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Ratings Agencies Express Concern Over Maryland Pension Debt, But Uphold Rating

The major ratings agencies all upheld Maryland’s AAA bond rating this week.

But all three agencies expressed concern over the state’s pension debt. S&P in particular warned that pension liabilities, if not addressed, could lead to a rating downgrade in the future.

From the Maryland Reporter:

Fitch Ratings and Moody’s Investor Services call Maryland’s debt “moderate,” but Standard & Poor’s report says it is “above average.”

Moody’s said “low retirement system funded levels” represent a credit challenge for the state and “failure to adhere to plans to address low pension funded ratios” could make the rating go down.

Comptroller Peter Franchot said Wednesday he was concerned that the legislature would be tempted to cut the state’s pension contribution in order to find money for other programs.

Fitch Ratings noted, “Despite pensions being a comparative credit weakness, the state has taken multiple steps to reduce their burden and improve sustainability over time.”

S&P noted “implementation of various reforms and some improvements in funded ratios,” But it said “the state’s below-average pension funded ratios and annual contributions that do not meet the full [annual contribution] also continue to represent downside risk to the rating.”

The Fitch report can be read here.

The Moody’s report can be read here.

The S&P report can be read here.

Photo credit: Lendingmemo

How Credit Rating Agencies Reacted to Illinois Pension Ruling

None of the three major rating agencies changed their outlook on Illinois’ credit in the wake of a lower court ruling that deemed the state’s pension reform law unconstitutional.

But rating agencies are certainly keeping a close watch on the state as the reform law moves up to the Supreme Court. And all three agencies had something to say after the ruling.

Moody’s had the harshest take, calling the ruling “credit negative” that leaves the door open for a rating downgrade. Summarized by Governing:

[Moody’s] issued an analysis on Nov. 24 that said the “state’s negative outlook indicates the possibility that factors such as further growth in the state’s pension liabilities will drive the rating lower still.” The state is appealing the decision to the Illinois Supreme Court but Moody’s was wary of its chances and pointed out that the top court this summer indicated in a separate case on retiree health benefits that would adhere strictly to the pension protection clause.

A top Moody’s official commented further in a WUIS report:

“The average state from our perspective or the expected rating for a state is AA1, which is our second highest rating. And so Illinois is A3, so that’s five rating notches below that,” said Ted Hampton, a Vice President at Moody’s Investor Service. “Which is to say, it’s still an investment-grade rating. It’s still a strong rating in the context of every kind of security that we rate. But it’s far below all of the other states.”

Hampton says Moody’s saw Illinois’ passage of the pension overhaul as beneficial, but not enough to move the credit ratings needle – because a court challenge was suspected. The recent court ruling likewise wasn’t not enough to prompt a change, though Moody’s called the decision “credit negative” in a notice sent out Tues., Nov. 24.

“We do get a lot of inquiries about states, particularly Illinois where there are problems that are in the news, and where the situation is in flux. And publishing these comments helps us get our opinion out to those investors, or to the general public,” Hampton said.

Fitch and S&P said the pension ruling didn’t move the needle much as far as the state’s credit rating. From Governing:

Fitch Ratings and Standard & Poor’s were far more forgiving. Both said they had already factored in the likelihood of court challenge into their current ratings for Illinois. “More importantly, from a credit perspective,” S&P added, savings from the pension reform are not included in the fiscal 2015 budget.”

Interestingly, Fitch’s main concern wasn’t the pension ruling. Instead, the agency said the real concern was the expiration of several tax increases. From Governing:

Fitch did note another trouble spot for Illinois’ credit lurking just ahead: the scheduled expiration of temporary tax increases in 2015. “The state passed a placeholder budget for the current fiscal year with a stated intent to revisit the issue after the November elections,” Fitch said. “Taking steps to address the long-standing structural mismatch between revenues and spending would put the state on more solid financial footing, while failure to take action would be a return to past practices and leave the state poorly positioned to confront future downturns.”

Fitch Downgrades Pennsylvania; “Weakened” Pension System Drives Demotion

Credit rating agency Fitch has downgraded Pennsylvania’s general obligation bonds one notch, from AA to AA-.

What’s more, Fitch changed the state’s outlook from “stable” to “negative” – meaning another downgrade could be coming if Pennsylvania doesn’t address the structural problems that led to this recent demotion.

