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Pundit says 20 percent chance Illinois bonds will be restructured

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Dear Mr. Berko: What do you think of buying $50,000 worth of the recently issued 3.75 percent Illinois general obligation bonds due in 2028? And please tell me about Instructure. If you approve, then I’ll buy 1,000 shares. — RS, Akron, Ohio

Dear RS: If you understand and can afford the risks, then buy the general obligation bonds. These GO bonds are backed by the full credit and taxing power of the state of Illinois rather than revenues from a specific project, such as a bridge, a sewer system or a toll road. These tax-free bonds were issued with the dark hope that Illinois can repay its obligation via taxation and other revenues. Knowledgeable investors believe that’s unlikely.

The state issued $6 billion worth of GO bonds to shrink its unpaid $17 billion backlog of accumulated merchant and vendor debt. These bonds are rated BBB- by Standard & Poor’s and Baa3 by Moody’s Investors Service. Those ratings are investment-grade (though just barely; they’re a hair’s breadth above junk). However, a longtime acquaintance of mine at Moody’s isn’t so ebullient. Privately, he believes those bonds should be rated Ba1, which is non-investment-grade and speculative. He says the underlying foundation for Illinois’ financial system has been destroyed by the Legislature. Among the state’s most daunting financial problems is its pension plan, which is underfunded by $251 billion. It won’t be a picnic when 815,000 employees learn that their benefits may be reduced. I believe there’s an 80 percent chance these bonds will pay interest till maturity and then redeem at par value. And I think there’s a 20 percent chance these bonds will pay interest till maturity and then have their debt restructured so that you can get back 70 cents on the dollar. It’s a fair dinkum gamble!

Thoughts?

posted by Rich Miller
Thursday, Nov 2, 17 @ 10:15 am

Comments

The odds will depend on who wins future elections.

Comment by DuPage Thursday, Nov 2, 17 @ 10:21 am
” Among the state’s most daunting financial problems is its pension plan, which is underfunded by $251 billion.”
I’d like to see where the numbers come from!

Comment by WhoKnew Thursday, Nov 2, 17 @ 10:25 am
I know nothing of investing, but I really, really don’t think the GA would do something like that, they would just try to kick it further down the line. As for how long they can keep kicking it, I don’t know, but I don’t think another decade is unlikely. We’ll see.

Comment by Perrid Thursday, Nov 2, 17 @ 10:26 am
“It won’t be a picnic when 815,000 employees learn that their benefits may be reduced.” Not likely. There is that constitution thingy.

Comment by Huh? Thursday, Nov 2, 17 @ 10:35 am
== Not likely. There is that constitution thingy.==

What bondholders don’t know won’t hurt them…probably.

Comment by City Zen Thursday, Nov 2, 17 @ 10:43 am
I think this is about right. Bondholders will probably get paid, but not certainly given our financial distress.

Comment by Chicago Cynic Thursday, Nov 2, 17 @ 10:44 am
The reductions described third hand from the unnamed analyst are contrary to current law and would require a change to the state constitution or (maybe) a change to federal law that would certainly face legal challenge. But the writer is correct that the bonds pay good rates and are very secure. It’s a good deal for investors.

Comment by Anonymous Thursday, Nov 2, 17 @ 10:47 am
It’s clear from the numbers used that the pundit is buying into every worse case scenario the naysayers have been pushing about the pensions. That’s the only way you can come up with the $251B number he uses. It’s also clear he doesn’t understand the recent IL SC decisions. And the fact you would have to change Federal law, either or both contract and bankruptcy, to negate things.

I would give extremely high odds to drastically reduced services before a GO bond or pension default.

After all, we’ve just learned you can go 2 years without paying some of the State’s bills. /s

Comment by RNUG Thursday, Nov 2, 17 @ 10:56 am
“Knowledgeable investors believe that’s unlikely.” Truly knowledgeable investors know that IL has a GDP higher than Switzerland, and the probability of debt restructuring is less than zero.

Comment by Angry Republican Thursday, Nov 2, 17 @ 11:00 am
This guy is wrong. Under the Constitution- Illinois pays bond indebtedness FIRST- Bonds even have priority over pensions. These bonds are safe period

Comment by Sue Thursday, Nov 2, 17 @ 11:04 am
Berko: “He says the underlying foundation for Illinois’ financial system has been destroyed by the Legislature.”

RNUG: “It’s clear from the numbers used that the pundit is buying into every worse case scenario the naysayers have been pushing about the pensions. That’s the only way you can come up with the $251B number he uses. It’s also clear he doesn’t understand the recent IL SC decisions. And the fact you would have to change Federal law, either or both contract and bankruptcy, to negate things.”

Seems like Mr. Berko’s “longtime acquaintance” is still pushing a doomsday narrative previously — and repeatedly — debunked by knowledgeable commenters like RNUG.

Caveat emptor.

