Guide to Municipal Finance
Credit Raters Make Their Mark
The governor was on the road when his cell phone rang. It was an urgent call from the state's deputy treasurer. The state, which was piling up deficits despite deep spending cuts, was about to be placed on the Moody's Watch List for a possible credit downgrade. The governor scurried home, rounded up a delegation of state leaders and headed for the rating company's offices. He wanted to persuade Moody's not to do anything precipitous--the state had been AAA rated for over 60 years. But he also wanted the delegation to see for itself the connection between the fate of the state's bond rating and the failure of a reluctant legislature to pass his budget proposals, which included the raising of taxes.
Such is the power and scope of the credit-rating system, where the summary opinions of a very few--the rating agencies--shape the markets for myriad debt obligations, including those of states and localities. Three rating agencies--Moody's Investors Service, Standard & Poor's and Fitch--hold sway as a priesthood of creditworthiness. By adding a plus or a minus to a rating or by going nuclear in changing a letter grade, they move markets, affect borrowing costs and influence the budgeting decisions of governments.
In a sense, they are the apotheosis of what competitive markets need to survive: purveyors of information that help make sense out of hundreds of thousands of bonds and other debt obligations in the market. They are powerful and their recipes for the ratings they assign are trade secrets. As the agencies themselves assert, they are only as good as their opinions. But, then again, theirs are pretty much the only opinions that count.
Ratings are so basic to the municipal bond market that no bond issuer of any size would think of going to market without one. Absence of a rating signals that something is very peculiar. The rating agencies, which use pretty much the same analytical techniques, agree more often than not on a grade. But the ratings are not always the same, and the agencies stress different factors in arriving at their opinions.
As they sort through the thousands of new bonds parading to market each year, the agencies measure each issuer's propensity toward financial difficulty by building files, making field trips and applying their proprietary methods for judging credit quality. Much of the analysis is based on lessons learned from the Great Depression, the last time that the state and local sector experienced wholesale defaults.
The general obligation credit rating of the state is of key importance, since if a state is downgraded, there is likely to be a cascading effect, leading to lower ratings among a multitude of downstream authorities and localities. The state possesses the ultimate financial power, and many localities depend on and pledge future state aid payments to service their debt. Thus, a rating agency will spend considerable energy to determine just how much debt within a state is dependent on state tax revenues. The willingness of a state to allow its credit rating to slip sends a signal to lenders that the state is beginning to slip down the rating slope to the final perdition of below-investment grade status--that is, below BBB rating, the last rung on the investment-grade ladder.
That was almost the case with the golden state of California. In the late 1990s, the tech boom brought a surge in revenues. Unfortunately, the state's spending mounted even faster. When the dot-com bubble burst, the state was running large deficits financed with an ever- expanding pool of $12 billion in short-term borrowing. In the summer of 2003, the credit rating agencies took action and sent the state's rating plummeting to BBB. After his election in October, Governor Arnold Schwarzenegger took to the streets and won passage of constitutional amendments that allowed the state to fund out its accumulated deficit with long-term bond issues. With that and the passage of some other initiatives, the rating agencies gave the state a fresh start. California climbed out of the rating basement to an A rating. But it remains shaky, since it's no secret that the state's budget continues to be "balanced" by borrowing.
Usually, it takes more time to recover from a BBB. The states of Louisiana and Massachusetts were sent there in the early 1990s, and it took them each nearly a decade to improve their ratings to A+ and AA-, respectively.
Most states manage to swim in the relatively placid pond of the prime grades. They are seen as presenting little risk of default. No state has yet to sink below BBB. In that nether land, bonds become junk and interest rates spiral.
WHAT'S A RATING WORTH?
State grades take a hit when there is an economic downturn: Revenues start to flag and deficits emerge, and it may take a while for a state to react to the satisfaction of the agencies--hence a lowering of the rating. More than prestige is involved. A downgrade costs an issuer money.
Today, around 10 basis points (or 1/10th of a percent) separate each of the top three letter grades. The gap is more pronounced in the BBB category, where there can be an additional 30 basis points. On a $100 million bond, that would mean a difference of $300,000 a year in interest payments between a single-A and a triple-B bond, but over a 10-year period, the cost would be a more startling $3 million.
That said, there aren't that many BBB issues around. Most creditworthy BBB issuers purchase bond insurance and that insurance catapults the credit into the AAA category, although insured bonds carry rates of interest that are more like those of natural A-rated bonds.
REVIEWING THE RATERS
The credit-rating agencies caught a lot of flack in the corporate bond market for not catching the declining fortunes or fraudulent behavior of several large companies, such as Enron and WorldCom. In the municipal bond market, there has generally been much less cause for concern about fumbling the ball on impending defaults. There have, fortunately, been precious few of them. Only the Orange County, California, default and bankruptcy of a decade ago blemishes an otherwise outstanding record among tax-supported municipal issuers.
In the muni-bond sector, the rating agencies are more likely to play the role of the cop on the beat, giving warnings to issuers that fail to balance their books or that plunge too heavily into debt. Of course, there are other varieties of tax-exempt bonds issued by special districts and various local agencies that represent much more risk and that are frequently not rated. In fact, the lack of ratings for the sub-prime category is seen as a real weakness in the muni-bond market. In other words, not all municipal bonds are beautiful by any means, but all those that are rated are pretty good looking--or they do not choose to be rated.
Wielding so much influence draws critics. While few dispute the favorable impact that ratings have on maintaining order in the markets, many complain about the oligopolistic nature of the business. The rating agencies have expanded their business lines, sometimes provide consulting services to the issuers they rate, and akin to the criticism that auditing companies got when they expanded into consulting, face questions regarding the potential for conflicts of interest.
Credit ratings, by their very nature, present a quandary for regulators. The ratings are provided by private firms, but their existence is supported by various state and federal laws--often the rating agencies are named in state laws and regulations. Investment contracts and loans are laced with references to them. For example, interest rates on loans to a government may be conditioned to the state or locality maintaining a specified minimum credit rating.
Usually, this type of "official" reliance calls for a certain amount of regulation. For example, accounting firms that provide corporate audits are supposed to follow the precepts of the Financial Accounting Standards Board, which carries the imprimatur of the Securities and Exchange Commission. The SEC has stepped--but only hesitatingly--into the credit-rating issue, since it is responsible under federal securities laws for certifying what is a "recognized rating agency." Thus far, Moody's, Standard & Poor's and Fitch (and two much smaller regional firms) have been so designated.
Being priests in the temple of capitalism is not easy work. The future is uncertain and mistaken prophecies can undermine authority. The rating agencies have their work cut out for them as they fend off regulation, avoid conflicts of interest and keep the muni market--and the governments they rate--humming.