The structural problems in question are largely linked with the state’s pension system. From the Fitch report:

CONTINUED FISCAL IMBALANCE DRIVES DOWNGRADE: The downgrade to ‘AA-‘ reflects the commonwealth’s continued inability to address its fiscal challenges with structural and recurring measures. After an unexpected revenue shortfall in fiscal 2014, the current year budget includes a substantial amount of one-time revenue and expense items to achieve balance and continues the deferral of statutory requirements to replenish reserves which were utilized during the recession. The commonwealth’s rapid growth in fixed costs, particularly the escalating pension burden, poses a key ongoing challenge, although Fitch expects budgetary planning and management to mitigate these pressures in a manner consistent with the ‘AA-‘ rating.

PENSION FUNDING DEMANDS: The funding levels of the commonwealth’s pension systems have materially weakened as a result of annual contribution levels that have been well below actuarially determined annual required contribution (ARC) levels. Under current law, contributions are projected to reach the ARC for the two primary pension systems by as soon as fiscal 2017, but the budgetary burden will increase, crowding out other funding priorities.

INCREASING BUT STILL MODERATE LONG-TERM LIABILITIES: The commonwealth’s debt ratios are in line with the median for U.S. states. However, the commonwealth’s combined debt plus Fitch-adjusted pension liabilities is above-average, and will likely continue growing given the current statutory schedule of pension underfunding for at least the next few years. Fitch views Pennsylvania’s long-term liability burden as manageable at the ‘AA-‘ rating so long as the commonwealth adheres to its funding schedule, or enacts reforms that do not materially increase liability or annual funding pressure.

[…]

Without structural expense reform, or broad revenue increases, pension costs will consume a larger share of state resources and limit the commonwealth’s overall fiscal flexibility. In fiscal 2015, commonwealth contributions will increase over $600 million from the prior year to $2.7 billion on a $30 billion general fund budget (9.1%). Based on the statutory framework and the pension systems’ historical data and actuarial projections for contributions, Fitch anticipates increases for fiscal 2016 and 2017 will be similar though somewhat lower. While substantial, Fitch views the anticipated increases in annual contributions and unfunded liabilities laid out in the current statutory framework as within the commonwealth’s capacity to absorb at the ‘AA-‘ rating level.

Moody’s downgraded Pennsylvania in July.

Fitch Weighs In On New CalPERS Compensation Rules

This week, CalPERS approved 99 types of additional income that workers can include in their pension calculations.

The change will increase the pensions of many workers in the CalPERS system, and the fund has already drawn flak from California Governor Jerry Brown.

Now, the credit rating agency Fitch is in on the game, too. Fitch says the changes will increase pension liabilities and present additional costs to the state. From Fitch:

The expanded definition of pensionable compensation exposes public employers to higher pension liabilities and contribution expenses, and appears to be a step backward from recent reforms. The Public Employees’ Pension Reform Act of 2013 (PEPRA) narrowed the definition of pensionable compensation for public employees in an effort to address “pension spiking,” the inflation of base pay for purposes of pension benefit calculations. This decision expands the definition of pensionable compensation, in apparent conflict with PEPRA, and will increase pension costs for public employers if implemented.

The magnitude of impact from this decision is not yet clear, but it raises more questions about the sustainability of California’s pension reform efforts, which continue to face legal and institutional challenges. Particularly worrisome to Fitch is the absence of detailed information on the analysis of its projected costs. The decision has been sharply criticized by Gov. Jerry Brown, who cited its conflicts with recent state legislation intended to reduce pension costs. City-led pension reform efforts in San Diego and San Jose remain mired in litigation while this CalPERS decision appears to open up a new front for challenging reform efforts.

Gov. Brown was actually open to most of the 99 “special pay items”. But he adamantly opposed the measures that contradicted the reform law Brown passed in 2012.

“Today Calpers got it wrong,” Brown said in a statement on Wednesday. “This vote undermines the pension reforms enacted just two years ago. I’ve asked my staff to determine what actions can be taken to protect the integrity of the Public Employees’ Pension Reform Act.”

Puerto Rico’s Pension Obligations May Lead to US-Style Bankruptcy

Puerto Rico may not have statehood status, but it’s picking up some of the United States’ habits. Lately, that means weighing bankruptcy. And, like the United States, ballooning pension obligations are a major reason Puerto Rico is wearing the proverbial fiscal handcuffs.

From Reuters:

Momentum is building toward a deal that would make painful losses inevitable for investors holding about $20 billion in bonds issued by Puerto Rico’s highway, water and electricity authorities even as some big U.S. mutual funds launch a legal battle to squelch a new law that authorizes a restructuring.

