Municipal Credit Ratings May Crumble Under New Rules

Edward Ring

Senior Fellow

Edward Ring
January 8, 2013

Municipal Credit Ratings May Crumble Under New Rules

Everyone remembers how thousands of bankers and millions of homeowners were caught by surprise when the real estate bubble collapsed in late 2008. One of the major reasons this prodigious bubble was allowed to inflate in the first place was because credit rating agencies did not properly evaluate the financial risks inherent in collateralized mortgage debt securities.

Once bitten, twice shy. Credit rating agencies these days are loath to make that mistake again. The two biggest credit rating agencies in the world are Moody’s Investors Service and Standard & Poors, with each of them commanding about 40% of the global market for credit analysis. On July 2, 2012, Moody’s, which specializes in bond credit ratings, announced proposed adjustments to how they will evaluate public sector pension data. Using Moody’s new criteria, the credit ratings of municipal bonds will be severely downgraded.

For the past several years, John Dickerson, a financial professional living in Mendocino County who is involved in public sector pension analysis and reform, has been analyzing the impact of unfunded pension debt on the 21 California counties that operate their own independent Pension Funds. He publishes his findings on, a website he established as a resource for citizens concerned about the solvency of public sector pensions. Earlier this week, he allowed the California Public Policy Center to post his most recent work, “The Impact of Moody’s Proposed Changes in Analyzing Government Pension Data.”

In Dickerson’s remarkably thorough analysis, he calculated the impact of Moody’s adjustments on the size of the unfunded pension liability for six California counties, Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma. He also calculated how, using Moody’s revised criteria for assessing the solvency of pension funds, how much, for each of the six counties, annual payments into these pension funds would have to increase.

It is challenging to discuss pension finance without delving into jargon and introducing concepts that may seem arcane to anyone not already well familiar with the discipline. Unfortunately, however, it is the obligation of any journalist, activist, policymaker, financial professional, or concerned citizen, to do exactly that. The failure of a critical mass of individuals to intellectually grapple with pension finance, to honestly assess what it all means, and then do something about it, will spell bankruptcy for virtually every public entity in California. So here goes.

Moody’s has proposed three fundamental changes to how they will evaluate the solvency of pension funds:

(1) They will change the assumed rate of return on pension fund investments from the commonly used projection of 7.0% or more to a much lower 5.5%.

(2) They will require a 17 year time horizon for catch-up payments to reduce unfunded pension liabilities to zero, instead of the 20 to 30 year intervals currently used.

(3) They will require catch-up payments to use a “level payment” method, similar to how payments on a typical home mortgage are structured, instead of the commonly used “percent of payroll” method which actually incurs negative amortization – i.e., the amount of unfunded pension debt actually grows – for the first third of the payment period.

Using unassailable logic, Dickerson’s study – which was reviewed by other pension experts and financial professionals before release – comes to some sobering and indisputable conclusions:

  • The annual contribution for ongoing pension funding obligations – not catch-up payments, but normal ongoing payments, will increase for the six counties combined from the current $312 million per year to $550 million per year, a jump of 79%.
  • The annual catch-up payments to eliminate the unfunded pension liability will increase for the six counties combined from the current $327 million per year to $890 million per year, a jump of 192%.
  • The payments necessary to pay off pension obligation bonds – which were incurred when the local governments borrowed money in order to have enough cash to make their normal pension contribution – will add another $177 million to the annual payments necessary to service existing pension debt and maintain pension fund solvency.

If you add this all up, the six counties analyzed by Dickerson – according to Moody’s – are going to need to increase their annual pension payments from today’s $817 million to over $1.6 billion. Put another way, in order to preserve their credit ratings once Moody’s adjustments take effect, the six counties analyzed will need to double the amount of money they spend each year to maintain their pension funds.

To put this in perspective, Dickerson compared the amount that the six counties combined will need to pay each year for their pensions, $1.6 billion, to the total property tax revenues retained by these six counties last year, which is also $1.6 billion. Get it? “My property tax, your pension,” is not mere rhetoric. Literally 100% of the property tax revenue available to these counties will be just enough to fund the pensions for county workers in the coming years.

For anyone so inclined, wading through the entire 10,000 word study produced by Dickerson is well worth the time. Because the counties he evaluated, Alameda, Contra Costa, Marin, Mendocino, San Mateo, and Sonoma, are not unique. Even though all six of them have their own independent pension funds, the differences between how Dickerson’s analysis affected them were too insignificant to mention here. And what they are going to face is unlikely to differ significantly from any of California’s other local government pension funds, or CalPERS or CalSTRS for that matter.

This is the context in which the pension debate rages onwards. Pension reformers are accused of being economic pessimists, afflicted with pension envy, tools of Wall Street bankers (a supreme irony since government employee pension funds and government borrowing are one of the biggest sources of Wall Street profits), right-wing zealots, libertarian whackos, Darwinian brutes, tea-bagging extremists, union bashers, destroyers of the middle class and “working families,” mean spirited, disrespectful – people who deserve to fend for themselves since they obviously don’t appreciate police or firefighters, and on, and on, and on. And all of these accusations are nothing more than well-funded, utterly misleading propaganda.

The arithmetic, fact-based reality is this: We are on track to spend more money each year to pay public sector pensions than we will spend on social security for five times as many citizens. The average government employee retires with benefits that are five times more lucrative than the average social security recipient. Government employee pension funds are employing desperate tactics to achieve the unachievable 7.5% rate of return and in the process they are endangering the stability and liquidity of America’s financial markets, as well as extracting over-market returns that in-turn deny opportunities to small investors who also need to save for retirement. And taxpayers are being tapped to guarantee pension fund solvency – based on unrealistic projections for pension fund returns – yet have no access to remotely comparable risk-free rates of return on their own investments.

Moody’s has fired a shot that will be heard around the world. Accountants, open your spreadsheets and sharpen your pencils. It is up to financially trained citizen volunteers like John Dickerson to cast a bright light on the true state of California’s public employee pension funds, since those officially tasked with this great responsibility continue to downplay the problem.

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