Credit ratings are complex, a mix of hard numbers and impressionistic, if experienced, judgment. All three of the major rating agencies-- Moody's Investors Service, Standard & Poor's Corp. and Fitch--look at pretty much the same factors in assigning a government a rating: the local economy, financial performance and condition, the debt burden and structure, and managerial and political factors. No alchemy here. Each of the agencies has its own way of weighting the individual factors in coming up with a rating.
One thing the agencies are agreed upon is that the management factor- -how well governments plan for, execute and report their financial affairs--is becoming decisive in determining a rating. This new prominence for management has happened for a good reason: A weak economy, heavy debt loads and even poor financial condition have had no value in predicting where bond defaults would occur. The only significant credit difficulties that general governments have had have been due to bad management. The only general obligation bond default of consequence in the past 25 years was Orange County, California, which at the time was rated AA by the agencies. But it was unwittingly indulging in speculative investments, with no real oversight being exercised by its poorly informed and gullible elected officials.
Orange County was the exception that made the rule. If an otherwise very strong government could be laid low by bad management, while the vast multitude of supposedly weaker credits performed flawlessly, then maybe management is the most important factor of all. As a result, the rating agencies have been reconsidering the ratings of all general government issuers and generally raising them. Thus, a key to improving municipal ratings has been better management practices--an ability to plan ahead, to save and adjust to changing conditions. According to Steve Levine of Moody's, "Local governments have been more conservative with the largesse of the recent prosperity. They have not been adding to their fixed costs and are more sensitive to the long-term consequences of their actions."
A number of individual factors have been identified by the agencies as indicators of good management. Last year, both Standard & Poor's and Fitch published detailed explanations of the specific management factors they consider most important in making ratings.
At the top of both lists was the building up of reserves, especially rainy day funds that would be available if there was an unexpected downturn. Many states and localities have been diligent in this regard and, as a result, enter the current slowdown with a much stronger reserve position. In 1990 and 1991, the downturn was severe for both states and localities, as both income and sales taxes plummeted and, with a vengeance that made up for the lag, property taxes followed suit. This time around, fund balances are twice what they were 10 years ago, and states have amassed rainy day funds, many with "triggers" to govern a doling out of funds.
Also at the top of the agencies' lists of management factors are formal capital-improvement plans, debt-affordability analyses and multi-year financial plans. Undergoing the rigor of scheduling facility needs, determining how financing will affect debt ratios, and having plans of what to do if things don't work out are significant indices of strong management. The often voluminous documents that result may be doorstops to most people, but they are read and understood by the analysts. It's the self-improvement literature of finance: Governments can set their own mileposts, but the agency analysts keep score as to how often and well they are met.
This coming fiscal year will test management's response. When faced with declining current revenues, governments have four options. They can draw down fund balances, but blowing all the reserves at the first chilly blast is not good policy. They can reduce spending and postpone new programs until the fiscal situation clarifies itself. They can paper things over with one-shot revenues and financial juggling, but analysts are onto such tricks. Or they can indulge in short-term borrowing, but going into debt to cover an expected revenue shortfall is the credit analyst's secular equivalent to original sin.
In viewing management, the rating agencies realize that governments need to adjust to changing conditions. The important thing is not the incurring of an unexpected deficit. Rather, it is how, given fair warning that revenue intake is slowing, governments adjust. The next couple of months will be a huge test to see if the agencies are right- -that governments, as they adopt their fiscal year budgets, have become more sophisticated and realistic managers of their finances.
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