The Puerto Rican government and most of its creditors have hired U.S.-based bankruptcy experts to advise them through the Caribbean island’s efforts to solve its debt problem, and the resolution figures to look a lot like a U.S.-style bankruptcy.

The crisis came to a head late last month when Governor Alejandro Garcia Padilla pushed through the Public Corporations Debt Enforcement and Recovery Act to create a bankruptcy-like process for restructuring the debt of commonwealth-run corporations.

This isn’t coming out of nowhere; the writing has been on the wall recently. Just two weeks ago, Fitch downgraded a number of Puerto Rico’s bonds. From a Fitch press release via Business Wire:

Puerto Rico’s bonded debt levels and unfunded pension liabilities are very high relative to U.S. states, with a large amount of outstanding debt issued for deficit financing purposes. Pension funding will remain exceptionally low even with the significant pension reform effort undertaken by the current administration, and the April 2014 Puerto Rico Supreme Court decision finding recent reforms of the teachers’ retirement system unconstitutional presented the administration with yet another challenge. The Commonwealth has stated in the past that without reform the teachers retirement system would confront an annual cash flow deficit beginning in fiscal 2020.

Puerto Rico tried earlier this year to reform its teacher pension system, which is set to run out of money by 2020. The Island passed a law that increased retirement ages and employee contributions, while mandating that the system adopt more 401(k) qualities. But a court struck down the law in April.

Is S&P Downplaying the Instability of Local Governments Saddled With Pension Obligation?

Local governments around the country are increasingly saddled with mounting debts due to outstanding pension obligations. So why are many of them seeing boosts in their credit ratings?

At least one credit analyst is wondering aloud whether rating agencies –specifically, S&P– are purposely downplaying the risk of investing with local governments. From Governing:

Since last fall, when S&P released new scoring criteria, the agency has been reassessing ratings for thousands of local governments. Generally, and as predicted by S&P itself, the new criteria resulted in more upgrades of governments than downgrades. But a Janney Montgomery Scott analyst pointed out in his July note on the bond market that those changes have not put S&P’s ratings more in line with competitors Moody’s Investors Service and Fitch Ratings.

In some cases, rather, agencies’ ratings scores for the same local governments have diverged even more.

“I do not remember a time when I saw so many credits with not just a one-or-so-notch difference here and there, but multiple-notch differences in some cases,” said Tom Kozlik, the analyst who wrote the note. “This is not part of the typical ratings cycle (where sometimes one rating agency is a little higher and vice versa, I suspect). As a result, I expect that rating shopping could be on the rise if the current trend continues.”

In other words, the fear is that S&P is going easy on local governments in hopes that those governments will prioritize S&P’s rating services over those of its main competitors, Moody’s and Fitch. If a government published only its highest rating, it can mislead investors as to the risk of an investment. And, that appears to be exactly what is happening. From Governing:

There has been a pattern of governments only publishing an S&P rating. In June, for example, there were a little more than 200 local governments that sold debt competitively. Of those, one-quarter of them only published an S&P rating, according to Kozlik’s review. Another 11 governments only published an S&P rating but also had an outstanding Moody’s rating within the past three years (Kozlik dismisses 16 cases where the outstanding Moody’s rating is prior to 2011).

Like S&P, Moody’s has also revamped its ratings criteria in the wake of the financial crisis, however changes have mostly focused on giving pension and other long-term liabilities more weight in the final score. Most local government pension liabilities shot up during the financial crisis and many have still not gained back much – if any – ground. This change has contributed to Moody’s issuing more downgrades.

S&P has been quick to defend their ratings. The man behind the ratings change talked to Governing about the controversy:

Jeff Previdi, the S&P managing director for local governments who spearheaded the agency’s criteria change, defended the process. He said that the criteria had been heavily tested and had gone through a public comment period. The new criteria scores municipalities in seven categories: management, economy, budgetary flexibility, institutional framework (governance), budgetary performance, liquidity and debt/liabilities. The score for economy counts for 30 percent of the total score; all other categories are given a 10 percent weight.

The intent was to make the process and scoring as transparent as possible, Previdi said. Additionally, he added, the upgrades have tended to outpace downgrades for a very simple reason: Governments are doing better now than when they were last assessed.

“When we are reviewing under the new criteria, we’re not working with the same metrics of the old criteria,” he said. “It’s not done in a vacuum. Over this time we’ve been in a generally positive environment for local governments — that’s informing some of the results you see.”

While S&P is upgrading many local governments, Moody’s has been doing the opposite: the agency has issued twice as many downgrades as upgrades, according to Kozlik.