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“Why Illinois’ Bond Ratings Don’t Add Up”

Friday, Jun 28, 2013 - Posted by Rich Miller

* Marc Joffe over at Real Clear Markets has a must-read piece on Illinois and the bond rating agencies

With all the bad news about state pensions, how can one possibly conclude that Illinois bonds are not as risky as rating agencies and the markets seem to think? The reason for the different conclusion is the confusion produced by the rating scales themselves.

As I report in the study, Illinois last defaulted on bond payments 170 years ago. In fact, no state has defaulted on general obligation bonds since 1933, and most states weathered the Depression scot-free. This means that state general obligation bonds have a very strong historical track record.

How does that compare to other types of bonds-especially those rated AAA? In the years before the financial crisis, rating agencies assigned AAA ratings to tens of thousands of mortgage-backed securities and collateralized debt obligations. At the time, these asset classes had only been in existence for 20 years or less, so none of these types of “structured finance” obligations had established a payment record comparable to state general obligations.

During the crisis, many of these AAA-rated structured finance bonds defaulted, yet states continued to pay their general obligation bondholders on time and in full. Today, issuance of structured finance assets is rebounding and many still receive AAA ratings-yet Illinois bonds are thought to be so risky that they merit only a single A. Notably, this ratings inconsistency doesn’t only involve structured finance. Some kinds of companies also seem to be rated more leniently. Perhaps the strangest example of this phenomenon involves companies that insure municipal bonds.

Before the crisis, Ambac and FGIC-two municipal bond insurers-were rated AAA. During the crisis, both went bankrupt. A third AAA-bond insurer, MBIA, was downgraded well into the “B” range-substantially below where Illinois sits today. In the pre-crisis world, these firms rented their AAA ratings to states and cities. Government bond issuers would pay the insurers a premium to guarantee payment on their bonds; allowing their debt to trade as if it were AAA rated.

It was a great business for the bond insurers, since so few municipal bonds defaulted. In fact, these companies felt so confident about the safety of government bonds that they levered themselves to the hilt. According to hedge-fund titan Bill Ackman, MBIA had 139 times more insurance than capital back in 2002. Ackman tried to convince rating agencies to downgrade MBIA, but his arguments fell on deaf ears.

The municipal bond insurance industry might have survived the financial crisis and continued to profit from the misalignment of municipal and corporate ratings if the companies had stuck to their core government bond business. Instead, they diversified into insuring structured finance securities-perhaps becoming bedazzled by the inflated ratings of these instruments. Ultimately it was defaults among insured mortgage-backed securities that marked the undoing of these formerly AAA rated firms.

Returning to my findings, I don’t dispute that Illinois has uniquely bad fiscal policies and the worst outlook of any state. However, because of constitutional limitations, most states have relatively little debt. Illinois’ state debt is only 6 percent of economic output; the analogous ratio for the federal government is 74 percent. Pension underfunding is a serious issue, but because state workers and teachers only account for about 2 percent of the Illinois’ population, it is a much more limited problem than the underfunding of social security and Medicare at the federal level. Finally, unlike depressed cities such as Detroit, a large state such as Illinois has a very diverse and growing revenue base.

Just as the worst swimmer at the Olympics is probably better than anyone at the neighborhood pool, the worst state bonds are probably a lot safer than bonds issued by entities that can’t guarantee revenue by taxing their customers. If rating agencies are going to rate the Olympian and the weekend warrior on the same scale, they need to keep this in mind.

This is, by the way, the same, basic argument that our commenter Wordslinger has been making here for years.


  1. - Been There - Friday, Jun 28, 13 @ 12:04 pm:

    If a state has a bad rating, lets say the same as a corporation that is struggling, it will still have a lot lower rate than that particular company. The corp may be paying 12-15% compared to the state at 4-5%. As we saw yesterday, the market, not the rating companies dictate the rate.
    But that 4-5% is still a few basis points higher than the AAA states. And since they are dealing in billions that translates into millions in extra interest.

  2. - "Edge" - Friday, Jun 28, 13 @ 12:05 pm:

    Its amazing how many investors wanted to buy the latest Illinois issue. Maybe having such a “bad” bond rating wasn’t so bad afterall.

  3. - in the know - Friday, Jun 28, 13 @ 12:05 pm:

    I’d love a real comparison to some of fahner’s acolytes. I’m guessing they couldn’t withstand the scrutiny.

  4. - David P. Graf - Friday, Jun 28, 13 @ 12:22 pm:

    I’m just not impressed. I recently read in a book the accounts of survivors on the Titanic of how stewards went around after the collision assuring everyone that there was no danger.

  5. - Six Degrees of Separation - Friday, Jun 28, 13 @ 12:25 pm:

    What a coincidence. I was reading about Olympian swimmers here just as I was passing thru Olympia Fields.

  6. - Ummmm - Friday, Jun 28, 13 @ 12:30 pm:

    Can you say Detroit?

  7. - Rich Miller - Friday, Jun 28, 13 @ 12:35 pm:

    ===Can you say Detroit? ===

    Can you read?

  8. - Bill White - Friday, Jun 28, 13 @ 12:39 pm:

    === Can you say Detroit? ===


    === Finally, unlike depressed cities such as Detroit, a large state such as Illinois has a very diverse and growing revenue base. ===

  9. - Diogenes in DuPage - Friday, Jun 28, 13 @ 12:54 pm:

    So, maybe solving the pension crisis is really not about our state’s bond rating or the longterm solvency of the pension systems, but about ….. reducing taxes for “over-burdened corporations” operating in our state … or freeing up state budget dollars to expand services for those who have lobbyists who shower our legislators with “attention” …. or … ?

  10. - PublicServant - Friday, Jun 28, 13 @ 12:55 pm:

    This Marc Joffe is just another lib taker from the lame-stream media who cannot be taken seriously, and must be ignored!

    Why? Because the sky is falling, I tell you!

    Who do you believe? Me, or a guy who can’t even spell Mark correctly?

  11. - Waffle Fries - Friday, Jun 28, 13 @ 1:30 pm:

    We’re not even close to the point, and I don’t see how we get there, where our ability to make our debt service payments is in question…

    So is the morale of this story, ratings agencies, why are you so focused on the pension issue?

  12. - Tommydanger - Friday, Jun 28, 13 @ 1:36 pm:

    All rise and hail to the Wordslinger. Nicely done.

  13. - Fred's Mustache - Friday, Jun 28, 13 @ 2:03 pm:

    === So is the morale of this story, ratings agencies, why are you so focused on the pension issue? ===

    Im not usually the conspiracy theorist but…

    they focus on pensions because ratings agencies are just pawns of the big banks… and the big banks want people to have 401(k) style plans so they can reap huge fees and commissions

  14. - Fred's Mustache - Friday, Jun 28, 13 @ 2:34 pm:

    Just some backup for my last comment:

  15. - Illinoyed - Friday, Jun 28, 13 @ 3:34 pm:

    Joffe’s piece clearly rebuts the sky-is-falling claim implicit in the “police powers” legal theory. His points are even more sharply elaborated in his Trib contribution today, which walks through a thought experiment showing IL’s financial viability would remain secure even if its pension funds were completely reduced to zero (forcing it into a Social Security-style “pay as you go” system). Even in that (imaginary) extreme case, IL’s ratio of interest + pension expenses over total revenue would be only 12.7% (vs. the current 10%) — nowhere near the 30% threshold that, according to Joffe, really would portend falling skies.,0,4807040.story

Sorry, comments for this post are now closed.

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