According to a report by Bloomberg News, the former head of structured finance at Standard and Poors says big investors no longer believe the credit judgments issued by S&P, Moody’s and Fitch because of the inflated ratings the agencies gave to sub-prime debt in the run-up to the 2008 financial meltdown:
"They're there because people have to have them, not because people believe in them," David Jacob told Bloomberg. "Maybe retail investors do, that's the unfortunate part, but I think institutional investors don't."
Meanwhile, recent events in this state may provide new lessons on why the judgments of these and related institutions can’t be trusted to protect investors and taxpayers. A few weeks ago, Michigan House Republicans turned their back on a real and transformational school pension system reform passed by the state Senate, which would have closed the current "defined benefit" system to new hires, leading to the gradual elimination of most government employee legacy costs in the Great Lake State. That reform would have genuinely increased the chances that the state would make good on its debt in future years.
Instead, the House approved a sleight of hand to “game” the system which they insinuate will earn approving nods from the credit rating agencies, despite doing nothing to improve the quality of Michigan government debt. Specifically, House Republicans voted to “prefund” the optional health insurance benefits currently provided to Michigan school retirees.
Unlike their pension checks, the state has no obligation to provide these optional benefits to retirees, and could trim or eliminate them at any time. For this reason these are not real “liabilities” in accounting terms, and so technically shouldn’t affect credit ratings. The only “liability” here is political – it’s the “debt” owed by the state’s bipartisan political class to arguably the most politically powerful special interest in this and other states: government employee unions.
Moreover, consider the likely fate of hundreds of millions of “prefunding” dollars the House proposes to set aside. We might as well call the account holding that money the “Michigan Rainy Day Fund 2,” because it will almost certainly get “raided” by future politicians the first time an economic hiccup causes state revenues to come in below expectations. This is not speculation – it’s exactly what happened during an earlier episode of “prefunding” back in the 1990s.
Nevertheless, because of an accounting trick allowed by another highly compromised "watchdog" institution, the Government Accounting Standards Board, “prefunding” has the effect of slathering a coat of lipstick over this political liability. Here’s how the House Fiscal Agency describes the trick (and also how optional benefits get misrepresented as real accounting liabilities):
“Prefunding triggers a change in the accounting method used to calculate future unfunded liabilities, allowing MPSERS to use an 8% discount rate rather than a 4% discount rate. This will reduce the UAL, currently calculated at $27.6 billion, by $10.8 billion.”
Translation: The prefunding pretense allows the state to claim a $10.8 billion reduction in “unfunded liabilities” by pretending that the money it sets aside will earn an unrealistically high 8 percent rate of return. In fact, the state’s pension funds have only averaged a 5.4 percent annual return since 1997.
In other words, the House, the state, the GASB and very possibly the big credit ratings agencies will all play a little trick on investors, making Michigan bonds appear more secure than these entities’ own assumptions suggest they should be.
Some might say that it’s not these various institutions’ job to make political judgments about the likely fate of the “prefunding” money. However, they’re already making another political judgment – that current and future lawmakers will never have the guts to trim these optional retiree health benefits (even though, like the rest of us, the beneficiaries are all eligible for Medicare at age 65).
Plus, that assumption of political class timidity has already been partially debunked: The state Senate actually did vote to trim these benefits, reducing them from 90 percent of the cost of retiree health insurance to 80 percent. Among the House Republican capitulations to the MEA teachers union in their pension reform bill was dropping this provision, but the precedent has been set. In the end, economic reality and competing demands will force these benefits to be trimmed in the future and probably eliminated.
The Michigan Senate voted for real and meaningful school pension reform. Michigan House Republicans said “no thanks,” and instead adopted a gimmick favored by the special interests who benefit from the status quo, including the teachers union and the bureaucratic “pension industrial complex.” Even a former key player in the credit rating agencies, who are the proximate target of the game-playing, suggests big investors have become wise to such games.
Unfortunately for Michigan taxpayers, this gimmick may nevertheless accomplish the real goal of these various special interests, which is derailing the genuine reform passed by the state Senate. It’s just more evidence that politicians and governments can’t be trusted to run defined-benefit pension systems.
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