MuniLand

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.

If municipal bonds lose their tax-exempt status, as some in the corridors of power in Washington are suggesting, municipalities will increasingly be competing with corporations for investors. As this competition intensifies, municipalities with poor accounting and disclosure practices could find it difficult attracting capital.

Let’s say you’re an investor looking to buy the bonds of either Goldman Sachs or New York City and to help guide your decision, you seek out their most recent financial statements. As a public company, Goldman Sachs is subject to the SEC’s disclosure regulations which mandate the filing of audited annual financial statements 60 days after the end of the year. If Goldman does not file within the 60 day window then the SEC has the authority to restrict certain simplified securities offerings and the New York Stock Exchange, which lists their securities, can take action too.

Contrast that with the Municipal Securities Rulemaking Board, New York’s regulator, which encourages municipalities to make public their audited statements, which are called CAFRs or Comprehensive Annual Financial Report within 120 days of the end of their fiscal year. Unlike the SEC, the MSRB has no authority to discipline issuers who file late, other than suggesting the municipality issue a notification of late filing.

Disclosure is the beat

On Tuesday at the SIFMA Muni Bond Summit in New York, much of the discussion by bond market participants related to transparency and disclosure issues. A lot of this was in response to new requirements in Dodd-Frank, but there was also an acknowledgement that many problems in the crisis of 2007-2009 came from a lack of information and data in many parts of the market. For example small municipal issuers had more trouble accessing the bond market to issue new bonds if their public reporting was deficient or out of date.

The heavy hitter of the bond summit was SEC Commissioner Elise Walter, who appeared by video link and broke news that the SEC would not ask Congress to overturn the Tower Amendment, a 1975 law that bars the SEC from interfering in the fiscal affairs of state and local governments. She discussed current legislation that would skirt the Tower Amendment and give the SEC authority to require municipal issuers to file disclosure, though it would grant no authority to review and approve those filings. From the Bond Buyer:

Walter repeated her call for Congress to increase the SEC’s authority so that it could set “baseline disclosure requirements.”

The municipal bond market is often thought of as complex and murky. This is understandable; after all, there are over 50,000 issuers of bonds and a million plus specific municipal-bond issues. It’s staggering to imagine so many different securities.

A specific bond issue can be as small as the $995,000 offer that the city of Moose Lake, MN has coming to market this week, or as big as last week’s jumbo-sized $10 billion “State of Texas Tax and Revenue Anticipation Notes, Series 2011A”. (The Texas notes mature in one year and are paying 2.50 percent interest — they’re hot as griddle cakes.)

Municipal bonds also come in many different shapes because there is very little standardization of structure among municipal bonds. A straight bond generally has a fixed interest rate, or yield, and a set maturity date, or time of repayment. But many municipal bonds have floating interest rates; many others can be called or refinanced when interest rates go down. Regulatory agencies like the MSRB or the SEC don’t require that bonds have a certain structure or feature, only that the details are fully and accurately disclosed.

The middle sadness

Paul Mason, the economics editor of the BBC’s Newsnight program, recently retraced John Steinbeck’s footsteps during America’s Great Depression.  What he found was a broad swath of sadness as he observed many citizens who have lost jobs and homes. It’s the invisible America. From the BBC:

I drop down into Albuquerque, into Joy Junction, which in the red dusk looks like a scene from Steinbeck. There are 300 homeless people staying here, all families.

Jeremy Reynalds, an expat Brit who runs the place, tells me frankly that the mainstay of the place are people with drug, alcohol and domestic violence issues. But as the years of crisis have dragged on, there is a new phenomenon – the homeless middle-class.

Singing the passion song

Kathleen Kennedy Townsend, the former lieutenant governor of Maryland, writes passionately in The Atlantic about the need to create jobs in the United States, especially those linked to infrastructure. I welcome her opinion as we need more passionate voices drawing attention to the need to stop outsourcing American jobs. We will never recover if we make economic decisions solely on the the basis of manufacturing costs. Ms. Townsend says:

As a country we have to decide what our values are. Do we really want to be a nation that funds our spending spree through the Chinese, who then make our goods and do our work while we go into debt and remain unemployed? Work is more important than saving tax dollars. Jobs are critical. Work, not an unemployment check, is what makes people feel they are worth something.

I hope the combined forces of politicians, the unions, and the Chamber [of Commerce] will eventually overcome the resistance to the infrastructure bank. We need to create jobs, and we need to rebuild our roads, railways, sewage, and water systems. Most of all, we need to revive our sense of energy and excitement — the deep fulfillment that comes of making things we can touch and feel, things that really improve our lives.

If you say “Jefferson County” to a professional in muniland, you will likely get a shudder of mild revulsion. This Alabama county is the biggest example of Wall Street aggression towards a public entity since Orange County, California declared bankruptcy in 1994 after buying too many interest-rate derivatives. Dodd-Frank, the financial-reform law that’s been in effect for a year, changed the rules for municipal bonds and derivatives.  But did it change them enough to avert a repeat scenario?

First, a little background: Jefferson County was ordered by the federal EPA to build a sewer system at an estimated cost of $1.2 billion. The construction went over budget and was rife with massive corruption that has ensnared 17 people. The funding of the sewer project was equally corrupt. JP Morgan was under investigation for bribery in 2009 and eventually reached a settlement with the SEC. The Washington Post reported this at the time:

J.P. Morgan Chase agreed to a $722 million settlement with federal regulators over accusations that the bank and two former executives made illegal payments to win municipal bond business from Jefferson County, Ala.

Can too-big-to-fail banks be restrained from engaging in fraudulent and manipulative practices? Or should we expect large, global banks to keep breaking the rules over and over again?

Today JP Morgan Securities reached a settlement with 25 state attorneys general and five federal regulators regarding their practice of using “sham bids” in the municipal market. The global bank will pay $211 million to settle federal and state charges, according to Reuters.

The details of the settlement are a little mind-numbing if you don’t follow muniland, but they mirror charges of “sham bids” in the auction-rate securities market that JP Morgan first settled in 2006. After violating that SEC’s “cease and desist” order, the bank had to settle for the second time with the North American Securities Administrators Association (NASAA), the Illinois Securities Department, the Florida Office of Financial Regulation and the New York Office of the Attorney Genera in 2008.

Quis custodiet ipsos custodes? Or “who watches the watchmen?” Credit-rating agencies are the main watchmen of the financial system.  But can we judge their performance, or are they just black holes filled with “opinions?”

The credit-rating agencies continue to make headlines as they try and keep pace with a slowly sinking Europe and the efforts there to rescue bondholders. European banks, the ECB, and officials from the EU are trying desperately to concoct some kind of structured investment vehicle that will solve the Greek sovereign debt crisis without requiring a default. So far, the rating agencies are not eating their “inventive” cooking, and they have yet to bless any new “solution.”

Many observers believe that credit raters completely mis-rated mortgage bonds and that this caused the global financial crisis. Meredith Whitney implies that credit raters are vastly underestimating the riskiness of municipal bonds and have overlooked pension and other liabilities when judging state and local governments’ creditworthiness. But do we have any statistical evidence of any this? Are credit raters getting the ratings wrong on every type of bond?

Green shoots?

Reuters reports on recent data from the U.S. Census Bureau that shows how tax revenues are improving:

State and local governments brought in record first-quarter revenues this year, according to a Census Bureau report released on Tuesday that offered a sign their budget crises may be abating.

Total state and local revenues for the first quarter reached $321 billion, a 4.7 percent rise from the first quarter of 2010 and the highest level on records going back to 1988. It marked “the sixth consecutive quarter of positive year-over-year growth,” the Census said.