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Home Publications Blogs Beat the Press Moody's, Which Rated Hundreds of Billions of Dollars of Subprime Mortgage Backed Securities As Investment Grade, Claims Public Pension Liabilities are Much Higher Than Previously Reported

Moody's, Which Rated Hundreds of Billions of Dollars of Subprime Mortgage Backed Securities As Investment Grade, Claims Public Pension Liabilities are Much Higher Than Previously Reported

Friday, 27 September 2013 07:03

The Washington Post ran an article highlighting new calculations of city pension liabilities from Moody's, the bond rating agency. Moody's is probably best known to most people for rating hundreds of billions of dollars' worth of subprime mortgage backed securities as investment grade during the housing bubble years. It received tens of millions of dollars in fees for these ratings from the investment banks that issued these securities.

The new pension liability figures are obtained by using a discount rate for pension liabilities that is considerably lower than the expected rate of return on pension assets. This methodology increases pension liabilities by around 50 percent compared with the traditional method.

If a pension fund was fully funded according to the new Moody's methodology, but continued to invest in a mix of assets that gave a much higher rate of return than the discount rate used for calculating liabilities, then it would have effectively overfunded its pension. That would mean taxing current taxpayers more than necessary in order to allow future taxpayers to pay substantially less in taxes to finance public services. Usually economists believe that each generation should pay taxes that are roughly proportional to the services they receive. Moody's methodology would not lead to this result if it became the basis for pension funding decisions.

It would have been worth highlighting this point about the Moody's methodology. Most readers are unlikely to be aware of the strange policy implications of following the methodology and thereby assume that governments would be wrong not to accept it.

It is worth noting that public pensions did grossly exaggerate the expected returns on their assets in the stock bubble years of the late 1990s and at the market peaks hit in the last decade. Unfortunately, unlike some of us, Moody's did not point this problem out at the time. One result was that many state and local governments raised their pensions and made additional payouts to workers which would not have been justified if they had used a discount rate that was consistent with the expected return on their assets.     

Comments (5)Add Comment
Intellectual Property.
written by Alan, September 27, 2013 11:59
Call me surpised. I wanted to read Dean Baker's past comments on public pensions and lo. It's behind a paywall. Quoting Mankiw

"Although I disagree with Baker on a wide range of topics, I will give him credit for one thing: He is not a hypocrite. Baker is distributing his new book free over the internet."

Maybe Mankiw was wrong to say that you are not a hypocrite (All said in jest) :).
The AIG Solution
written by Last Mover, September 27, 2013 12:13

There's a simple solution to the problem of rating agencies missing the mark so widely. Just have AIG insure them for the corresponding economic losses.

As AIG goes under due to massive payouts for bad ratings, its executives will be paid bonuses at the same time it asks for a government bailout.

When the government balks at the rescue of AIG due to the bonuses, the head of AIG will whine that it's equivalent to southern lynchings. The government will back off and subsidize the insurance payouts and bonuses to keep everyone whole except taxpayers.

Be cautious however with underratings that turn out to give investors an unexpected windfall because it was a bad rating. In that case AIG requires a cut equal to the entire windfall since its policy is to provide insurance for both the upside and downside.

Bonuses are necessary for incentives you know. Pay based on anything that even looks like a free market is considered a bad investment that deserves a bad rating.
written by PeonInChief, September 28, 2013 11:52
One of the interesting notes in the Detroit case is that, not only was the city not making its required contributions, it was taking money from the pension fund for other city spending.
This brings to mind the jobs-losing crisis in the US Post Office
written by Rachel, September 29, 2013 10:52

In the USPS case, the situation was created by the 2006 Congress manipulating accounts, much to the advantage of Senator Feinstein's current husband. (I think I liked her better when she was married to a humble surgeon.)

And now there are new ways to assess city pension liabilities which make them seem greater. And might this too be used to inflame the fears of the uninitiated, and promote fire sales and the loss of jobs?
written by NWsteve, October 05, 2013 10:20
is it even remotely possible (wink-wink) that Moody's is using its methodology to *promote* an increase in funding-requirements for pension plans -- many of whose "investments" would include stocks and bonds?

just curious...

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.