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).

Credit ratings beyond the S&P case

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 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.

How risky is that rating?

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.

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.

Project Sugar has soured

Missouri has a sweet mess on its hands. A half-completed manufacturing facility, financed with industrial revenue bonds underwritten by the small municipality of Moberly, has gone bust.

The politics around the project, called Project Sugar, also appear very messy. Originated by the American and Chinese firm Mamtek, the project was shopped around to 13 communities without adequate due diligence by the Missouri state economic development agency. The SEC has issued subpoenas to most of the players in the project.

Maybe over-eagerness to create jobs in a hard-pressed area made so many public officials blind to the viability of Mamtek. On the other hand, maybe there is criminal wrongdoing. Project Sugar will surely become the poster child for improper use of municipal revenue bonds and the fallibility of government officials as they try to pick economic winners and losers.

The gusher of municipal bond information

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.

Political heat at S&P for ratings downgrades?

The Daily Show – What Are You Friggin’ Nuts Over There?


S&P replaces president after U.S. downgrade

The board of directors of McGraw-Hill met Monday and voted to oust Deven Sharma as president of their Standard & Poor’s rating division. This forced resignation comes approximately three weeks after S&P downgraded the debt of the United States. Jon Stewart, in the clip above, jokes about political pressure brought to bear on the company by the U.S. government. I think he is spot on with his humor.

Last week the U.S. Department of Justice just happened to discuss publicly an investigation of S&P and the other major raters about ratings assigned before the financial crisis to mortgage-backed securities, even though this investigation has been ongoing since 2009. Why the sudden need to reiterate this publicly? S&P’s downgrade was a brave action. It’s a pity that Deven Sharma has to pay for it with his job. As I wrote previously:

Standard & Poor’s took one of the bravest actions that I’ve ever seen a rater take when it downgraded the United States one notch. Furthermore, this marks a new beginning for accurate credit analysis and truth in fixed-income markets. Keep speaking the truth, S&P.

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.

Fitch gives USA its stamp of approval

Fitch leaves munis tied to U.S. rating at AAA, S&P downgrades

Fitch Ratings, one of the three major rating agencies and the one considered the most accurate by institutional investors, has affirmed the credit rating of the debt of the United States at AAA. As a follow-on to this action they have also maintained the AAA credit rating of municipal entities tied to U.S. Treasuries.

Going in the opposite direction, Standard & Poor’s downgraded the investment portfolio of the city of Los Angeles to AA+ because it holds 80% of its assets in U.S. Treasuries.  This follows S&P’s recent downgrade of U.S. Treasuries to AA+. The Bond Buyer reports what happened next:

Los Angeles has dropped Standard & Poor’s from rating its $7 billion investment portfolio after the agency downgraded it along with the United States last week.

  • # Editors & Key Contributors