A little over a month ago, Moody’s downgraded the city of Chicago to junk, triggering over $2 billion in accelerated payment rights for creditors and complicating an effort by Mayor Rahm Emanuel to refinance some $900 million in floating rate debt and borrow another $200 million to pay off the related swaps.
The decision by Moody’s came on the heels of an Illinois Supreme Court decision that struck down a pension reform bid. Although not binding on other states, that verdict effectively set a precedent as it relates to ‘implicit contracts’ between employers and employees, meaning state and local officials across the country will need to find creative ways to fill budget gaps.
When it comes to underfunded pension liabilities one major concern is that in a world characterized by ZIRP and NIRP, it’s not entirely clear that public pension funds are using realistic investment return assumptions. As you can see from the table below, the assumed rates of return for Chicago’s pension funds are nowhere near the risk-free rate, meaning one of two things must be true: 1) fund managers are taking greater risks to hit the targets, or 2) the targets won’t be hit. If the latter is true, then the present value of the funds’ liabilities is likely much larger than reported.
After 2008, Moody’s stopped relying on the investment return assumptions of cities and states opting instead to use its own models. Unsurprisingly, this led the ratings agency to adopt a much less favorable view of state and local government finances and as WSJ reports, rather than admit that their return assumptions are indeed unrealistic, local governments have opted to drop Moody’s instead. Here’s more:
More than a year before Moody’s Investors Service downgraded Chicago’s bonds to junk status, one of its senior analysts asked top city officials to explain why the third-largest U.S. city was healthier than a troubled island commonwealth flirting with insolvency, according to people familiar with the conversation.
“Help me understand why Chicago is different than Puerto Rico?” said the Moody’s analyst, Rachel Cortez, during a February 2014 meeting that Mayor Rahm Emanuel attended, two of these people said. A spokesman for Moody’s and Ms. Cortez said the firm doesn’t discuss “private meetings with issuers or other capital-market participants.”
The exchange inside City Hall came to embody a more aggressive stance by the world’s second-largest ratings firm as Moody’s cut Chicago’s credit rating by seven notches over a two-year period. City officials were taken aback by the Puerto Rico comment and then angered by Moody’s final move to junk in May 2015, a stance that differed from more optimistic conclusions made by other ratings firms. Since last summer, the city has left the Moody’s Corp. unit off four bond deals..
Tim Blake, a Moody’s managing director who heads its public pension task force, said the firm is “rationally applying” its ratings models. “Our job is to make judgments on credit risk as we see it,” said Mr. Blake, noting some issuers with improved pension situations have been upgraded.
Other cities and counties from California to Florida are reconsidering their relationship with Moody’s as it expands its stricter ratings approach around the U.S., threatening a seal of approval that for decades was all but a necessity in the municipal-bond world..
Moody’s metamorphosis began after the 2008 crisis as ratings firms drew criticism in Congress and from regulators for their rosy grades on mortgage bonds that went sour. For local governments, the key change came in 2013 when Moody’s decided it would no longer rely on cities’ and states’ targets for investment returns when it calculates pension liabilities—one of the biggest costs shouldered by local governments. Moody’s own estimates are more conservative, meaning holes in pension funds look bigger.
As Moody’s adopted the stricter ratings methodology, it diverged from rivals Standard & Poor’s Ratings Services and Fitch Ratings in its assessment of problems facing local governments across the U.S. From 2002 to 2007, Moody’s and S&P upgraded issuers at about the same rate. But from 2008 to 2014, S&P had seven upgrades for every one of Moody’s, according to a recent Nuveen Asset Management LLC report.
Santa Clara County, Calif., omitted Moody’s from its past two deals because of the firm’s disagreement over how some property-tax revenues were to be distributed. “We became convinced that Moody’s was not being responsible and so therefore we moved away from them,” said Jeff Smith, who oversees the operations of the county, which includes San Jose. “We don’t think it has had, or will have, any effect on our ability to sell bonds.”
The latest government to back away from Moody’s is Miami-Dade County, which last week decided to hire Kroll Bond Rating Agency Inc. instead of Moody’s for its $534 million sale of airport bonds. Kroll’s rating is two notches higher than Moody’s.
“We wanted a fresh set of eyes,” said Anne Lee, chief financial officer of the Miami-Dade aviation department, of the decision to not hire Moody’s, which she adds charges “30% to 40%” more than other rivals.
Yes, a "fresh set of eyes," and preferably a set that will not take a realistic look at pension fund return assumptions.
Perhaps the most unnerving thing about the above is that state and local governments across the country are already facing huge pension funding gaps using their own unrealistically high return assumptions.
If they were to adopt Moody's standards, they would likely find that the holes are orders of magnitude larger and rather than face reality, officials have apparently opted to go with the Wall Street approach to dealing with people who try to spoil the fun: namely, when someone blows the whistle, you simply fire them.
Pray for the pensioners.