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Will Illinois Bondholders Suffer The Same Fate As Puerto Rico?

May 30, 2017 Blog

Mom and pop bondholders in fiscally troubled Illinois could soon find themselves in the same rocky boat as Puerto Rico bond investors.

Puerto Rico this month declared bankruptcy on $123 billion in debt and pension obligations. Indeed, Puerto Rico has become, in the immortal words of Thomas Hobbes, “the war of all against all” with competing bondholders fighting for position and a bigger share of the scraps at the bond payment table.

Due to a massive state budget shortfall, Illinois bonds are likely to be downgraded to “junk” status soon, just as Puerto Rico bonds were in February 2014.

It’s surprising this hasn’t happened sooner. Indeed, the bond ratings agencies could declare Illinois bonds to be junk by the end of the month if the state house and governor do not agree to a budget, according to an investment manager who recently testified before state lawmakers.

Illinois is facing a number of problems. The three major credit ratings have already downgraded its debt in the past two years, and it looks like another cut will happen before June 1.

“The ratings agencies’ statements provide vital information on how Illinois reached this point,” reports Bob Williams of the HuffPost. “S&P cited ‘long-term irresponsible deficits, growing pension costs and a lack of reforms’ as reasons for its downgrade. Fitch cited ‘the unprecedented failure’ of not having a budget for two years and the effects of ‘spending far in excess of available revenue.’ Moody’s reasons are similar for both the state of Illinois and for Chicago Public Schools, namely a ‘deepening structural deficit.’”

This should sound familiar to regular readers of this blog and is reminiscent of the bond crisis in Puerto Rico. Will Illinois bondholders wind up in a similar disaster?

It’s not panic time, yet. Illinois appears to be better off than Puerto Rico in some ways, according to John Miller, a Nuveen asset manager, who testified recently before the Illinois legislature.

Miller assured the legislature that Illinois has more going for it than Puerto Rico, including a substantially better economic base, larger population, much more diverse array of businesses, lower debt per capita and a more stable economy.

That doesn’t mean Illinois bondholders will get off easy. “The state faces a $13 billion backlog of bills, most of which have piled up since the budget impasse began between Republican Gov. Bruce Rauner and longtime Illinois House Speaker Michael Madigan, D-Chicago, began in 2015,” according to Law360. “If the state reaches junk bond status, it cannot sell its bonds to pension funds, a major buyer of bonds worldwide.”

It’s becoming clear that brokers sold many clients Puerto Rico bonds when they knew they were in trouble. Perhaps the same can be said for Illinois?

“By the time you get to the end of 2012, sophisticated market professionals, including the ones at Santander, knew that Puerto Rican municipal bonds should be considered junk,” said Craig McCann recently to Bloomberg. McCann is the principal at the Securities Litigation & Consulting Group. “Even though they hadn’t been downgraded to junk status yet, they were trading at credit spreads consistent with them being junk bonds.”

Between late 2012 and October 2013, Santander marketed more than $280 million in Puerto Rico municipal bonds and its closed-end funds to clients while unloading its holdings of the securities, according to Bloomberg. UBS and Santander would eventually agree to pay fines through settlements with the industry regulator, FINRA, for inadequately monitoring the risks of closed-end funds.

McCann told Bloomberg that he expects that the number of claims will rise now that the island has begun a bankruptcy proceeding.

It seems that Illinois bond investors, like those who own Puerto Rico debt, may be headed for the chaotic world that a downgrade would bring. That includes massive losses and securities arbitration claims against their brokers. In short, a world of pain.

Is stock market history repeating itself? We certainly hope not. But Mom and Pop investors need to fight the urge to invest heavily at the top of the market. They may get crushed again.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.