Standardizing AAA

June 22, 2011

For many years, a AA-rated municipal bond did not have the same risk of default as a AA-rated corporate bond. In fact, the corporate bond was about 6 times more likely to default.

Over the last two years, credit rating agencies have standardized the municipal and corporate rating scales. This was a substantial change for the municipal bond market and had the effect of raising the credit rating of thousands of municipal issues. Many don’t understand why this large structural change was made, so I thought it would be helpful to share the history.

Many professionals within muniland have said that a substantial amount of “granularity” was lost in the municipal rating scale when it was equalized with the corporate bond scale. A municipal bond previously rated A2 was likely moved four notches up the rating scale to Aa1. This has the effect of “bunching” municipal ratings into a tighter band than they had previously been in, and it obscured the prior “granularity” that the muni scale had.

In May 2009 Congressman Michael Capuano, a Democrat representing the Eighth Congressional District of Massachusetts, introduced H.R. 2549 the Municipal Bond Fairness Act. Prior to joining Congress, Mr. Capuano served as mayor and alderman of Somerville, Massachusetts.

Congressman Capuano had direct experience dealing with credit rating agencies as a municipal borrower. He had worked to get the best rating and the lowest cost of borrowing he could for Somerville. He knew that a municipal security at the same rating level as a corporate security had a significantly lower risk of default. Because of this he had either to pay more to borrow or buy bond insurance to raise his town’s credit rating.

To overcome these market shortcomings the Congressman wrote legislation which required raters to “clearly define any rating symbol and apply it consistently.” Put simply a muni “AA” must have the same probability of default as a corporate “AA” from the same rating agency.

With the endorsement of Barney Frank, the House Financial Services Committee Chairman,the legislation got the credit rating agencies attention. On a voluntary basis Moody’s and Fitch re-rated substantial number of municipal bonds using a rating scale that reflected the same level of default risk as corporate securities. Standard and Poor’s maintained that they had always used one global scale for all asset classes.

In a Financial Service Committee hearing on May 21, 2009, Sean Egan of Egan-Jones Rating Agency said the following in his written testimony:

From a credit quality perspective, it has always been the case that public securities [municipal bonds] have both a low probability of default and an extremely low level of anticipated loss even in the event of default.

Hence, the probability of investors not receiving their payments on time and in full was minimal. Nevertheless, it is accurate to point out, as the Committee did in its Statement of May 14, 2009, that “municipal bonds with equal or lower default rates than corporate bonds have been given lower ratings by the major NRSROs.”

The standardization of the rating scales has been very important for issuers. It has mostly removed the need for bond insurance except among unrated securities. It has also made it easier for investors to make simple risk and return comparisons between corporate and muni bonds after adjusting for tax advantages. This will bring growing demand into the muni space.

The Securities and Exchange Commission is currently conducting a study whether they should require all credit rating agencies to standardize their rating symbols and the conditions under which ratings are determined (SEC Release No. 34-63573). This would have the effect of standardizing ratings between credit rating agencies. I believe that the SEC will not recommend to Congress that they impose standardized symbols on the rating agencies. You can see all the responses to the SEC including my comment here.

There remains one last and critical frontier for the standardization of ratings: the adoption of “equivalent disclosure” (ED). ED requires that an issuer share their material, non-public information with every rating agency recognized by the SEC in their asset class. As it is now an issuer can “ratings shop” to find the agencies who will give them the best rating. The SEC has adopted equivalent disclosure for structured finance products but not for corporate or municipal securities. By requiring issuers to share their information on an equivalant basis many more rating agencies could emerge because they would have the information they need to rate an issuer or security. These new agencies could easily be funded by investors rather than issuers or have any business model that made sense for the credit rating agency.

From Sean Egan’s testimony (emphasis mine):

The SEC currently has proposed that any issuer or other sponsor of a security seeking a credit rating from an NRSRO provide the same financial information given to a solicited NRSRO to all other NRSROs designated to offer ratings for that particular type of security. This would be true competition in that it would allow unsolicited NRSROs to issue pre-sale and ongoing reports to the investment community.

We have standardized corporate and municipal ratings.  Now let’s standardize the information flow that creates these ratings.

A version of this piece was previously published by Ipreo.


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As usual – a great article. Thanks for your great work.
B Almich / Raleigh

Posted by WYmuniguy | Report as abusive

The author states “The standardization of the rating scales has been very important for issuers. It has mostly removed the need for bond insurance except among unrated securities”

While bond insurance penetration in the muni world has dropped to very low levels, the standardization of ratings had little to do with this. Go back to 2005 and look at insurance penetration in muniland it was 70% or so. It was very common for highly Aa/AA rated issuers to buy bond insurance because there was value in obtaining the policy. The savings gained (lower borrowing costs with the insurance wrap) more than offset the premium paid for the bond insurance.

Fast forward to 2008 and 2009, the monoline bond insurers imploded due to MBS, CDOS and various other bad transactions which drove their corporate financial statements to ruin. The aftermath is one viable insurer (Assured Guaranty) who writes new business today, the penetration has dropped significantly because people don’t value the policy nearly as much and there is only one provider (Warren’s Buffett insurer hasn’t participated on any sizable scale).

Furthermore, the standardization was done by Moody’s in April 2010. Look back at insurance penetration and you will see it dropped dramatically in 2008 and 2009 as the insurer’s (MBIA, Ambac and FGIC) were downgraded from their Aaa/AAA pristine ratings to junk bond status, BB, B and CC levels.

Yes the need for insurance has been removed, but that is primarily due to the insurer’s disappeared as viable corporaions, not because of the standardization. The timing of the severe decline of insurance penetration simply doesn’t support the writer’s rationale.

Posted by rjfisher | Report as abusive

Credit Ratings Across Asset Classes: A ≡ A? bstract_id=1909091

Posted by Cate_Long | Report as abusive