Recent news that S&P might upgrade Delta Airlines (DAL) took me by surprise, to say the least.

I do not think S&P’s analysts are aware of Delta’s staggering $22.3 billion in off-balance sheet liabilities, which include $14.1 billion in underfunded pensions and $8.2 in operating leases. Does S&P remember what happened to American Airlines’ (AAMRQ.PK) last year? Its pensions were underfunded by $8.1 billion coming out of 2010, and it filed bankruptcy about 11 months later with its pensions underfunded by about $10 billion.

Note: this is not the first time that S&P’s ratings have made us wonder whether or not their analysts read footnotes. We regularly see S&P debt ratings that are way too positive for the analysts to be aware of the company’s off-balance sheet debt. In fact, we have developed our own debt rating system to override S&P’s ratings when they are so far off as to appear ridiculous to us.

Not only is Delta underfunding its pensions, it is understating, in my opinion, the cost of its pensions in earnings. Delta’s 2011 earnings would have been lat least $0.09 per share lwoer that if DAL had not chosen to use an abnormally high assumption for the expected return on the assets in its pension plan.

Here’s the scoop: DAL boosted its 2011 earnings by increasing its expected return on plan assets (“EROPA”) assumption for its pensions to 8.93%, up from 8.82% in 2010. Page 78 in DAL’s 2012 10-K filing has the details.

For readers who wonder whether 8.93% is abnormally high, the answer is yes. Out of the 1,021 companies with pensions that I cover, 98% of them have a lower EROPA. Only 96 of the 1,021 raised their EROPAs in 2012 while 525 lowered and 400 made no changes. In other words, DAL’s EROPA assumption is not only among the highest but it is also rising when the majority is falling.

Raising its EROPA in 2012 looks worse when compared to my estimates of the company’s actual return on plan assets. I estimate 2011’s actual return on plan assets was -0.6%. I estimate the average return since the company emerged from bankruptcy is between 1.5% and 3.8%. These estimates are based on dividing the “Actual (loss) gain on plan assets” by the “Fair value of plan assets at the beginning of the period”. I get that data from the company’s annual reports as detailed in the model used to calculate the actual return on plan assets, which is based on data from the 2011, 2010, 2009 and 2008 10-Ks.

I think S&P should be considering a downgrade not an upgrade. More details are in Bail Out of DAL Before the Stock Crashes.

Disclosure: I am short DAL.

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