- Lack of market access

- Further growth of debt burden

- Further deterioration in pension funding and lack of progress to achieve long-term solutions

Moody's adopts all necessary measures so that the information it uses in assigning a credit rating is of sufficient quality and from sources Moody's considers to be reliable including, when appropriate, independent third-party sources. However, Moody's is not an auditor and cannot in every instance independently verify or validate information received in the rating process.

Please see ratings tab on the issuer/entity page on Moodys.com for the last rating action and the rating history.

The date on which some Credit Ratings were first released goes back to a time before Moody's Investors Service's Credit Ratings were fully digitized and accurate data may not be available. Consequently, Moody's Investors Service provides a date that it believes is the most reliable and accurate based on the information that is available to it. Please see the ratings disclosure page on our website www.moodys.com for further information.

Please see the Credit Policy page on Moodys.com for the methodologies used in determining ratings, further information on the meaning of each rating category and the definition of default and recovery.

Analysts

Edward Hampton
Analyst
Public Finance Group
Moody's Investors Service

Marcia Van Wagner
Backup Analyst
Public Finance Group
Moody's Investors Service

Contacts

Journalists: (212) 553-0376
Research Clients: (212) 553-1653


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MOODY'S AFFIRMS ILLINOIS' NEGATIVE OUTLOOK AND A1 GENERAL OBLIGATION DEBT RATING
No Related Data.
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