What is not written about, but is much more important these days, is the quality of governance and the resulting "political risk" that underlies ratings. That is, what the owners and board of directors of the government--namely, the voters and elected officials--tell the finance managers to do and the resources they give them to do it. The issue of political risk is front-page news when it comes to the debt of foreign countries, such as Argentina and Brazil. Until now, the risks attached to sound governance have been vague and inferential in the United States. That may be changing.
The current severe travail in government finances is a test for the rating agencies as well as the governments. States are facing their biggest fiscal bust since the Great Depression, and local governments are likely to follow suit.
In the mid- to late-1990s, the agencies saw the fortunes of these governments flower and responded by granting widespread upgrades. Rating upgrades seemed not only justified by the absence of financial difficulties but by historical facts.
Over the past three years, each of the agencies has conducted studies that examined how many of the municipal bonds they rate have defaulted. There are several nuances in measuring a default, but the kind that matters most is when the borrower flat out stops paying debt service on time and in full. By that measure, tax-supported state and local debt (what we normally think of as general obligation debt) has an almost flawless record of repayment stretching over the past 60 years, making traditional G.O. debt virtually risk free.
There are some soft spots in the rating agencies' analysis of defaults, however. First, the default records that are reliable cover only bonds that have been rated. There is a stratum of unrated bonds that is much harder to measure. These bonds run the gamut from rock- ribbed, high-quality obligations that are small in size and locally held to large high-risk, private-purpose obligations that are very risky indeed but which qualify as "tax-exempt" securities. Since the issuers of these bonds disclose limited information after sale, their post-sale performance, including occurrences of default, remains a mystery--although it is undoubtedly much higher than that of tax- supported bonds.
The second soft spot in ratings goes back to the issue of political risk. What the agencies' default studies have demonstrated is that quantitative factors such as debt burden and local income and wealth have not been good predictors in the extremely rare defaults on tax- supported debt. Faced with this conundrum, the agencies began to ferret out what should explain differences in behavior. The answer arrived at, while smacking of a certain amount of circular reasoning, seems to be as follows: A better credit risk is a government that shows those characteristics providing reassurance that it manages its resources well and fully discloses its activities to investors.
The dilemma is that in a beauty contest where all the entrants are pretty, the judges must themselves decide what others should think constitutes beauty. Good financial management and disclosure practices seem to have taken the first prize in good times. And, such good habits once instilled should let us know when times are not so good.
These observations may seem fatuous, but they are not. The role of the rating agency, given the paucity of defaults among rated tax- supported bonds, has changed. The most risky bonds are not rated; they select themselves out of the beauty contest. Moreover, among those bonds that are rated, emphasis on good management means that the agencies are acknowledging the principal role that ratings now play. It is a beauty contest that distinguishes not so much quantitative measures of financial risk among the contestants but the relative esteem in which borrowers should be held by investors.
There is an important subtext to the good management criterion. While it seems to foster virtuous behavior in good times, its precepts are subject to violation when times turn sour. States and cities may plan ahead and keep their books clearly and accurately. But if they are saddled with volatile revenue systems and political leaders that neither cut spending nor raise taxes accordingly, they will see their ratings drop. Because of good management and reporting practices, the rating agencies will have an earlier and better read on the political risks. These governance factors will be the ultimate determinants of the credit ratings.
