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from MuniLand:

Does the market trust corporate issuers more?

Darrell Preston of Bloomberg News wrote a great piece comparing the yields on trades of comparably rated corporate and municipal bonds. He highlighted that corporate bonds have a much higher risk of default than municipal bonds but have similar yields. His analysis suggests that risk is not being properly priced if in fact ratings between asset classes are comparable and that municipal issuers are paying interest rates that are too high.

Two years after Moody’s Investors Service and Fitch Ratings changed standards to put municipal credits on the same footing as corporates, California and Illinois are among states that still pay more for debt than similarly or lower-rated corporations, according to data compiled by Bloomberg. Yet Moody’s says companies default at 86 times the municipal rate.

“Taxpayers continue to get a raw deal,” said Tom Dresslar, spokesman for California Treasurer Bill Lockyer, who pressed for the rating changes. “Not much has changed.”

Preston's article compares the yield for recent trades for the state of California and a private energy producer, which are rated at near-equivalent levels:

When California and A2 rated Idaho Power both sold 30-year debt this month, the utility’s bonds priced 6 basis points lower than California’s ... according to data compiled by Bloomberg. The Boise company provides electricity for southern Idaho and eastern Oregon. The state is rated one step higher at A1 and offers tax-exempt securities to provide an incentive to investors to accept a lower yield.

Preston's article addresses one of the most fundamental issues of the fixed-income markets. If credit rating agencies are doing their job accurately and rating bonds with similar risk at the same rating category, why is the market pricing the debt as if they are different?

Bob Nelson, who leads Thomson Reuters Municipal Market Data group responded to Preston's article in a tweet of less than 140 characters:

Bob Nelson  @BNels22 you can blame tax-exemption, serial bond structure, poor disclosure for #muniland yield disparity http://bloom.bg/IaZB8t

from Breakingviews:

Moody’s shows UK needs more austerity, not less

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

How cruel. Moody’s is threatening to dump the UK’s triple-A rating. Its justification – “materially weaker growth prospects” – has been seized by the government’s opponents to attack spending cuts. But Moody’s warning is in reality a Valentine to austerity. George Osborne, the UK Chancellor, really does need to continue his policy of tough love.

The UK’s big problem, half forgotten amid the euro crisis, is that its fiscal deficit, at over 8 percent of GDP, is double the average for the euro area, where only Greece and Ireland have a bigger gap. That government cuts have wounded growth in the short term is true. But how much deficit-spending do the critics want? This year, if the cuts go according to plan, the government will still spend 120 billion pounds more than it takes in taxes. That would normally be considered pump-priming on a heroic scale.

The risk for the UK is that if the huge deficit is not brought down fast, government debt will become problematic. At present it amounts to 64 percent of GDP which, at half Italy’s level, looks rather good. But the Office for Budget Responsibility, the government’s fiscal watchdog, forecasts a rise in the debt to GDP ratio to 78 percent in 2014-15, even if the government sticks to its policies.

The real policy dilemma would come if cuts were to send the UK into deep recession – as has happened in the euro zone periphery. But fortunately that doesn’t seem likely. Current data point to stabilisation. The prospect is for a pickup in growth later this year. An easing of inflation, down to 3.6 percent in January from 4.2 percent in December, will help. Britons’ earnings are not set to be eroded as swiftly as before.

Moody’s growth warning may be overdone. And provided the government sticks to the task of aggressively reducing its deficit – so-called “Plan A” – the country will remain highly creditworthy. That is how the markets, buying UK 10-year bonds for a yield of just 2.2 percent, see it for now. Of course, the Bank of England’s abundant money printing and debt purchases are a factor in those low yields. But they wouldn’t stay low if markets saw the government unveiling a cuddlier side.

from Breakingviews:

France is capable of wasting a good ratings crisis

By Pierre Briançon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

France’s two main political parties have greeted the long-expected Standard & Poor’s ratings downgrade in a depressingly familiar way. The socialist presidential candidate Francois Hollande said that it was Nicolas Sarkozy’s policies, not France, which was downgraded. In return, the French prime minister Francois Fillon suggested Hollande submit his electoral platform to S&P for evaluation. Bickering and escapism are the order of the day, and France is on track to waste what could have been a good ratings crisis.

The downgrade’s consequences will be mostly political and diplomatic. France’s pride will be hurt more than its finances, and its ability to negotiate on equal terms with euro zone über-leader Germany is gone. The country’s sovereign bond yields didn’t move on the S&P decision. First because it had already been priced in, second because French bonds have benefited from investors’ flight to safety since the onset of the debt crisis – the 3.2 percent yield on 10-year paper is still 60 basis points lower than it was in January, 2010.

