Credit Rater Woes
Can new competition in the credit-rating arena reignite the municipal bond market?
The big three credit rating agencies -- Fitch, Moody's and Standard & Poor's -- are under siege. They messed up big time on rating collateralized debt obligations -- in particular, giving low-risk grades to mortgage-backed securities that eventually became worthless. Back in 2000, they failed to sniff out problems with Enron and, more recently, their role in rating Greek bonds has been somewhat suspect -- suspect enough that the European Commission may set up a competitive credit rating agency.
Now, Congress has hauled them into hearings to debate the hows and ways of changing the regulations under which they operate. Their fate is part of the financial reform bills that have been passed by the House and Senate, and are in the process of being reconciled.
The troubles the credit rating agencies -- CRAs -- have gotten themselves into are not only leading to more regulation, they have diminished the agencies' reputation as the gold-standard arbiters of credit ratings. While the actions that have caused the problems are far removed from anything taking place in the municipal bond market, the taint slops over. And that raises an important question for state and local governments: Will the sullied reputation of the CRAs affect issuers' capacity to borrow money?
It's a particularly relevant question today since bond insurance companies have, for all intents and purposes, disappeared from the scene. Five years ago, about 55 percent of muni bonds were issued with insurance; today only 11 percent carry such guarantees. Without the ability to buy triple-A ratings from an insurance company and without a gold-standard for credit ratings, where does that leave state and local governments who want to raise money in the capital markets? "To the extent investors don't believe ratings as well as they used to and have less faith in them," says Gary Witt, an associate professor at Temple University, "that makes people perceive the investing universe as more risky than before. I wouldn't think that would be good for municipal bond issuers."
There are those that argue that it won't matter if CRAs disappear, that institutional investors who are the big players do their own research. But households -- that is, individuals -- represents a significant chunk of muni bond ownership and that chunk is growing. In the first quarter of 2010, household ownership reached a high-water mark: Households own more than $1 trillion muni bonds for the first time ever.
"Markets need a credible third party to assess risk," says Scott Testa, an assistant professor of business at Cabrini College in Philadelphia. He doesn't see CRAs disappearing from the scene. The more likely scenario, he suggests, "is that they are going to be much more careful and possibly rate issuers lower than they have in the past because they are under pressure and scrutiny to do that."
CRAs have long had to register with the Securities and Exchange Commission but now Congress is doing what it can to increase SEC oversight. Witt, who used to be a structured-bond analyst for Moody's Investor Services, has been following the financial reform legislation as it moves through Congress. Based on his observations of testimony before the congressional committees, Witt sees three things the SEC needs to do to keep the CRAs credible. One is to define the standards -- but not the methodology -- for rating entities. Another is to measure and publicize the CRA's performance, and finally, a third is to impose fines for poor performance. Although most of the measures in the financial reform bill are aimed at rating problems with structured bonds (such as mortgage-backed securities), "these are general principles for any credit rating market," Witt says.
In 2006, Congress tried to inject more competition into the rating game. It passed a law encouraging the SEC to change the process of registering rating agencies so there would be more Nationally Recognized Statistical Rating Organizations. In 2008, the SEC granted the Egan-Jones Rating Company NRSRO status. Unlike existing CRAs, Egan-Jones is not paid by issuers but solely by institutional investors.
There's another budding upstart in the private sector. Kroll Bond Ratings Inc. will initially offer unpaid opinions on outstanding securities -- mainly U.S. home-loan debt. Kroll Bond Ratings is starting out by funding itself -- it is part of Kroll, the global risk consulting and investigation firm -- but plans eventually to charge debt issuers for its grades.
Ratings are also available from the National Association of Insurance Commissioners. NAIC's Securities Valuation Office (SVO) is responsible for the day-to-day credit quality assessment and valuation of securities owned by state-regulated insurance companies. According to the NAIC website, its "designations are not produced to aid the investment decision-making process and therefore are not suitable for use by anyone other than NAIC members." Nevertheless, Maine became the first state or locality to ask NAIC's SVO for a rating opinion on a new issue of municipal bonds. Maine's Treasurer David Lemoine has said that he hoped other state treasurers and municipal bond issuers would "begin seeking original-issue opinions from this nonprofit ratings service and that fixed-income investors beyond the insurance industry will come to recognize its value as a tool for judging default risks."
In long run, the rating-agency competition is likely to be a good thing for states and localities that want to borrow money for capital projects. Yes, it takes time for a new credit-rating entity to gain the confidence of investors. But that may be why newcomers are entering the field: investor confidence in existing CRAs is shaken. There's room for new players, and that can't hurt the muni bond market or its state and local issuers.
Heartening news from two of the hardest hit states:
In April, reports say that Arizona saw the first year-over-year gain in monthly tax collections since September 2007, with a 4.1 percent increase above the April 2009 level. Legislative analysts called this "evidence of the stabilization of the economy," along with April's increase in sales tax collections over 2009. That ends 26 months of year-over-year reduced sales tax collections.
In California, an economic brief released a few weeks ago by Comerica Bank suggests that the recession-depressed state could begin to outperform the nation next year, with the housing sector leading the way. The report notes that California home prices are rising while the inventory of mortgage foreclosures is dropping. "The odds are growing," wrote economist Dana Johnson in the research brief, "that later this year or early in 2011, the state will get a bigger boost from homebuilding and could begin outperforming national trends."
In addition, the Golden State's tally of tax receipts in May showed that general fund revenues were $592 million higher than expected, boosted by sharp jumps in personal and corporate income taxes.
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