“Washington, D.C., March 11, 2013-The Securities and Exchange Commission today charged the State of Illinois with securities fraud for misleading municipal bond investors about the state’s approach to funding its pension obligations.”
SEC memo headline, 2013-37 click to read

“Illinois believed it to be in its best interests to enter into a settlement with the SEC….the State has cooperated fully with the SEC throughout the inquiry…..the State neither admits nor denies the findings in the order, which carries no fines or penalties.”
Statement from the governor’s Office of Management and Budget

The cold winds of mid-March blew strong through the state capitol both meteorologically and metaphorically speaking.

The SEC settlement is sandwiched between the state’s January failed bond auction and its scheduled April 2nd redo auction of upwards of $800 million of various types of general obligation bonds. State officials have travelled across the country in recent months in hopes of easing concern over its battered credit and stressing its pension disclosure has been greatly improved in the last two years. Market reaction to the upcoming auction will tell us much about investors’ interest in lending to the State of Illinois. Currently, investors demand approximately 125 basis points extra yield to buy 10 year State of Illinois bonds.

The significant negativity surrounding State of Illinois credit aside, there is the potential the SEC settlement is an augur its finances will improve from their current low point. Perhaps it hit rock bottom this month. Time will tell and much, much work is needed, no doubt, before we are convinced of this possibility (our outlook for many local credits located within the state remains positive).

But here are a few observations to consider regarding certain events this month:

  1. The SEC settlement over charges of misleading public pension disclosures concerns years between 2005 and 2009. According to the SEC order, since then Illinois has taken multiple steps beginning in 2009 to correct deficiencies and enhance pension disclosures. We believe the settlement will result in better disclosure by the State going forward. This is a credit positive. 
  2. In recent weeks, various pension reform proposals have been put forth for votes in both chambers by both Democrat and Republican legislators. One, serious effort was a bi-partisan proposal. This is progress when compared to the inaction of recent years. We remain wary until pension reform legislation passes both the House and the Senate, legislation that does more than nibbles at the edges of the underfunding problem. Clearly, enactment of a substantive solution needs to occur soon given the State’s fiscal 2014 general fund budget increases pension payments by $900 million to $ 6 billion. This represents 19% of the general fund budget compared to 8% in 2008. 
  3. An Illinois judge’s dismissal this month of litigation challenging the state’s retirement health care reforms is also a credit positive, if upheld. Last year the state enacted legislation revamping retired state employees’ post- employment benefits (OPEB). The legislation requires retirees to pay a greater share of health care premium costs based on their income. For decades the state fully covered the health care premiums of those who retired prior to 1998. Until last year’s change, post 1998 retirees received a 5% health care premium subsidy from the state for every year of employment.

Siding with the State’s position, Sangamon County Circuit Court Judge Steven Nardulli wrote “health insurance benefits are not guaranteed pension benefits protected by the Pension Protection Clause.”

Governor Pat Quinn was naturally pleased with the ruling stating, “This is good news for the taxpayers and another step forward in our effort to restore fiscal stability to Illinois.”

The ruling will result in significant budget savings. The state funded, health care subsidy amounts to almost $900 million in the current fiscal year.

The ruling will most likely be appealed so a resolution of this issue is still uncertain. Nonetheless, the ruling may motivate opposing parties to agree to an overall pension agreement in order to reduce risking an even less favorable outcome.


U. S. Bankruptcy Judge Christopher M. Klein will rule the first week of April if Stockton, California can remain in bankruptcy. If the Judge rules favorably for Stockton, it will be protected from creditor lawsuits and free to pursue its debt reduction plan which includes more than a $300 million haircut to debt holders. If successful, this reduction in outstanding liabilities would represent approximately 44% of the concessions called for in the city’s reorganization plan. Debt service currently amounts to less than 10% of its baseline expenses. The City’s plan does not reduce pension payments to California Public Employees’ Retirement System (CALPERS), its largest creditor, and does not raise any new taxes or fees. Creditors are upset the City failed to seek any impairment of its single largest unpaid liability owed to CALPERS.

Last week a city forecast showed its annual budget deficits may total $100 million over the next decade even with all of the cuts it wanted before filing Chapter 9.

Three thousand miles to the east a court decision moved a municipality’s financial distress in a positive direction when a Rhode Island Superior Court Judge ruled the settlement negotiated between Providence, Rhode Island and its retired police and firemen is “fair, adequate and reasonable.”

