We do not invest in direct general-obligation bonds of the State of Illinois. At Cumberland we feel the state is plagued by political gridlock, an inflexible state constitution, a severely underfunded pension plan, and slow growth. In order for the state to avoid dealing with its issues when it had a cash shortage, in 2011 the state established the Vendor Payment Program (VPP) which pays vendors anywhere from 9% to 12% in late fees for as long as the bill is unpaid. The program also designated Qualified Purchasers (QP) that could pay vendors the unpaid bills. The purchaser would take the risk of receiving payments from the state, allowing the vendor to continue to provide services to the state. This program exploded during the 2015–2017 budget stalemate, with the state’s amassing over $16 billion in unpaid bills. There were contentious budget deliberations at the time, and the state’s ability to kick the can down the road reduced the urgency of the parties negotiating the budget.
The budget stalemate and the VPP have exponentially increased debt and interest expense for the state and resulted in downgrades to the state’s debt. In late 2017, $6 billion of bond proceeds were used to reduce the backlog of bills and, according to Moody’s, contributed to a 16% increase in tax-supported debt, which rose to $37.4 billion at a time when most states were reducing debt levels. In addition, Moody’s calculates that the net pension liability of Illinois is $239 billion, making pensions the biggest issue the state needs to address. The Illinois state comptroller noted in a recent press release that between 1998 and 2015, late payment interest penalties totaled $1 billion, while in just the past two and a half years the state has accrued $1.1 billion in penalties.
The chart below compares the lowest-rated states’ pension funding levels and measures of debt and fixed costs for a number of states. Illinois has one of the lowest levels of funded pensions and the highest pension burden per capita. While debt per capita is reasonable, fixed costs due to debt, pensions, and other postemployment benefits such as health care are high.
Chart Data as of May 11, 2018 * Highest is Wisconsin at 99%; lowest is Illinois; average is 66%. ** Moody’s ANPL = adjusted net pension liability. *** 2016 data as a % of own-source funds. Fixed costs include debt service, pensions and OPEB (other post-employment benefits).
In many cases, the QPs have securitized the payment stream of unpaid bills and late fees from the state into investment securities. The securities are nonrated private placements. Proceeds from the sale of the securities enable the QP to acquire more unpaid vendor bills. An April 24th Reuter’s article reports that some QPs’ ability to pay unpaid vendor bills is reduced by the uncertainty as to when late-fee penalties will be paid to the QPs and by the balances of late fees due to the QPs. The vendors here are not just sellers of office products; they are vendors that supply services such as health care to the citizens of the state.
In addition to kicking the can down the road, the VPP program has increased costs to the state and has likely strained relationships with its vendors and other creditors. For the same reason that we do not buy the state’s debt, we would not own the unpaid bill securitization bonds offered by the QPs. Since they are a derivative of the state, they are not liquid; and the timing of the repayment stream is uncertain. At Cumberland we invest in high-quality, liquid bonds that enable us to execute our total-return active management style.