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What Illinois’s Credit Rating Downgrade Really Means

by Ben VanMetre on January 13, 2012

in Debt, Tax and Budget

Last week Moody’s Investment Service downgraded Illinois’s credit rating from A2 to A1, thus labeling the state’s debt as the riskiest in the nation. There seems to be some confusion, however, on what this downgrade means for state borrowing, how it will affect taxpayers, and how it will impact the state’s fiscal future.

To put this downgrade into perspective, it’s important to consider that it came just a few days before the state had planned to borrow $800 million to pay for roads, schools, and bridges. Many individuals predicted that this downgrade would make it more expensive for the state to follow through with its planned bonds sale. Illinois Treasure Dan Rutherford estimated that the downgrade would likely cost the state an additional $65 million in order to issue the $800 million in bonds. Bloomberg predicted that Illinois would face borrowing costs more than quadruple the average that it has paid over the past ten years.

But if the rating downgrade was supposed to make borrowing more expensive, how then was Illinois able to secure historically low interest rates in its bond sale this week?

This is precisely the source of much of the confusion and there are a few things that need to be considered. First and foremost, it’s important to point out that a credit downgrade does not necessarily increase the cost of borrowing (as we saw when the cost of borrowing decreased after the U.S treasury was downgraded). A downgrade is just that, a grade. It’s an assessment by a credit rating agency.  A downgrade will generally only change lending terms if it teaches the lenders something new. For example, if lenders (i.e. bond buyers) know that Illinois is flunking math, then they have already built that into their lending habits – the information is “baked into the price.” It’s well known that Illinois is in poor fiscal shape and thus this downgrade did not surprise lenders.

Another thing that needs to be considered is the fact that interest rates on all bonds are currently very low which certainly helped the state obtain the low rate. Additionally, as the Wall Street Journal points out, the relative scarcity of new bonds in the municipal bond market this year aided the reception of Illinois’s $800 million bond sale. And finally, it’s true that Illinois secured historically low rates on its recent bond sale but, more importantly, it’s also true that the state may have secured even lower rates if its credit rating would have been higher. In other words, even though the state was able to borrow at relatively low rates, the borrowing may have been more expensive than it would have otherwise been in the absence of a rating downgrade.

Adding to the confusion, Governor Quinn described the state’s downgrade as an “outlier decision.” It’s difficult to label this downgrade as an outlier, however, considering that Illinois has had its credit rating downgraded nine times in three years.

Not only was the downgrade not an outlier but there is simply no reason to believe that the state’s credit is going to improve in the near future. Given Illinois’s habitual utilization of budgetary gimmicks, its customary practice of issuing debt to avoid making necessary budget cuts and its vastly underfunded pension system – it’s likely that the state’s credit rating will continue to decrease unless Quinn and the state legislature start making serious institutional reform.

Most importantly, this downgrade could mean that Illinois taxpayers will now get less bang for their buck. As legislators continue to push off significant reform, borrowing costs will likely continue to increase and more taxpayer dollars will be going towards interest payments instead of building schools and roads. Paying more money for fewer services is something Illinoisans can simply not afford – especially in the wake of last year’s tax hike which increased the average family’s state tax bill by $1,594.

So to clear up any confusion, what Illinois’s recent credit downgrade really means is that the state’s long run borrowing costs may be higher than they would have otherwise been, Illinois taxpayers are now paying more for less, and Illinois’s fiscal future will suffer if the state continues to hold the riskiest debt in the nation.

  • Kate

    Last year, many state budget and pension problems came to light. Do you think we’ll see more downgrades like this over the course of the year?

    • Ben VanMetre

      That’s a good question Kate. You’re certainly right in
      saying that a lot of state budget problems came to light last year and I think this
      is something we are going to see more of in the coming few years (especially on
      the municipal level). As states continue to deal with their fiscal problems, I think
      we will learn a lot more about what they are really on the hook for in terms of
      local debt. It’s definitely going to be interesting to watch it all unfold and
      I am sure that additional state and local downgrades will be a part of the
      story.  

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