Still, the downgrade could have been seen by French politicians of all stripes as an opportunity to focus on the country’s economic problems and its poor growth prospects. France is not only falling behind Germany. Once Mario Monti unveils his long-term reform plans, as early as this week, Italy may have a more potent growth-booster.

But instead of laying out their plans for reform, France’s political camps are simply sparring over the right type of austerity. Sarkozy, who foolishly cut taxes five years ago, wants spending freezes. Hollande goes for the old soak-the-rich approach, which he sees as a way to court the radicalised left’s votes in the May presidential election.

After a 37-year uninterrupted string of budget deficits, there’s no doubt that France needs fiscal discipline at last. But unless it undertakes serious reforms, it will be condemned to a death spiral of austerity-fuelled recessions. If none of the main candidates can articulate a clear rationale and a credible plan for economic change, expect a destructively strong showing from extreme parties of left and right in the elections. Then Spring in Paris won’t be pretty.

from Breakingviews:

Stalling German motor is Europe’s other difficulty

By Ian Campbell The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

There’s no downgrading Germany. Standard and Poor’s spared the country in its Friday attack on European sovereigns. No wonder – the German fiscal deficit came in at just 1 percent of GDP in 2011. But Germany is a big problem in another way. Its motor has just stalled again. The euro zone needs growth. Germany, its power plant, can’t even propel itself.

The latest stall is typical. In the fourth quarter the German economy probably contracted by about 0.25 percent, the statistics office admitted last week. And yet the engine had recently appeared to be humming. German GDP grew by 3 percent in 2011, the statistics office said. But consumer spending’s best rise in five years was of a meagre 1.5 percent.

The German problem remains the same. Its engine remains reliant on foreign gas and lacks dynamism of its own. In 2010 trade supplied 1.5 percentage points of 3.7 percent growth and in 2011 0.8 percent of 3 percent growth. When foreigners are buying, all Germany’s lights are green. German companies invest in machinery and equipment – which rose by 8.3 percent in 2011, supplying 0.6 percentage points of overall GDP growth. But now that consumers in the euro zone, eastern Europe and around the world aren’t buying so readily, Germany immediately stalls.

For Germany itself that is not disastrous. Unemployment, at 6.8 percent, is the best since 1991. Being locked into the euro has suited Germany. The deutschmark, if it existed now, would have soared in the midst of European fiscal crisis just as its new proxy, the Swiss franc, has. That would have hurt German exports but helped the competitiveness of the rest of Europe. Now the compensating mechanism is gone.

There have been calls for the German government to help in a different way by stimulating growth. But that would go against German fiscal conservatism. And the consumers in a shrinking and ageing population prefer to save, not spend. Immigration, which might bolster spending and growth, also goes against the grain.

There is no easy way to speed Germany’s slow growth. Germany itself doesn’t even seem to see the big problem.

from Breakingviews:

Euro zone’s New Year hopes hit triple downer

By Neil Unmack The author is a Reuters Breakingviews columnist. The opinions expressed are his own

European governments have suffered a triple setback. Standard & Poor’s has stripped France and Austria of their triple-A ratings, and cut Italy to the same level as Ireland. Greek debt talks have broken down, while the European Central Bank has criticised the region’s fiscal pact. After a brief lull, the euro zone’s sovereign debt crisis is back with a vengeance.

The S&P downgrades had been widely anticipated and were less severe than some feared: Germany kept its triple-A rating. Investors have taken the news in their stride: yields on French and Italian 10-year bonds actually fell on the morning of Jan. 16.

Nevertheless, with France and Austria stripped of their top status, the European Financial Stability Facility will struggle to keep its triple-A rating, pushing up funding costs for future rescues. Alternatively, the bailout fund will have to shrink, reducing the euro zone’s crisis-fighting resources. Italy’s lowly rating – S&P now has the country just three steps above junk – will keep funding costs high for its banks and companies.

The decision by Greek bondholders to call off talks over a deal to cut in half 200 billion euros of private debt is also worrying. As the debt swap is a precondition for Greece’s second bailout, the impasse raises the risk of a disorderly default. Even if a deal can be salvaged, Greece’s bailout costs are rising: according to the country’s finance minister, Greek banks will need 40 billion euros in additional capital to counteract a worrying deposit run.

The euro zone could handle the downgrades and a Greek default if it had a compelling plan. But the current scheme has flaws. As S&P pointed out, economic policies that emphasise austerity can be self-defeating. And even this commitment to austerity, enshrined in a “fiscal compact” last December, could be under threat. Joerg Asmussen, an ECB executive board member, has criticised the draft treaty implementing the compact, arguing that it is too easy for governments to breach fiscal rules.

