Illinois and California: Similar Challenges, Different Approaches

Every state faces challenges when it comes to balancing the books, but not every state is equally effective at tackling them. The responses of California and Illinois to post-2008 difficulties show how different the approaches can be—and how much is at stake.

The period after the Great Recession, with jobs scarce and tax collections plummeting, was tough for most states. California and Illinois were especially hard hit, but only one has succeeded in turning its finances around. The two states’ stories highlight the diversity of the US municipal bond market and how quickly a state’s trajectory can change with effective political leadership.

By 2011, the budget shortfalls of Illinois and California dominated municipal-market headlines. Lower tax revenues and the end of federal stimulus money meant officials had to find ways to balance their budgets with cuts in spending, increases in taxes and fees, and reductions to employee salaries and benefits. Based on market yields at the time, investors seemed skeptical that either state could pull off a U-turn.

Illinois Muddles Along—and Stumbles

Illinois initially took action by raising both personal and corporate tax rates while putting a four-year spending cap in place. But the tax increases were only enough to stabilize finances—not improve them.

And there hasn’t been much more progress since then. In particular, desperately needed pension reform has stalled.

With the income-tax increase scheduled to be phased out beginning in fiscal year 2015, Illinois still faces a $7.5 billion payment backlog, a Medicaid spending gap and higher pension payments (the result of underfunding and increased benefits). An even bigger problem: Illinois’ government consistently seems to be in crisis-management mode—waiting too long to act and losing the public’s confidence in the process. The income-tax increase, for example, took an agonizingly long time.

The state government’s inability to execute decisively leaves a yawning pension funding gap that has increased its borrowing costs and undermined its credit rating. In June 2013, both Fitch Ratings and Moody's Investors Service downgraded Illinois general-obligation bonds. Standard & Poor’s had already knocked its rating down to A–, making Illinois the lowest-rated state. Residents now pay higher financing costs due to ineffective political leadership.

California Moves to the Head of the Class

California’s outcome was different. Two years ago, it faced a $26 billion budget gap and had run up $35 billion in budgetary borrowing. Even after deep cuts to education, libraries and public parks created a doomsday mood, the budget was still in the red. Today, California has a balanced budget and steadily improving credit ratings.

What happened? Governor Brown worked closely with the state legislature to craft solutions that cut spending and extended temporary tax increases.

But it wasn’t an easy path, especially in the beginning. California tax increases require a two-thirds legislative majority; this requirement had gridlocked Democrats’ efforts to raise taxes. Brown broke the impasse by taking his plans straight to the people—voters in 2012 opted for tax increases rather than further draconian program cuts.

In the end, California’s aggressive path paved the way for a turnaround, and California municipal bonds have performed well. But even when the state was in bad shape, it wasn’t close to defaulting. Neither is Illinois, for that matter. Many state and local governments have faced challenges, but most have sidestepped severe fiscal stress. However, investor perceptions create ominous headlines and hurt bond prices. And lower credit ratings make it more expensive for states to borrow money.

In the end, the municipal bond market’s immensity and diversity are part of its appeal for active managers. It’s always possible to find issuers headed up and others headed down. That presents a lot of opportunity to stand out through fundamental credit research. In our view, knowing when to respond to a state’s troubles by reducing exposure, and when to increase and catch the state on the upswing, is the key to building strong returns.

The views expressed herein do not constitute research, tax advice, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

Joseph Rosenblum

Director—Municipal Credit Research
Joseph Rosenblum is the Director of Municipal Credit Research and a member of the Tax-Exempt Fixed Income Investment Policy Group. Prior to joining the firm in 1990, he spent nine and a half years at Moody’s Investors Service, initially as managing director of Western Regional Ratings and then as vice president and managing director of Customer Services. Rosenblum is a member of the Municipal Analysts Group of New York (and past treasurer and chairman), the National Federation of Municipal Analysts (and formerly served on its Board of Governors) and of the Society of Municipal Analysts. He holds a BA in sociology and urban studies from Brooklyn College and an MCP from Harvard University. Location: New York

Neene Jenkins

Research Analyst—Municipal Credit
Neene Jenkins is a Vice President and Research Analyst for Municipal Credit. She has extensive experience with distressed credits, including Jefferson County, Alabama, and Detroit, Michigan. In addition, Jenkins covers high-grade and high-yield debt, focusing on higher education, charter school, and state and local credits. She previously spent almost five years on the Public Finance team at Moody’s Investors Service. Jenkins holds a BA in applied mathematics from the University of Buffalo and an MPA in public finance from the Robert F. Wagner Graduate School of Public Service at New York University, where she is an adjunct professor. She is a member of the National Federation of Municipal Analysts and the Municipal Analysts Group of New York. Location: New York

John Ceffalio

Municipal Credit Research Analyst
John Ceffalio joined AllianceBernstein in 2010 as a Municipal Credit Research Analyst in the Global Credit Group. He has been a municipal credit analyst for over six years, working at Fitch Ratings, Bear Stearns and, most recently, Moody’s Investors Service. Ceffalio also served under the administration of former Alaska Governor Tony Knowles for nearly eight years, including four years as a special assistant to the governor. He earned a BA from the University of Alaska Anchorage in 1994 and a master’s in governmental administration from the University of Pennsylvania in 2004. Location: New York

Related Posts