The false equivalence of credit ratings

In a new report, Janney Capital Markets analyst Tom Kozlik calls out Standard & Poor’s for credit ratings on local governments that he says are too liberal. Kozlik claims that S&P is inflating ratings. I think his analysis is solid, but inconclusive given the size of his claim. Kozlik opens the door to more critical analysis of the comparability of ratings.

The Bond Buyer wrote:

Since S&P updated its criteria, it is more common for issuers to have ratings from S&P that are multiple notches higher than their ratings from Moody’s. ‘This leads us to believe that ratings shopping will continue, perhaps at an even faster pace than before,’ Kozlik wrote.

Ratings are opinions. There is nothing in federal law or the SEC rules that says one rater must be as conservative as another. Credit rating firms are free to analyze bond issuers however they want, as long as they disclose the methodology. Kozlik seems to believe, like most of the market, that raters should assign alphanumeric ratings in a standardized way to signal risk on an equal scale.

Issuers obviously want the highest rating possible so they can borrow money at the lowest cost. Investors want the opposite — for issuers to get critical ratings so they can get paid higher interest rates. Issuers often “shop” their ratings to find the best one.

There are ten raters that are officially “recognized” by the SEC to assign ratings. Four of these firms assign ratings for muniland (Fitch, Kroll, Moody’s and S&P).

The ‘new stable’ for local governments

Moody’s Ratings made a big sector call last week in its U.S. Public Finance outlook:

Moody’s Investors Service has revised its outlook for the US local governments to stable from negative as housing markets continue to stabilize, municipalities’ fund balances remain stable, and cities and school districts modify their expenses.

Moody’s has held a negative outlook on local governments for five years, so the outlook change was a big one. But it had some caveats:

Moody’s flawed estimate on public pension liabilities

As the debate continues over public pension funding levels, we have this headline from the Financial Times this week: “US States need $980 billion to fill pension gap, says Moody’s.” This is not exactly news. A number of studies, including ones from the Pew Trust and the Public Fund Survey, have identified a massive shortfall for public pension funds. In fact, the Pew Trust said that the shortfall in 2010 was $1.38 trillion, so perhaps we should be applauding state legislatures for improving the gap since then.

The shortfall numbers in these studies, to put it simply, are all over the place. There are many variables that go into these models, but the main factor that causes variation is the expected rate of return on the assets in the plans. The official assumed return on the assets that are held in trust to pay pension liabilities is 8 percent, according to the Public Fund Survey. Fiddling with this projected rate of return can cause swings in the amount of unfunded liabilities. The Moody’s study uses an unconventional assumption. According to the Adjustments to state pension liabilities document:

Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).

Moody’s provides criteria for U.S. Triple-A rating

The credit rating agency Moody’s is in a very delicate position. Its arch rival, Standard & Poor’s, was recently charged by the U.S. Department of Justice alleging that S&P committed mail and wire fraud by defrauding investors with faulty ratings. Moody’s was not charged, but there are a lot of questions about why it was left out of the investigation. At the same time, Moody’s is responsible for judging the creditworthiness of the U.S. government’s debt. There is little wonder that the rating agency is being very transparent in the benchmarks it is using.

Moody’s current rating for U.S. debt is Aaa (negative), which means that it could be downgraded. Unlike Paul Krugman and others who want the nation to issue more debt to attempt to spur economic activity, Moody’s wants the U.S. to reduce its debt-to-GDP ratio to improve its credit quality. In a detailed analysis, Steven A. Hess, Moody’s Senior Vice President, lays out what the agency is watching and the metrics it will use to judge the actions of Congress and the President.

First Hess describes how the recent tax increases on those earning $400,000 per year or more does not raise enough revenue to square up fiscal issues:

The downgrade grinder continues at Moody’s

Moody’s released a summary of its third-quarter rating actions today and the downgrade grinder continues to turn in muniland. Downgrades across U.S. public finance sectors totaled about $75 billion in the third quarter of 2012, with four issuers accounting for over 70% of the debt downgraded: The Port Authority of New York and New Jersey,  the Puerto Rico Sales Tax Financing Corporation, the Commonwealth of Pennsylvania and the Chicago O’Hare Airport Enterprise.

With the exception of heavily indebted Puerto Rico, the other three issuers are household names, and their weakening credit profile might surprise some people. Here is Moody’s rationale for downgrading the four issuers. You may start to see some patterns (emphasis mine):

Port Authority of New York and New Jersey – Consolidated bonds downgraded to Aa3/Stable from Aa2/Negative;  $18.2 billion of total debt affected.

Danville’s AAA disclosure

One of the most common complaints in muniland is over a lack of disclosure. Public officials often say too little too late about fiscal matters. That is why it was a pleasant surprise to come across the proactive response of Joseph Calabrigo, the town manager of Danville, California, to Moody’s announcement that it is reviewing credit ratings associated with lease-backed and/or general obligation debts issued by 32 cities in California.

Danville is a well-to-do town of 42,000 located about 30 miles east of San Francisco. The city has two sets of bonds outstanding that are included in the Moody’s review. These Certificates of Participation (COP) were issued  to acquire and construct public parking in the downtown area. In speaking about it, Calabrigo was separating the review of these bonds from the general credit quality of Danville, which is one notch higher at Aa1.

From the Danville town blog:

Danville has an overall credit rating of Aa1, as assigned by Moody’s.  This rating shows a strong credit profile and overall creditworthiness. The Town’s current Aa1 rating is not under review by Moody’s.

Moody’s muniland blacklist

Moody’s this week published a Special Comment (subscription required) that crystallizes a lot of the discussion regarding bankruptcies and defaults that has been going around muniland lately:

Recent decisions to seek bankruptcy protection by two large California cities – Stockton and San Bernardino – provide some indication that willingness to pay debt obligations may be eroding in the US municipal market. Although many municipalities have faced severe fiscal pressures since the start of financial crisis, only a handful of municipalities have chosen not to pay their debt.

Most of these municipalities have defaulted due to exposure to failing enterprises, such as a convention center, sports arena, or other project that was backed by a government until the project and related debt were left to falter. In contrast, Stockton and San Bernardino’s pursuit of bankruptcy are different and potentially more significant given that these defaults emanate not from enterprise risk but instead from stress on core government operations, notably high pension and other compensation costs and debt service.

The birds’-eye view of muniland

My Thomson Reuters colleague at Municipal Market Data, Daniel Berger, published an excellent report on the debt of the 40 poorest U.S. cities. His work is exclusively for MMD subscribers, but I excerpted the high-level part where he summarizes the general view the credit rating agencies have about municipalities. Here is what Dan had to say:


According to a recent report from Moody’s, the outlook for various… local governments remains negative. It cited a weak national economy and possible global risks to stock markets that could hurt state revenue. Another problem is the austerity measures of the federal government, which diminish any chance of more stimulus aid. This week Moody’s released the results of a default study of municipal bond issuers using default data from 1970 through 2011. They believe that revenue bonds will account for most of the troubled issuers and they foresee a “very small but growing number” of local government issuers defaulting on their debt.


Fitch has no single outlook for the local governments. However, localities face two big concerns. First, Fitch expects an inflation-adjusted 13% decline in property values. Taken together with the fact that assessments are catching up with previous declines, Fitch expects further declines in property tax revenues for local governments. These declines may pressure some local bonds.

Cutting the ratings agencies the tiniest bit of slack

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.

Does a downgrade cost anything?

The debt of the United States was downgraded by Standard & Poor’s several weeks ago, but the price of U.S. Treasuries have skyrocketed since then. This confuses many people because a baseline relationship in the fixed-income markets is that lower-rated, less-creditworthy bonds will be relatively cheap and investors will demand higher interest rates to compensate for additional risk.

To see this bond market truism, it’s much more instructive to look at the downgrade of the debt of New Jersey. Fitch lowered the state’s credit rating Wednesday citing heavy debt and benefit obligations. This followed downgrades by Moody’s and S&P earlier in the year. Municipal bond and credit default swap markets didn’t like this third downgrade and did what you would expect them to do: they required more yield in the case of cash bonds and more payment in the case of credit default swaps.

The graph above charts muni CDS prices for New Jersey (data supplied by Markit). You can see the move up in CDS prices began in June when Governor Christie and the state legislature made the final run to their agreement on the fiscal 2011 budget, which began on July 1. The uncertainty and contentiousness of the process must have spooked investors and dealers.

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