Judge Sarah Taft-Carter’s ruling allows parties to finalize an agreement that suspends cost of living adjustments (COLA) for 10 years and eliminates a 5%-6% COLA compounding formula. Additionally, retirees older than 65 years will move onto Medicare coverage.

The City’s annual required pension payment was $58 million in 2012 approximately 19% of its budget, up from 13% in 1996. According to the city, it would have increased to $94 million by 2022 absent this agreement. The city cut overall spending in its fiscal year 2012 by approximately $100 million with 20% of the cuts coming in the pension area. It expects to have a balanced budget in 2013.


“One of the great achievements of this country is its extensive infrastructure. For those of us that live here, we take it for granted that we can drive on roads to work, take our children to schools, turn on our faucets and get clean water, and know that there are police and courts to protect us. Yet for visitors, especially those from governmental agencies of developing nations, our infrastructure is a marvel that they wish to emulate.”

Statement of Christopher A. Taylor, former Executive Director, Municipal Securities Rulemaking Board to Committee of House Ways and Means, March 19, 2013

Mr. Taylor’s opening statement to House Ways and Means concisely and powerfully explains the vital importance of maintaining the tax-exempt status of public purpose municipal bonds.

Last month, we alerted issuer clients in advance, that the House Ways and Means Committee was meeting on March 19 to hear testimony on” Tax Reform and Tax Provisions Affecting State and Local Governments”. Additionally, in advance of the hearing we provided Chairman David Camp and Committee members Danny Davis, Thomas E, Price, Peter J. Roskam and Aaron Schock with a copy of our recently published white paper, “Repealing Tax Exemption-Impact on Small and Medium Sized Communities.” click to read.

Four nationally recognized experts addressed the Committee and shared their views on the subject at hand. The pro-exemption testimony was outstanding, explaining the critical role the current tax-exempt market plays in improving the everyday lives of citizens across the nation. Points made include:

-three quarters of all United States infrastructure investments are financed by tax-exempt bonds issued by more than 50,000 state and local governmental units

-virtually all long term tax-exempt bond issues finance capital investment

-the legal concept of intergovernmental immunity secures the right of state and local governments to raise capital to make local infrastructure investments independently of the federal government

-the perception the tax-exempt exclusion is merely a benefit for upper income investors is wrong because the distributional methods used by Treasury assume incorrectly all benefits of the exclusion flow to the investor. Treasury’s calculation methods ignore the implicit tax borne by the investor in the form of a lower interest rate earned. This is a cost borne by the investor. If tax- exemption is repealed, much of the burden from repeal would fall onto state and local governments which would be forced to pay higher borrowing costs. These increased costs would be passed onto residents.

-the tax exempt market exhibits certain inefficiencies, as do all financial markets; reinstating a modified Build America Bond program as an issuance option for state and local governments coupled with a reduction in the number of tax brackets and the nominal rate of the top bracket will go a long way to improving market efficiency.

Support for maintaining tax-exemption of public purpose bond issues came from members of both parties and was generally widespread. Here is a sample of some of the remarks made during the course of the hearing:

“Every single taxpayer in my district will have an increase in their taxes”(if tax-exemption is repealed) “ All we’re going to be doing is passing that tax down to another level.”
Representative Kenny Marchant, Texas Republican

“I’m having a hard time figuring out what the upside of getting rid of municipal bonds is…….how are we going to get the infrastructure built?”
Representative James McDermott, Massachusetts Democrat

“tax-exempt municipal bonds are the most important tool in the U.S. for financing investments in schools, roads, bridges, water and sewer systems. The reality is these projects just wouldn’t happen without muni bonds.”

Representative Richard Neal, Massachusetts Democrat

Private activity bonds (PABs) did not fare so well and were heavily criticized during the hearing.

All in all, the hearing was a positive event for maintaining tax-exemption of public purpose municipal bond issues while the validity of tax-exempt PABs was questioned.

The apparent success of the hearing aside, we remain wary. In Washington, statements are often made for public consumption, but in the end all that matters is the vote count.

We will continue to lead on this topic and keep you informed as new developments occur.

We hope you find our commentary helpful. Thank you for your continued confidence.

Ronald P. Bernardi
President and CEO
Bernardi Securities, Inc.
April 1, 2013