These are not fresh concerns. But after period during which cheap three-year loans to banks from the ECB helped to support Italian and Spanish bond yields, and equity markets rallied, euro zone governments might have believed the crisis was easing a bit. Any optimism emerging from the New Year festivities has now been dashed.

from MuniLand:

How risky is that rating?

The Municipal Securities Rulemaking Board's data platform for municipal bonds, EMMA, recently added credit ratings from Fitch and Standard & Poors to the system. This makes it really simple for investors to get a snapshot of the relative risk of one bond over another when doing research.

Typically the higher the rating, the lower the likelihood that a bond will default. New rules issued in 2008 for credit rating agencies required them to disclose the quantitative results of their ratings and show over time how many bonds defaulted in each rating category. This allows investors to map the performance of ratings over time and allows comparisons between agencies. The system looks at the occurrence of default 1, 3 and 10 years after the bond was issued.

The SEC views default statistics as a window into the accuracy of credit rating agencies' analysis. Raters are required to publish this data, separated into bond classifications, on an annual basis on SEC Form NRSRO (Fitch's 2011 NRSRO). I published the comparable data for municipal bonds from Standard & Poors in August. The two raters are broadly similar but not identical.

Investing in municipal bonds does have risk. Looking at default data is the best way to understand how much.

Fitch Ratings One-, Three-, and 10-Year Default Rates By Rating Modifier for Public Finance (%) 2010

from MuniLand:

How Jefferson County trips up national reporters

The New York Times really needs to improve the quality of its reporting on the municipal bond market. Mary Williams Walsh makes such a terrible hash of the situation in Jefferson County, Alabama, that she is bound to set off another muniland hysteria in the mold of Meredith Whitney.

In the opening paragraphs, Walsh contends that general obligation bonds (GO) issued by state and local governments and with the pledge of their "full faith and credit" may not be as creditworthy as always assumed. About half of the $3.7 trillion municipal bond market is general obligation bonds. She dramatically states that investors who own GO bonds might be in for a "surprise:"

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

What goes unmentioned is that the halted debt repayment is happening in the context of an insolvent county in bankruptcy. More importantly, general obligations bonds can be very high-quality from a strong issuer with top credit ratings, or they could be very low-quality from a near-insolvent municipality with the lowest possible credit ratings. The type of the bond is no assurance of ability to repay bondholders.

The point of a municipality seeking bankruptcy court protection is to halt the legal actions of creditors, including GO bondholders. This gives debtors time and a safe space to reorganize their finances. It's not in any way "breaking with convention" to halt paying GO bondholders in bankruptcy.

The U.S. Federal Court system's bankruptcy guide (page 49) describes Chapter 9 municipal bankruptcy:

The purpose of chapter 9 is to provide a financially-distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.

from Breakingviews:

France isn’t ready for recession

By Pierre Briançon The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

France may pay a heavy price for 37 uninterrupted years of budget deficits. Even after two significant rounds of fiscal tightening in the last three months, the government may fall short of its goal of shrinking the deficit to the euro zone-imposed limit of 3 percent by 2013. Markets are already impatient with the country’s half-hearted approach to tackling its structural primary budget deficit. They are likely to become harsher if high government bond yields across the monetary union tip the region’s economy into a recession next year.

Even without a recession, the government should adjust its plans, which assume 1 percent GDP growth in 2012. The European Commission predicts a 0.6 percent increase, at best. Ironically, euro zone heads decided at their summit last month that budget plans should be based on independent forecasts. France is missing a chance to lead by example.

A full-blown recession would make the challenge much greater. France, like all welfare states, has many “stabilisers” in its budget. Higher benefits and lower taxes help soften the economic blow, but add to the fiscal pressure. HSBC reckons that a 1 percent decline in French GDP in 2012 would increase the budget deficit from 5.8 percent of GDP in 2011 to 5.9 in 2012 – and a still too-high 5 percent in 2013.

French politicians should be preparing for the worst, but they do not seem to take the 3 percent of GDP target seriously. They are using the April presidential election to play politics rather than to face reality. Nicolas Sarkozy, the unpopular incumbent, doesn’t want to add to his latest austerity plan, and socialist contender Francois Hollande is doing everything he can to avoid mentioning painful options.

