CHICAGO Moody's Investors Service dropped Illinois' debt rating from A1 to A2 on Friday, the lowest rating level among the U.S. states it rates.
The move, which affects $32 billion of the state's debt, was triggered by legislative inaction on dealing with Illinois' underfunded pensions and unpaid bills, the ratings agency said.
"Failure to address these challenges undermines near- to intermediate-term prospects for fiscal recovery," Moody's said in a statement.
The rating agency also questioned the state's "political willingness to impose durable policies leading to fiscal strength."
The state is currently projecting a $507 million deficit in the current budget. Illinois faces heavy fiscal pressure as pension funding will rise to $5.3 billion in fiscal 2013 -- $1 billion more than in the current fiscal year, according to an economic and fiscal policy report released by the governor's office of management and budget this week.
A $7 billion backlog of unpaid bills also hangs over the state, and the governor has renewed his call for issuing bonds to pay off that debt.
A statement from a spokeswoman for Governor Pat Quinn said while the state has taken steps to curb its pension liability and pension system abuses, more needs to be done.
"All three rating agencies as well as the investors in our bonds are clearly telling us we need more pension reform," said Kelly Kraft, adding that "swift bipartisan action" was needed on further reforms and cost reductions in the upcoming legislative session.
Moody's noted that state legal provisions that give debt-service payments priority over other spending, supported a revision in the rating outlook to stable from negative.
Meanwhile, the increase in Illinois' income tax rates enacted a year ago has helped the state to compensate for a sharp drop-off in federal funding due to the end of the U.S. stimulus act, a state legislative commission reported on Thursday.
The other two major credit-rating agencies maintained current ratings for the state. Standard & Poor's Ratings Services on Friday affirmed an A-plus rating but retained a negative outlook, warning a downgrade could be triggered by a significant increase in debt levels or a decrease in pension funding levels.
Fitch Ratings on Thursday affirmed the state's A rating and stable outlook, but warned the state lacks a plan to "resolve the mismatch between spending and revenues" as big income tax rate hikes are scheduled for a roll-back in fiscal 2015.
Moody's general obligation rating downgrade came ahead of Illinois' scheduled sale of $800 million of tax-exempt and taxable bonds next week.
In the deal's preliminary official statement, the state disclosed an unfunded pension liability of $82.9 billion on an accrual basis.
The Commission on Government Forecasting and Accountability said while corporate income and sale tax collections were outperforming expectations, personal income taxes are struggling to grow apart from the rate increase. General fund revenue at the mid-point of fiscal 2012 was up $1.1 billion or 8.1 percent over the same period in fiscal 2011.
(Reporting by Karen Pierog; Editing by James Dalgleish)