Illinois Bond Spreads Explode As Market Pukes On Latest Batch Of Bad News

On June 1, first S&P the Moody's almost concurrently downgraded Illinois to the lowest non-Junk rating, BB+/Baa3 respectively, with both rating agencies warning that the ongoing legislative gridlock and budget crisis need to be resolved, or else Illinois will be the first ever US state downgraded to junk status.

S&P analyst Gabriel Petek explicitly warned that "the unrelenting political brinkmanship now poses a threat to the timely payment of the state’s core priority payments" and warned about Illinois' inability to pass a budget for the past two years amid a clash between the Democrat-run legislature and Republican Governor Bruce Rauner. As we have documented previously, the ongoing confrontation has left the fifth most-populous US state with a record $14.5 billion of unpaid bills, ravaged entities like universities and social service providers that rely on state aid and undermined Illinois’s standing in the bond market, where investors have demanded higher premiums for the risk of owning its debt.

Bypassing its traditional 90-day review, a terse S&P also warned that Illinois will likely be downgraded around July 1, when the new fiscal year begins if leaders haven’t agreed on a budget that starts addressing the state’s chronic deficits.

Unfortunately for Illinois, and its bondholders, the downgrade - and the subsequent imminent "junking" - was just the tip of the iceberg.

As Bank of America wrote in its latest muni market report, among the $14.7bn backlog of bills (as of 5 June) to be paid by the state of Illinois due to the protracted budget impasse is some $2bn-plus in Medicaid-related payments owed to the private insurers the state contracted with to manage roughly two-thirds of its Medicaid recipients. Those payments amount to some $300mn per month. A number of private insurers have sued in U.S. District Court for the Northern District of Illinois to prioritize their payments over those due to other vendors.

Then last Wednesday, following the Illinois downgrades, the court ruled against the state. The judge ordered the parties to "continue to negotiate to achieve substantial compliance with the consent decrees in these cases. If they cannot reach a negotiated solution, either party may make an appropriate motion, to be noticed for presentment on June 20, 2017."

The day before the court ruled, the state submitted a filing with the Court, arguing that should the court prioritize those payments - effectively making them on par with so-called "core payments" which include debt service - it could trigger another downgrade from the rating agencies. Indeed, included in Moody's downgrade report under the headline "Factors that could lead to a downgrade," Moody's points to "[c]ourt rulings that increase the volume of payment obligations that are legally prioritized."

The state asked the court in that filing that, if it were to rule against the state and prioritize those Medicaid payments, that it make its order effective 1 July, requesting so for two reasons:

  • It "likely will avoid an immediate downgrade and also would send a message to the Illinois General Assembly and Governor that they have until June 30 to resolve the State's budget impasse and avoid the consequences of the Court's order. If the budget impasse is not resolved by July 1, that fact alone likely will lead to a rating downgrade, regardless of the effective date of the Court's order."
  • It "will give Defendants some additional time to determine how to comply with the Court's order."

Additionally, the Illinois Comptroller warned against an adverse ruling, saying the state would "have to go to the courts and ask them: 'OK, out of all of these court-mandated payments, which ones am I allowed to violate?'"

With all that, the court still ruled against the state saying that the Court said it believes the Comptroller "faces an unenviable situation," though it finds "that minimally funding the obligations of the decrees while fully funding other obligations fails to comply not only with the consent decrees, but also with this court's previous order."

So for anyone confused, here is a summary of what happened: a judge ruled last Wednesday the state is violating consent decrees and previous orders, and instructed the state to achieve "substantial compliance with consent decrees in these case." The order may prioritize those payments, elevating them to the level of "core payments," such as for debt service. The state has warned that could trigger an immediate downgrade from Moody's. The state asked the court that the order become effective on 1 July as it could pressure the state to end its protracted budget impasse.

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Separately, there was a glimmer of hope for the woefully underfunded state: according to the Illinois Commission on Government Forecasting and Accountability's (CGFA) May Monthly briefing, May net revenues of $2.19bn were up $144mn, or 7.0% compared to the same month a year ago. Personal income tax collections performed well during the month, bringing in $1.17bn, $179mn, or 18.1% more than in April 2016. Sales tax collections also performed well, outperforming April 2016's collections by $36mn, or 5.5%. However, the state's other significant revenue stream - the corporate income tax - underperformed, with collections of $81mn coming in $72mn, or 47.1% less than a year ago.