Both men say they want to keep the country’s triple-A rating; its loss would add up to three billion euros a year to the interest bill, according the chief of the French government’s debt agency. Voters and investors should force the contenders to explain exactly what type of rigor they are thinking about – if only to find out that they aren’t thinking at all.

from MuniLand:

Muniland’s dynamic living entities

This is an absolutely perfect muniland discussion between Matt Fabian of Municipal Market Advisors, Tom Keene of Bloomberg Television and David Kotok, chief investment officer at Cumberland Advisors. For people unfamiliar with the muni market it really shows how fluid and dynamic conditions are for state and local issuers. It's really worth listening to several times.

Matt Fabian is one of muniland's brightest stars and really does an excellent job debunking some common myths about muniland. For example, some predicted there would be hundreds of billions of dollars lost in municipal defaults this year; so far there has been $1.2 billion. For a year Fabian has been saying we would not have a lot of defaults.

It's at minute mark 6:50, though, where I would challenge Fabian. Contrary to conventional wisdom, as well as the signals from credit ratings and credit-default swaps, he says he would buy the state bonds of California and Illinois. These two are considered some of the worst of state issuers with very heavy debt burdens. Fabian's rationale is that there are "structural protections for bondholders," meaning that state law has deemed interest and principal payments to bondholders more important than any other payments the state is required to make.

But the thing I wonder about and would challenge Fabian on is the increasing use of bank loans by state and local borrowers. For example in July of this year California borrowed $5.4 billion as a bridge loan from Wall Street in case the federal government shut down and halted payments to states. California quickly repaid the loan and they have done a good job of disclosing the terms of their borrowing. Nevertheless, states and municipalities have no legal requirement to disclose these borrowings. They are really off balance sheet, at least until their annual audited financial statements are filed, which can mean a delay of a year or more. The MSRB has been examining muni bank loans and has asked the SEC for more guidance. From Bloomberg:

Officials with the Municipal Securities Rulemaking Board, which writes regulations for the $2.9 trillion tax-exempt bond market, have discussed the issue with the Securities and Exchange Commission, Alan Polsky, chairman of the MSRB, said on a conference call with reporters today.

“The SEC and the MSRB are both concerned about bank loans,” Polsky said.

Standard & Poor’s in July estimated that municipalities may borrow as much as $75 billion from banks this year, while Fitch Ratings has also said localities should disclose information about such direct deals with banks. The MSRB, based in Alexandria, Virginia, said in August that loans could fall under some securities rules. It is urging the SEC to weigh in on the matter.

The loans may leave investors unaware about rising debt obligations that could affect their credit ratings, Polsky said.

So Fabian is right to reference "structural protections" for bond payments. But it's the dark, unknown borrowing that might have more seniority that we don't know about.

from MuniLand:

Cutting the ratings agencies the tiniest bit of slack

http://www.youtube.com/watch?v=Bumfpo4FW0I

After polluting the global financial system with hundreds of billions of dollars of overrated mortgage-backed securities and helping bring down the world economy, the credit rating agencies have been struggling mightily to repair their reputations. It's been an uphill climb, and they were dealt another blow on Friday when a Bloomberg piece detailed academic research showing how fees influenced the assignment of higher ratings. Municipal issuers got the harshest ratings because they paid the lowest fees, according to the article.

Although higher fees definitely played a part in inflated ratings, I think there are a lot more powerful market forces at work than the study and article suggest. The academic study that the Bloomberg piece highlighted -- Jess Cornaggia, Kimberly Cornaggia and John Hund's “Credit ratings across asset classes: A ≡ A?” -- focused on 30 years of data from one rating agency, Moody's. From that data, the authors extrapolated the results to all the major raters. Here's what Bloomberg had to say:

While the study was based on Moody’s data, it would find about identical results with data from S&P and Fitch because each firm’s grades closely track each other, Cornaggia said in an Oct. 14 e-mail.

If you work around credit markets you realize that although raters can track each other, there are often "split ratings," or situations where the raters assign different levels to the same security or issuer. Another difference between the raters is that some move faster than others to downgrade. Fitch is typically known as the most aggressive rater in downgrading.

Practically every law and regulation that references credit ratings has a requirement for two ratings. If every rater were identical to the others, it would be redundant for laws to require two. The need for two ratings reflects the undesirability of relying on only one agency.

But put that all to the side for now. The biggest miss in the Corneggia study and the Bloomberg article is the behavior of issuers who "rating shop" and push the different agencies to inflate ratings. The Corneggia study essentially lays all the blame on the agencies for ratings inflation, but I'd suggest that the behavior of sophisticated issuers contributes a lot to the problem, too.  Here's what Columbia Law professor John Coffee told the Senate Banking Committee in September 2007: