MuniLand

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 American Taxpayer Relief Act (ATRA), passed on 1 January, was the first significant fiscal measure of the year. We expect the various tax measures in the act, including an increase in the income tax rate for individuals with annual income of $400,000 and above, to raise government revenue by more than $600 billion over the next 10 years. However, we do not expect this amount to be sufficient to ensure a decline in the ratio of federal government debt to GDP. The Congressional Budget Office (CBO), for example, projects that this ratio, after falling somewhat in the middle of the decade, will begin to rise again at the end of the decade. Therefore, further measures are required to ensure a downward debt trajectory.

Moody’s reminds us of how the basic procedures for developing a budget have not been followed:

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.

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 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.

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:

Moody’s

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

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.

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.

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.

More alarms are ringing in muniland today. Moody’s issued a statement announcing that it was putting on review five states which have Aaa ratings. Aaa is Moody’s highest rating, and the agency is concerned that knock-on effects from the federal government could weaken the ratings of these states.

I made this chart detailing the specific rationale Moody’s used for each state from the statement they released today. Note that states which have a large dependence on federal jobs and contracts dominate the list. ————– Sensitivity to natl trends Fed workers as % of employment Fed contracts as % of state GDP Medicaid as high % of budget Low rainy day fund Maryland *** *** New Mexico *** *** *** South Carolina *** *** *** Tennessee *** *** *** *** Virginia *** *** *** ***

Insurers have “manageable” muniland risk

Meredith Whitney has made many assertions about muniland, but the only one that I had not heard from others before she stepped onto the national stage was her contention that insurance companies would be forced to sell their municipal bonds into a declining price spiral. She alleged this would collapse muniland, so it’s very interesting to see Moody’s assess the risk for insurance industry. From Property Casualty 360:

Property and casualty insurers remain the most exposed sector among financial institutions to volatility within the municipal-bond market, holding about $355 billion in municipal bonds, but the overall level of risk should be manageable, Moody’s says.

In a Special Comment, Moody’s says municipal bonds represent 60 percent of the industry’s equity capital base, as measured by policyholders’ surplus. This figure is down from the prior year, when the industry held about $370 billion in municipal bonds, representing about 70 percent of policyholders’ surplus.

There is a very interesting class of municipals that you may not know about.

They are called “variable rate demand obligations” (VRDOs).

Moody’s estimates the market size at about $380 billion or 13% of the $3 trillion municipal market.

Moody’s issued a report today saying that this class of munis is finding its sea legs. This is good news for muniland. The health status of VRDOs was a big concern for market participants and Moody’s is cautiously optimistic.

VRDO’s are bonds issued with longer maturities (up to 30 years) that you can put back to the trustee or tender agent with a little notice.