The bond-rating agency Moody’s made itself famous for giving subprime mortgage backed securities triple-A ratings at the peak of the housing bubble. This made it easy for investment banks like Goldman Sachs and Morgan Stanley to sell these securities all around the world. And it allowed the housing bubble to grow ever bigger and more dangerous. And we know where that has left us.
Well, Moody’s is back. They announced plans to change the way they treat pension obligations in assessing state and local government debt.
Instead of accepting projections of pension fund returns based on the assets they hold, Moody’s wants to use a risk-free discount rate to assess pension fund liabilities. This will make public pensions seem much worse funded than the current method.
While this might seem like a nerdy and technical point, it has very real consequences. If the Moody’s methodology is accepted as the basis for accounting by state and local governments then they will suddenly need large amounts of revenue to make their pensions properly funded. This will directly pit public sector workers, who are counting on the pensions they have earned, against school children, low-income families, and others who count on state supported services.
In other words, this is exactly the sort of politics that the Wall Street and the One Percent types love. No matter which side loses, they win. While public sector workers fight the people dependent on state and local services, they get to walk off with all the money.
Wall Street is expert at these sorts of accounting tricks; it is after all what they do for a living. And this is not the first time that they have played these sorts of games to advance their agenda.
The current crisis of the Postal Service, which is looking at massive layoffs and cutbacks in delivery, is largely the result of accounting gimmicks. In 2006 Congress passed a law requiring an unprecedented level of pre-funding for retiree health care benefits. The Postal Service is not only required to build up a massive level of prefunding, it also is using more pessimistic assumptions about cost growth than any known plan in the private sector.
This requirement is the basis for the horror stories of multi-billion losses that feature prominently in news stories about the Postal Service. The Postal Service would face difficulties adjusting to rapid declines in traditional mail service in any case (it doesn’t help that they are prohibited from using their enormous resources to expand into new lines of business), but this accounting maneuver is imposing an impossible burden. The change in pension fund accounting could have a comparable impact on state and local governments.
Moody’s change in accounting is not just bad politics, it is horrible policy. The key question is how we should assess the returns that pension funds can anticipate on the assets they hold in the stock market. Moody’s and other bond rating agencies did flunk the test horribly in the 1990s and 2000s. They assumed that the stock market would provide the historic rate of return even when price to earnings ratios were more than twice the historic average at the peak of the stock bubble.
While some of us did try to issue warnings at the time (here) and (here) the bond rating agencies were not interested. As a result, when the stock market plunged, many pensions that had previously appeared to be solidly funded, suddenly faced substantial shortfalls.
It is possible to construct a methodology that projects future returns based on current market valuations and projected profit growth that maintain proper funding levels, while minimizing the variation in contributions through time. By contrast, if the pension funds adopted the Moody’s methodology as the basis for their contribution schedules, they would find themselves making very large contributions in some years followed by years in which they made little or no contribution.
A state or local government that used the Moody’s methodology to guide their contributions would effectively be prefunding their pensions in the same way that it would be prefunding education to build up a huge bank account so that K-12 education was paid from the annual interest. While it would be nice to have the cost of these services fully covered for all time, no one thinks this policy makes sense. We would be hugely overtaxing current workers so that future generations could get a huge tax break.
Even worse, Moody’s scoring of pensions may discourage pension managers from holding stock as an asset. They would be held accountable for any losses in bad years, but would not get credit for the higher expected returns on stock. For this reason, risk averse pension managers may decide to hold safe but low yielding bonds.
This would lead to the perverse situation in which collectively invested funds held in pensions only hold safe bonds, even though market timing carries little risk for them. On the other hand individual investors, who are hugely vulnerable to market timing, would be holding stock in their 401(k)s.
That outcome makes no sense. But of course it didn’t make sense that subprime mortgage backed securities were Aaa. This is Moody’s we’re talking about.