Illinois lawmakers are considering a huge income tax increase to plug the state's massive $13 billion deficit as wary municipal-bond investors weigh the hazards of betting on the state's debt.
Meeting behind closed doors, Governor Pat Quinn and key Democratic leaders reached an agreement Thursday to raise the personal income tax that could give skeptical investors enough confidence to hold onto their Illinois bonds.
If approved, the proposal would raise the rate to 5.25% from 3%, a person familiar with the matter told The Wall Street Journal. The person said negotiations on the state's first income tax increase in roughly two decades were "still fluid" and the deal was not final.
A spokeswoman for Illinois Senate President John Cullerton described the agreement as "just an initial framework" that leaders can take back to their caucuses.
Democratic leaders are trying to pass the tax increase before the new legislative session begins Jan. 12 and Republicans gain more seats. Republicans have strongly opposed an income-tax hike and instead pushed for spending cuts.
The negotiations in Illinois, the fifth-largest issuer in the nation's $2.9 trillion bond market, are being closely monitored as state legislatures around the country convene this month to face big budget deficits and tough decisions on taxes and spending.
The biggest question in investors' minds is whether states will finally undergo the painful, long-term fixes needed to restore fiscal sanity to their budgets, or once again take on more debt.
Illinois is under particularly intense pressure from bond investors because the state has increasingly issued new debt to pay its bills, instead of making deep spending cuts or raising taxes to increase revenue.
Doubts have been rising in recent weeks that Illinois would swallow the tough medicine needed to straighten its finances. The cost of insuring the state's bonds' against default keeps rising and they now have the highest perceived risk of default of any state, according to Thomson Reuters data.
The risk premium priced into Illinois's 10-year bonds widened in recent weeks to 2.1 percentage points above a broader muni-market benchmark. A year ago, that spread was less than one percentage point, The Journal reported.
Illinois is the worst state in the nation when it comes to not paying its bills, according to state Comptroller Dan Hynes, who says when creditors call and ask for money, the best he can do is apologize.
"The state of Illinois is known as a deadbeat state," Hynes said in a recent interview on 60 Minutes. "This is a reputation that has taken us years to earn, and we've reached the heights of becoming the worst in the country."
Moody's Investors Service said last week the United States may be entering a period of "decreased investor appetite for municipal debt," and that states such as Illinois that have relied heavily on debt to fund operating deficits are most vulnerable.
And it's not just Illinois that represents a danger to investors' wallets.
In a Money Morning article last week, Contributing Editor Martin Hutchinson warned investors to stay away from the muni-bond market in general.
"These states are now stuck with a bigger-than-warranted debt load – which can't be covered by the property tax stream that's been reduced by record-level housing defaults," Hutchinson wrote. "The bottom line: Avoid the sector, except the very-highest-rated issues; and even then, given the low yields available, there are clearly lower-risk/higher-profit opportunities for your money."
Meanwhile, some of the world's biggest banks are lining up to profit from concerns over the shaky finances of U.S. cities and states.
Switzerland's UBS AG (NYSE: UBS) has begun making markets in derivatives tied to municipal bonds for the first time in two years, according to The Journal. The credit-default swaps (CDS) require swap sellers to repay buyers if a municipal issuer misses an interest payment or defaults on its debt.
Five other large derivatives dealers, including Bank of America Corp.'s (NYSE: BAC) Merrill Lynch unit, Citigroup Inc. (NYSE: C), Goldman Sachs Group Inc. (NYSE: GS), J.P. Morgan Chase & Co. (NYSE: JPM), and Morgan Stanley (NYSE: MS), met in New York in November to discuss standardizing the paperwork for "muni CDSs" to attract more buyers and sellers, The Journal reported.
Two-thirds of muni-bond buyers are individuals investing through mutual funds, who don't buy derivatives. Muni-bond swaps are thinly traded, with most being bought by hedge funds.
"In the spring, when we saw muni CDS costs start rising, we found out it was hedge funds trying to profit from a muni disaster. They're looking for the next subprime." Jeffrey Cleveland, senior economist at Los Angeles money manager Payden & Rygel told The Journal.
News & Related Story Links:
- Wall Street Journal:
Bond Buyers' Eyes Are on Illinois
- 60 Minutes:
Illinois, a deadbeat state?
- Money Morning:
Municipal Bond Forecast: Deadbeat States Emerge as Biggest Threat to Muni-Bond Investors
- Wall Street Journal:
Banks Look to Profit on Muni-Bond Fears