– MrJM

Comment by @MisterJayEm Thursday, Nov 2, 17 @ 11:07 am
== Bonds even have priority over pensions. ==

I don’t know of any Illinois’ case where that exact scenario has been tested in court. Given the clear “must be paid when due” ruling in the 1975 IFT case, I would say they are at least equal in priority

Comment by RNUG Thursday, Nov 2, 17 @ 11:16 am
Bonds are paid first. It’s the way they are structured and since the State has no mechanism for bankruptcy it would take the State to literally not have the funds at the very top for payment to not happen. We just saw what happens at the bottom of the waterfall of revenues with the bill backlog but all bonds were timely paid with no issue during that time. It’s nice to be at the top.

A 20% chance is a silly doomsday scenario and if the investors who bought the bonds thought that was even a 5% chance the yields would have been pretty much double.

Comment by Former Bartender Thursday, Nov 2, 17 @ 11:38 am
How come future pension costs are the only ones referred to in this way “underfunded by $251 billion”? How much are we going to be spending on roads, schools, health care, etc over the next 70 years?

Are those funds just lying around in a savings account somewhere? Then why don’t we hear that those future expenditures are underfunded by trillions of dollars?

Comment by chi Thursday, Nov 2, 17 @ 12:30 pm
Malcolm Berko is hardly a credible source for information on Illinois finances, as this excerpt shows. He’s a curmudgeonly stock picker who gets a few right and obnoxiously crows about each one. I’ve exchanged correspondence with him over some of his more agggressive recommendations to senior investors, to my total frustration.

This column should be considered as opinion and nothing more.

Comment by Arthur Andersen Thursday, Nov 2, 17 @ 12:31 pm
==It’s clear from the numbers used that the pundit is buying into every worse case scenario the naysayers have been pushing about the pensions. That’s the only way you can come up with the $251B number he uses==

That “he” would be Mr. Moody:

https://m.moodys.com/Research.html?docid=PR_904021452

Comment by City Zen Thursday, Nov 2, 17 @ 12:31 pm
“20 percent chance these bonds will pay interest till maturity and then have their debt restructured so that you can get back 70 cents on the dollar” = monster lawsuit

Comment by Huh? Thursday, Nov 2, 17 @ 12:32 pm
==How come future pension costs are the only ones referred to in this way “underfunded by $251 billion”? How much are we going to be spending on roads, schools, health care, etc over the next 70 years?==

Because pension costs are related to services already rendered. The others are not.

Roads are already amortized over multiple years in construction bonds. Schools are paid for every year (minus pensions, of course). Current employee health care is also paid for every year, although retiree health care liabilities, just like pensions, are in the tens of billions.

Comment by City Zen Thursday, Nov 2, 17 @ 12:42 pm
—bankruptcy it would take the State to literally not have the funds at the very top for payment to not happen.—

With our continued borrowing and spiking pension payment this could be a scenario eventually. But, like it was said in another post, in IL we wait for the crisis to hit in IL, then we react to it…

Comment by ughh... Thursday, Nov 2, 17 @ 12:45 pm
For the average Illinoisan, the worse scenario is that the bonds don’t default but other services like roads, corrections, education continue to be scaled back while bond debt and pension obligations under current law continue to be paid .
No one of any means would stick around the state long enough for that model to be sustained when it really reaches crisis levels, and that time is coming sooner than some want to admit for Illinois.

Comment by In a Minute Thursday, Nov 2, 17 @ 12:56 pm
Great so if we fail to meet obligations a judge could mandate tax increases of huge proportions to cover any deficiencies to bond holders. Hope the tax free incentive is worth the gamble

Comment by theCardinal Thursday, Nov 2, 17 @ 1:04 pm
Illinois could adopt a graduated income tax like most of its neighbors. So long as the top rate isn’t any higher than, say, Wisconsin’s, that would help alleviate the long-term debt.

Comment by anon2 Thursday, Nov 2, 17 @ 1:40 pm
==Illinois could adopt a graduated income tax like most of its neighbors.==

Or tax retirement income like ALL its neighbors.

Comment by City Zen Thursday, Nov 2, 17 @ 1:54 pm
Sue, I just looked at article IX of the Constitution. I didn’t see anything there about bonds being at the top of the revenue food chain. Do you have a citation to support that contention? My recall is that in Michigan (which has a different Constitution) the bond holders took a greater hit than the pensioners.

Same question for Former Bartender. While there are no known instances of bonds not being timely paid, the same holds true for pensioners.

Comment by Original Rambler Thursday, Nov 2, 17 @ 2:00 pm
== While there are no known instances of bonds not being timely paid, ==

There were a couple of bonds in Illinois (think they were canal bonds without checking) back in the 1800’s that had some delayed payment / bankruptcy issues.

Nationwide, the only more or less default of state GO bonds was in Arkansas during the Great Depression … and they were eventually paid / refinanced.

Bottom line: state GO bonds are as close to a sure thing as you can get, probably 99% safe versus other states that are 99.9%. And if you want to talk about the pension debt,if you take it as a percentage, NJ is in worse shape that IL.