And while April marks the third consecutive month of Y/Y outperformance, a glimmer of sunshine in an otherwise dready Illinois monetary landscape, the recent burst in receipts is likely a fluke especially since fiscal year-to-date collections of $26.54bn are $955mn, or 4.3% behind last year. The culprit: local businesses, as corporate income tax collections have been the main cause under-performance, falling $909mn, or 41.3% on a year-over-year basis.

What happened next? As Bank of America writes, with bondholders still digesting the recent downgrades and the inevitable downgrade to junk, news of the adverse court ruling caused spreads on Illinois' GOs to blow out. As of last Thursday, the month-to-date spreads on Illinois widened by 69bps, surging just shy of 250 bps as the market absorbed the headlines. Then according to Bloomberg, the OAS on Illinois 5% GO due Mah 2015, soared nearly 40 bps since last Thursday.

The chart below shows how the spreads have moved wider each day since the month began. On Thursday the spread widened out by 28bps, compared to average 8.2bps it moved the previous five days. Since then the move has accelerated.

Finally, Reuters today reported that Illinois appears to have essentially thrown in the towel on getting junked,  and has negotiated lower credit rating termination triggers for its interest-rate swap deals with banks, "which stood to pocket fat fees if the state is downgraded to junk as soon as next month, a spokeswoman for the governor's office said on Monday. "

Eleni Demertzis, the governor's spokeswoman, said the rating levels that would trigger the termination of four swaps - two with Barclays Bank, and one each with Bank of America and JP Morgan - were dropped a notch to the second level of junk - BB with S&P or Ba2 with Moody's.

Without this step, downgrades to the first level of junk by S&P or Moody's Investors Service could have forced the cash-strapped state to pay the banks as much as $39 million in fees to end the swaps, according to the Illinois Comptroller's office.

In short, while Illinois won't be punished with higher swap termination costs when the downgrade to junk hits, all other negative side effects of being the first "fallen angel" state in history will remain, chief among them far higher borrowing costs.

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And while the recent blow out in spreads has been nothing short of stunning for the otherwise sleepy muni market, a far bigger problem awaits both Illinois, which faces substantially higher borrowing costs, and bondholders, whose principal losses are starting to hurt, if the state fails to pass a budget for the third consecutive year and is downgraded to junk. A default is also not out of the question.

Traditionally, sharp moves in the bond market - such as thise one - have been sufficient to prompt politicians to reach a compromise, although in a world in which central banks have always stepped in to make things better, we fail to see how or why the Illinois auto pilot, which is currently set on collision course with insolvency, will change direction any time soon.


vato poco medium giraffe Mon, 06/12/2017 - 18:01 Permalink

serious question, gang from ZH: is there a way to short specific city/state munis? 'cause this whole 'IL begins going down the tubes' thing strikes me as the precursor to an avalanche. first, just a few pebbles and some loose dirt slide down the mountain, out of the blue, for no particular reason anyone can see ... meanwhile, just below the surface, the state of Connecticut thrashed in its death throes ...  

In reply to by medium giraffe

jcaz vato poco Mon, 06/12/2017 - 18:12 Permalink

Go ahead, buy em.  Illinois will pay you back.  Sure they will.  Count on it.Shorting Munis-  tough to short specific munis-  your broker would have to have inventory,  and then want to let you take the other side...  You could talk them into some sort of CDS,  but you'd need major up-front money to play,  $25M minimum-  short answer,  your better off looking for one of those funky 3X inverse muni ETF's.

In reply to by vato poco

Daily Bail serotonindumptruck Mon, 06/12/2017 - 18:52 Permalink

Shit's about to get real for Loretta Lynch. Story just published 20 minutes ago by Sara Carter. Also Lindsey Graham said yesterday on Face the Nation he believes the email is real, despite media reports, and that Comey has never told Congress it was fake.LORETTA LYNCH WENT ‘STEELY SILENT’ WHEN COMEY PRESENTED AN EMAIL SHOWING HER PROMISE TO PROTECT HILLARY CLINTON FROM DOJ PROSECUTION... 

