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Budget Battle Casualties

Illinois became the only state to not have an A-level rating this week when Fitch ratings agency slapped it with a credit downgrade to BBB+ for its extended budget impasse. Illinois’ Democrat-led legislature has been deadlocked with Republican Gov. Bruce Rauner pretty much since Rauner took office this year. The two sides can’t agree on how to make the spending cuts for fiscal year 2016 that Illinois needs so it can begin to pay down its ever-growing long-term liabilities -- most notably its sizeable pension debt. Illinois has one of the worst-funded state pension systems in the country and a recent court ruling blocked the state from making some benefits changes that would have reduced its liability.

Because of the deadlock, the lawmakers passed several budget extenders. But the 2015 budget had spending levels that prooved to be higher than the state's revenues. That budget was only balanced at the end of the year through several one-time fixes. So that means that as the state continues to spend in most areas at the fiscal 2015 rate, that will “lead to a sizeable deficit,” for this year. Fitch said in its Oct. 19 announcement. “As was the case during the most recent recession, this deficit spending is likely to be addressed by deferring state payments and increasing accumulated liabilities.”

Fitch also added that it expected Illinois would eventually turn to similar one-time gimmicks to balance this year’s budget. It warned that if lawmakers continued to stall on finding more lasting budget solutions beyond fiscal 2016, it could result in another downgrade.

Moody’s Investors Service also fired a warning shot in the direction of Pennsylvania this week, where lawmakers are at odds over a 2016 budget and pension funding. The ratings agency lowered its outlook on the state, an action that could lead to a downgrade if conditions continue. The situation is so dire for schools waiting on school funding that the Philadelphia School District said this week that it will soon have to borrow money to make payroll through the end of the year. Pennsylvania and Illinois are the only states without a budget passed this year.

More Protection for Bondholders

Michigan is considering following two other states this year in adding specified protections in its state law regarding investors who hold General Obligation bonds. Lansing lawmakers are taking up a statutory lien bill, which would give bondholders of unlimited tax general obligation (ULTGO) bonds priority over other creditors, including employees. The bill is a response to the criticism that the state’s municipalities received from the credit market when ULTGO bondholders took a backseat to Detroit’s pensioners in that city’s bankruptcy case. Those bondholders recovered 74 cents on the dollar while pensioners recovered around 90 cents on average.

Fitch said the legislation would help improve investor views on the state's local credits, however, the agency added, it will not reduce the risk of a default.

New Jersey and California enacted similar legislation this year. Louisiana and Rhode Island already have laws on the books.

Interestingly, Fitch said in a report earlier this year that statutory liens won’t improve a municipality’s credit because they don’t reduce the risk of a default. But this week, Fitch said not enacting the statutory lien law could hurt the credit of Michigan local issuers because “it indicates lawmakers desire to place bondholders on equal footing with ordinary creditors” and because the law would “significantly improve recovery value if a municipality defaults, compared to other general creditors.”

A New Kind of Bankrtupcy

The Obama administration this week announced an ambitious plan to try to guide Puerto Rico out of its decade-long financial spiral but stops short of bailing out the commonwealth as it grapples with $72 billion in debt and a recession that just won't quit. The announcement came the same day the Puerto Rico Government Development Bank (the commonwealth’s main financier) announced it had failed to come to terms with a creditors group on restructuring some of its debt. The bank has a bond payment of $300 million due on Dec. 1.

The deal was first reported by The New York Times Wednesday and administration officials presented it to Congress on Thursday. The proposal would essentially create new federal bankruptcy law, allowing U.S. territories to file for bankruptcy protection to restructure their debt and put it on a more sustainable financial plath going forward. (Currently, territories and states cannot file for bankruptcy; U.S. cities in certain states can.) The proposal would also establish a financial control board for Puerto Rico similar to the one Congress established in 1995 for the District of Columbia. The federal board had final say over the Capital city’s financial decisions for six years. During that time the board often proved to be the bane of local officials’ existence. But it set in place a number of rigid financial requirements -- namely having a politically independent CFO and banning borrowing money for its operating budget -- that provided much of the strong financial foundation for the city’s comeback over the past decade. New York City in 1975 was also taken over by a state-run financial control board that oversaw the city's finances for 11 years.