MuniLand

On Tuesday the SEC is holding a roundtable on credit ratings to address the ongoing question of ratings shopping. Rating shopping is when a bond issuer shops its deal to various credit rating agencies to see who will assign the highest rating. The rating agencies that will assign the best ratings are given the business and the rating fee. Here is how the SEC describes its event:

As previously announced, the roundtable will consist of three panels. The first panel will discuss the potential creation of a credit rating assignment system for asset-backed securities. The second panel will discuss the effectiveness of the SEC’s current system to encourage unsolicited ratings of asset-backed securities. The third panel will discuss other alternatives to the current issuer-pay business model in which the issuer selects and pays the firm it wants to provide credit ratings for its securities.

The possibility of a credit rating assignment system comes from legislation that Minnesota’s senator Al Franken inserted in Dodd-Frank. Franken’s law requires that the SEC study the feasibility of a bureau or panel that would assign a rating agency to rate an offering. Currently issuers choose which firms will rate their offering although for structured finance or asset-backed deals issuers must share the particulars of the new deal with all raters recognized by the SEC in that category. This is equivalent disclosure and something that I have advocated with the SEC since 2007 and Congress since 2008. It has slightly increased competition in rating structured finance securities as seen in the chart above although the size of the market has declined since 2007.

In theory the idea of a bureau that assigns rating agencies has much in it’s favor, but it goes against all the rest of the law related to credit ratings. Current law (Credit Rating Agency Reform Act of 2006) enshrines the principles of increasing transparency and competition for ratings. The Franken proposal moves in the opposite direction by narrowing the number of opinions on specific bond issue.

But maybe all of this is shooting in the wrong direction away from the real problems of rating asset-backed securities. Here is a comment from former Moody’s senior vice president William J Harrington made on a Financial Times story about the SEC Roundtable: 

It’s the season for credit rating default data. Credit rating agencies issue this data about bonds that defaulted, along with the ratings those bonds had been given. Investors can use this data to see how much default risk they assume when they purchase bonds rated AAA or A or B. It’s a quantitative risk road map for bonds.

The SEC wrote a series of rules that require that raters make this data available to the public. 90 days after the end of the year the data must be placed on the rater’s website. The rating agencies rarely used to publish these statistics for the municipal market (although corporate bond default data was published every year).

Fitch Ratings is the first out of the gate with its ‘quantitative’ measures of default risk. You can see the basic data in the chart above (or page 12, requires registration, which is free). The SEC requires that the rater track how often variously rated bonds default over a 1, 3 and 10-year period. You can see in the table that there were no defaults for Fitch-rated muni bonds until all the way down the scale to A- bonds that had been issued 2-years earlier. Defaults are rare in the Fitch-rated universe. Here is the proof.

The long awaited prosecution against a U.S. credit rating has finally arrived. The Department of Justice filed a civil suit this week alleging that Standard & Poor’s committed mail and wire fraud and defrauded investors with ratings of residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs). These securities are known in regulatory and market parlance as “asset backed securities” because loans or bonds are bundled into larger, more complex securities. Until this market collapsed in the 2008 financial crisis, it was the source of great profits for banks, investors and credit rating agencies. It also accelerated the collapse of the financial system as the securities were sold around the world to increasingly less sophisticated investors.

At the core of the allegations against S&P is that the ratings agency loosened its methodology to get more market share from Moody’s and Fitch, the other dominant raters. Bloomberg writes:

In 2004, S&P discussed changing its rating criteria as executives internally raised concerns about losing deals to competitors.

The state of Illinois was placed in the lower investment grade class last week when Standard & Poor’s downgraded the state to A- with a negative outlook.

Fitch

Moody’s

Standard & Poors

A  [negative watch]

A2  [Negative outlook]

A -  [Negative outlook]

On a market-based scale, the Fitch (A) and Moody’s (A2) ratings for Illinois are considered equivalent, while Standard & Poor’s is considered one notch lower. But more importantly, all the raters have a “negative watch or outlook” on the state. This means that it could be downgraded again. The ship is taking on water.

There are several reasons why raters view Illinois so negatively. The state’s spending is way out of line with its revenue and its deficit is about 25 percent of its annual budget. Unlike the federal government, Illinois cannot endlessly issue new bonds to cover annual shortfalls. Instead, the state simply delays paying its bills from year to year. From S&P’s rating action:

Moody’s released it’s long awaited opinion of Assured Guaranty’s creditworthiness on January 17th. Moody’s analysts were not feeling good about the subsidiary that insures the bonds of municipalities. They pushed the rating down three notches from Aa3 to A2. The Bond Buyer noted that “fundamental challenges inherent in the business model make a return to the Aa rating level unlikely.” Zap and you are dead.

In the municipal bond insurance space, firms make money by insuring (or wrapping) bonds of communities or public entities that have lower credit ratings. This saves money for the entity issuing the bonds because it has a lower cost of borrowing and the insurer is guaranteeing that they will repay investors if the bonds default. It also benefits the investors who know that they will be made whole if the issuer cannot make payments on their bonds.

However, when a bond insurer’s rating is lowered, that means the pool of bonds it can insure shrinks because many new bonds have higher credit ratings. Assured now has a lower credit rating than most bonds being brought to market.

The SEC is out with its second annual examination of “Nationally Recognized Statistical Rating Organizations,” otherwise known as credit rating agencies. A little known 2006 law, the Credit Rating Agency Reform Act, gave broad authority to the SEC to inspect raters as if they were broker dealers, and is what empowers the SEC to annually inspect raters. According to the law, raters must:

[M]ake certain public disclosures, make and retain certain records, furnish certain financial reports to the Commission, establish and enforce procedures to manage the handling of material non-public information, and disclose and manage conflicts of interest. The Commission’s rules also prohibit an NRSRO from having certain conflicts of interest and engaging in certain unfair, abusive, or otherwise coercive practices.

In other words raters must follow the rules, keep very good records and undergo something akin to an annual proctology exam by the SEC. Rating crimes were committed in the past and now the police are on the scene.

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.”

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.

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 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.