In reply to by serotonindumptruck

Freddie Daily Bail Tue, 06/13/2017 - 00:21 Permalink

Why do you think Trey Gowdy is going to do anything?  Lindsey Graham and ZWO-MIC stooge runs the corrupt SC GOP-e.  The govt is totally corrupt.  Gowdy and the rest are all sock puppets,Nothing will happen. The GOVT and USA are TOTALLY corrupt from top to bottom.  Trump might have be somewhat positive but as long as Soros-Kushner and his wife are there it is a wailing wall joke.

In reply to by Daily Bail

SDShack davinci7_gis Mon, 06/12/2017 - 19:17 Permalink

Destroying confidence in Govt Bonds is already a scenario they have planned for. When they crash the party next time, it will be 10x worse then the fix will be 10x bigger then TARP or QE 1,2,3 etc. Because next time they won't just crash Real Estate, Bonds and Equities. They have to factor in 0zer0care and Pension collapse too. There is a reason why MyRA was floated a few years ago. They will roll all these banker engineered collapses into the mother of all bailouts, and it will include IRA's, 401K's, pensions, social security, and medicare/medicaid/0zer0care. This will be the final destruction of the middle class when we all become debt slaves to the govt in order to just survive. The New Feudal World Order.

In reply to by davinci7_gis

rockstone jcaz Mon, 06/12/2017 - 18:20 Permalink

Where there's a will there's a way. We could create a nice package and sell it to CA as a play to save CALPERS. Do the same w CA bonds and we sell them to IL and sit down with some popcorn and watch the fun begin

But we have to eat the popcorn somewhere out of the country

In reply to by jcaz

Chauncey Gardener rockstone Mon, 06/12/2017 - 21:08 Permalink

Moonbeam's separated-at-birth "twin"--Oregon's own's first, self-proclaimed bi-sexual (ew, like this is worth bonus points?) Governor, Kate Brown, is having a fire sale of Oregon State "assets" and her lemming legislature of Mensa-Dim's is planning a heroic tax increase to help "make up for the state revenue deficit" to help bail out OR PERS. Of course, when all this is done, and there's record tax revenue, the broken record (Vinyl for you hipsters) will be stuck on "we don't have enough money." There's NEVER enough money for liberals.

In reply to by rockstone

Give Me Some Truth vato poco Mon, 06/12/2017 - 18:24 Permalink

If I was ranking the usual suspects of "black swans" with 1 being "no real worries" and 10 being the "real deal," I would give State Defaults/Credit Down Grades  a 9. These states can't print money and they do have obligations and people expecting to get paid.Good summary of situation in Illinois. I note the role that Medicaid obligations seems to be playing. I always thought that in all the hype/discussion about ObamaCare, the real story was buried. That story is the massive expansion of Medicaid. These new Medicaid patients are going to hospitals and doctors offices and the price tag for all these medical services is not going down. It appears the bill is already coming due and the state's are already struggling to pay. It will only get worse.

In reply to by vato poco

SDShack Give Me Some Truth Mon, 06/12/2017 - 19:05 Permalink

Yep, this is why so many Republican states opted out of the 0zer0care Medicaid expansion. They realized that 0zer0care would eventually collapse under it's own weight due to the inevitable death spiral of private insurance caused by strangling 0zer0care mandates. This has resulted in essentially an infinite increase in Medicaid to fill the gap. Even when subsidized 90% by the Fed Govt. the infinite growth of 10% of UNSUBSIDIZED Medicaid expansion falls 100% to the states, and is more then enough to tip the states budgets into insolvency over a relatively short time, especially if the ongoing recession gets worse. Of course, this was all planned when 0zer0care was passed by the Dumbcrats. They figured they would continue to control congress and the WH, so the Fed Govt would either bail out these Dumbcrat Welfare states, or best of all... use the implosion to adopt single payer. Either way, the Fed Govt makes everyone dependent upon Govt which is the ultimate goal, and the stupid Repukes in congress are just as complicit as the Dumbcrats in the whole mess.

In reply to by Give Me Some Truth

Offthebeach vato poco Mon, 06/12/2017 - 19:12 Permalink

There is a lot more to ruin, in a state.  The vast majority of sheeple will stay .....sheep.  So a state load of fkn everyone,  every way.  Up every fine fee tax license and invent new ones.  Stiff, delay, refuse every bill.  When they quit, give the work to friends, family and crony.  Sic the cops on everyone, everything.  They'll do it or else it's the dreaded private sector and there is no good money for skilled stand around a dead 17 year old .   

In reply to by vato poco