Comment by RNUG Thursday, Nov 2, 17 @ 2:31 pm
–These tax-free bonds were issued with the dark hope that Illinois can repay its obligation via taxation and other revenues. Knowledgeable investors believe that’s unlikely.–

Yet knowledgeable investors bought the whole $6B schmear in a New York-minute. How does Mr. Fair Dinkum square that circle?

This guy is really confused. GO bonds get paid first by law, and state revenues provide exponential coverage.

Comment by wordslinger Thursday, Nov 2, 17 @ 2:38 pm
“Great so if we fail to meet obligations a judge could mandate tax increases of huge proportions to cover any deficiencies to bond holders. ”

And what if the legislate refused? Any court cases on this?

Comment by a drop in Thursday, Nov 2, 17 @ 3:02 pm
RNUG, it was the bonds issued to build the I & M Canal that defaulted in the late 1800s. How I know this but can’t find my car keys half the time is inexplicable.

Comment by Arthur Andersen Thursday, Nov 2, 17 @ 4:10 pm
Seems like the default position on paying the pension debt is bankruptcy. If we were Mississippi that might be true but we’re not. A back of the envelope calculation will show that from a financial perspective a long term plan for repaying the pension debt is clearly possible. In 2015 Illinois taxpayers had an AGI of about $442 billion. The pension debt is $130 billion. Paying off this debt over 30 years at 4.5% requires payments of $8 billion or about 1.8% of Illinois AGI. Adding this incremental tax to the current rate means a flat tax of 6.75% would solve the problem. Of course, politics gets in the way when politicians start talking about fairness and shielding this or that cohort from the tax. Regardless of how the tax is imposed, flat or progressive, we can pay the bill. Think of the problem as someone with a $442,000 income trying to get a $130,000 mortgage. The world is awash with money seeking yield and with a US 30 year bond yield of less than 2.9% now would seem a good time to act.

Comment by CapnCrunch Thursday, Nov 2, 17 @ 4:50 pm
Point of Information:

Illinois partially defaulted on $13.5 million in bonds, mostly for I&M Canal construction, in January, 1842. Illinois resumed debt service payments in July, 1846, after Gov. Thomas Ford and the General Assembly approved in 1845 a state property tax of 10 cents for every $100 of equalized assessed valuation to repay the bond holders in full.
SOURCES:
English, W. B. (1996). “Understanding the Costs of Sovereign Default: American State Debts in the 1840′s.” The American Economic Review, 86, 259-275.
Krohe Jr., James. “Today’s leaders could learn from a forward thinker from yesteryear.” Illinois Issues, February, 2010.

Charlie Wheeler

Comment by charlie wheeler Thursday, Nov 2, 17 @ 5:14 pm
If we can sell bonds that are still investment grade(barely), can we put together a bond issue to cover pension repayment with a guaranteed funding with a corresponding change in the pension law provision in IL Constitution?

Comment by bear3 Thursday, Nov 2, 17 @ 5:39 pm
Charlie Weaver, thanks. I didn’t want to take the time to look it up.

Comment by RNUG Thursday, Nov 2, 17 @ 5:56 pm
== can we put together a bond issue to cover pension repayment ==

While that makes perfect financial sense from the perspective of protecting the retirees and current we employees, it doesn’t make political sense.

As I’ve previously explained, bonding out the pension debt requires the bonds be paid every month. The Legislature doesn’t want that; they WANT to be able to short or skip the pension payments when the budget gets tight.

History lesson: In the 1970 Illinois’ Constitution, a new income tax was approved to replace the personal and done other taxes that were previously used to fund state government. The initial rate was high enough that it brought in more money than the previous combination of taxes. But by 1974, the GA had enacted new programs / expanded existing programs to the point where the spending exceeded expected revenue. The GA’s solution was to short the pension fund payments in FY75. IFT and other unions sued on behalf of the retirees / employees, and we ended up with the IL SC decision that “pensions have to he paid when due”.

The point of history lesson is (1) the court ruled current GA’s can not obligate future GA’s to specific expenditures but the State does have to fulfill contractual obligations and (2) the Legislature WANTS an alternative to raising taxes when they overspend.

Comment by RNUG Thursday, Nov 2, 17 @ 6:15 pm
Darn. I can’t even spell Charlie’s name right on my phone. Apologies.

Comment by RNUG Thursday, Nov 2, 17 @ 6:16 pm
And to follow-up Charlie’s comment…. I believe that the internal improvement debt was finally paid off in the 1870’s. It took several decades, but IL did pay the debt.

Comment by Top of the State Friday, Nov 3, 17 @ 10:40 am
The reason why the pension liability is unfunded is because the state was “borrowing” from it’s pension fund when it decided not to make those payments.

They literally passed a law promising to make payments on the pension liability decades after the payments should have been made.

Comment by Anon Friday, Nov 3, 17 @ 1:25 pm