Moody's just downgraded the Chicago's debt to junk status while S&P has them rated at "investment grade."
The difference is due to the different methodologies: Moody's uses its own growth projections while S&P defers to the city's growth assumptions.
We have blogged extensively about the systematic underfunding of municipal pensions and the political pressure to under-save:
The city of Nashville uses discounting to decide how much to save for its future pension obligations. For a pension that pays out $100,000 in 20 years, Nashville must save $20,485=$100,000/(1.0825)^20 today, using an 8.25% discount rate. If the city invests the $20,485, and earns 8.25%, the savings will compound and be worth $100,000 in twenty years. If however, the investments return less than 8.25% (in fact they have done much worse),then the city will not have saved enough when the future finally gets here. Of course, a more realistic discount rate, say 6.5%, would mean much higher current savings, 28,380=$100,000/(1.065)^20 to fund the same future pension. But higher savings means less current spending, and spending is politically popular.
So, for the purposes of illustration, S&P is using a higher discount rate (like the 8% in the example above) and Moody's is using a much lower discount rate, (like 6.5% in the example above).
OK, now we are in a position of determining which of the agencies is doing a better job?
1. City assumptions are typically too high and are almost always backward looking, so after a long period of high returns, the assumptions will be for continued high returns. When in fact, high returns in the past are correlated with lower returns in the future.
2. I suspect that S&P gains clients for its consulting services from many of the same cities that it rates. Its favorable ratings may be an advertisement to financially strapped cities that S&P will come up with a low savings rate which will provide cover to politicians who want to continue their irresponsible behavior.
If this is correct, financially healthy cities may want to "signal" their financial health by hiring Moody's.
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ReplyDeleteUnder these circumstances, I would also trust Moody’s. For the S&P to trust the word of the city without doing their own growth research seems downright irresponsible and bad for their own reputation, let alone the future of the city of Chicago. Underfunding pensions is led by the assumption of continued growth, that the city will continue to have a population that will support the “buy now, pay later” mentality of so many cities (and people, for that matter) when it comes to retirement savings. A realistic discount rate would reveal that the city was not saving enough and that it will eventually have a pension crisis on its hands. That, in turn, will lead to the raising of property taxes and will make living in the suburbs a much more attractive proposition. That flight will then do the opposite of Chicago’s plans; it will make the city shrink, and they will find themselves with obligations that they have trouble repaying.
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