Rating the Ratings
For many issuers, going to market without insurance is unappetizing. But that may be changing.
The number of rock-solid, AAA-rated municipal bond insurers is thinning, insurance premiums are rising and, among issuers and investors alike, doubts are being raised about the protection that bond insurance provides. This is a big deal in a market where about one-half of the bond deals carry insurance. For many issuers, the prospect of going to market on the basis of their own underlying credit ratings is unappetizing. But should it be?
Credit ratings are widely accepted as independent estimations of how likely debtors are to pay their obligations on time and in full. These opinions, which look at a host of factors, are boiled down into letter grades that give comparative rank to the investment quality of debt. The highest category of quality is AAA and from that apex, there is a sequence of grades down to various levels of default (the catastrophic C and the dismal D at the bottom of the scale). The ratings have become deeply ingrained in the panoply of regulatory requirements covering banks and investment funds. They're also written into private contracts.
There's no conspiracy here. The demands of far-flung financial markets have fostered the use of ratings as a matter of convenience and economy: Individual investors, mutual funds and fiduciary institutional investors benefit by having a relatively simple, uniform way of "grading the eggs" that they want to put in their investment baskets -- and for judging the risk those baskets embody.
Three firms -- Moody's Investors Service, Standard & Poor's and Fitch Ratings -- dominate the credit-rating market, not only in the United States but globally as well. This dominance has been reinforced by the "nationally recognized agency" designation provided by the Securities and Exchange Commission, which registers the rating companies, but only lightly oversees their activities.
The municipal bond market, with its 12,000 to 13,000 new bond issues a year, has showcased the great utility and influence of the credit rating system. But there are some worrisome problems with credit ratings, which have lingered for years and now are surfacing. Let's start with some numbers.
In 2006 (the last year for which data are available), there were bond sales worth $387 billion. Of these, 90 percent carried ratings by the big-three firms. Rather amazingly, $227 billion were rated AAA, which amounts to two-thirds of all the ratings granted. But -- and here is the important point -- only $36 billion (about 16 percent) were "natural" AAAs -- that is, they were given the highest rating on their own credit merits. The vast bulk of the AAA-rated securities in the municipal market were insured or otherwise credit enhanced -- $191 billion or 84 percent of the total AAAs.
The insurers must know something that regular investors do not. The most important thing they know is that the sub-AAA credit ratings given to municipal issuers do not represent the same risk of default as they do for other borrowers. To be blunt: The credit ratings used in the U.S. municipal bond market do not correspond with those handed out in other markets.
According to a recent study by Municipal Market Advisors, cumulative default rates for bonds in the corporate sector have been 30 times higher in the "investment grade" category (bonds rated BBB or higher) than for those municipal bonds. In a nutshell, municipal issuers have been asked to jump over a bar that is set 30 times higher in achieving a particular rating grade when compared with their private-sector counterparts.
In a practical sense, this huge differential in the rating agencies' assessments of creditworthiness has meant that municipal credits have been a sitting duck for private bond insurance and other forms of credit enhancement. Bond insurance firms sold policies and collected premiums on bonds that had only an infinitesimal probability of defaulting. The problems for bond insurers came when the firms left this "backwoods" corner of the markets and began to insure the edgier and seemingly more profitable obligations of the taxable sector. Here, they learned -- to their ultimate regret -- that "investment grade" is a transitory concept and defaults much more likely.