Illinois Reduces Risk of Bank Swap Fees If Rating Is Cut to Junk

(Bloomberg) -- Illinois’s bankers agreed to soften the blow if the state’s bond rating is downgraded to junk.

Barclays Bank Plc, JPMorgan Chase & Co. and Bank of America Corp. revised interest-rate derivative contracts so Illinois won’t face some $38 million in fees as long as it’s not dropped any further than one step below investment grade, Eleni Demertzis, a spokeswoman for Governor Bruce Rauner, said in an emailed response to questions from Bloomberg News. That threshold had been one step higher, which would have allowed the banks to cancel the trades and demand payment for the full market value.

It’s become increasingly likely that Illinois will become the first state cut to junk-bond status because of the political impasse that’s left Illinois without a full-year budget since 2015. Moody’s Investors Service and S&P Global Ratings lowered its rating to one level above junk on June 1 and signaled another downgrade may follow if it doesn’t enact a spending plan that starts chipping away at chronic budget deficits.

“We have renegotiated all of the ratings triggers on the swaps associated with the state’s variable rate debt to below BB+ or Ba1,” said Demertzis.

The state’s gridlock has driven its backlog of unpaid bills to an all-time high of nearly $15 billion and hurt entities that depend on state aid. With the government avoiding a shutdown because of continuing appropriations and court orders, Illinois is spending more than it’s bringing in, leaving it on track to post a more than $6 billion deficit for the year that ends this month.

Illinois purchased the derivative contracts to protect against the risk that interest costs would increase on variable-rate debt, utilizing a financing technique that was popular before the 2008 financial crisis because it could be cheaper than selling traditional fixed-rate bonds.

But such contracts contained potentially costly provisions to protect banks if a government’s credit rating tumbled. The penalties owed to the three banks is based on the value of the swaps as of March 31, according to the state. Illinois’s swap with Deutsche Bank AG, valued at about $70 million, already had a lower threshold that wouldn’t be triggered until the rating drops below BB+ or Ba1, bond documents from October show.

Jessica Francisco, a spokeswoman for JPMorgan, and Bill Halldin, a spokesman for Bank of America, declined to comment. Andrew Smith, a spokesman for Barclays, had no immediate comment.

To contact the reporter on this story: Elizabeth Campbell in Chicago at ecampbell14@bloomberg.net.

To contact the editors responsible for this story: Christopher Maloney at cmaloney16@bloomberg.net, William Selway