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:
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.
Labor costs are local governments’ other big challenge. About two‐thirds of local government spending is for labor. The easy cuts to other sorts of spending have already been made. Governments might be considering gaining labor concessions. Decisions made related to labor costs will have the most impact this coming year on local governments’ financial situation. Whereas cuts to public safety previously were off the table, localities are now starting to consider that possibility. Meeting pension obligation gaps appears to be a bigger problem for local governments than it is for states.
Standard & Poor’s
According to an S&P report, most governments have started 2012 with far fewer resources than in the recent past. The report also discusses the role that liquidity continues to play in governments’ abilities to manage declining revenues. S&P does not expect “many defaults” and “even fewer are likely to occur among rated debt issuers.” However, this rating agency foresees the possibility of a greater divergence between strong and weaker credits emerging in 2012.
For the past two years S&P has consistently claimed to use its Global Rating Scale for municipal bonds. This week it announced changes in this methodology which will lead to the slight upgrade of nearly 3,800 (or about 1/3) of its outstanding municipal ratings. However, S&P refuses to call this a “recalibration.”
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.
Investing in municipal bonds does have risk. Looking at default data is the best way to understand how much.
Fitch Ratings One-, Three-, and 10-Year Default Rates By Rating Modifier for Public Finance (%) 2010
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.
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.
But put that all to the side for now. The biggest miss in the Corneggia study and the Bloomberg article is the behavior of issuers who “rating shop” and push the different agencies to inflate ratings. The Corneggia study essentially lays all the blame on the agencies for ratings inflation, but I’d suggest that the behavior of sophisticated issuers contributes a lot to the problem, too. Here’s what Columbia Law professor John Coffee told the Senate Banking Committee in September 2007:
In “Myth #13: It’s Best to Follow Expert Advice” of my book “Jackass Investing: Don’t do it. Profit from it.,” I recount the key role the credit ratings agencies played in causing the financial crisis of ’08. You can read that chapter using this complimentary link:
http://JackassInvesting.com/lookinside/l ookinside_myth_13-31.php
Mike Dever
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.
But the saga is not over; the Bond Buyer has the latest:
In the most recent development, the former chief executive officer of Mamtek has formed a new company and hopes to take over the project. The [bond] trustee is reviewing an agreement between the city and the new company, American Sucralose Manufacturing Inc., submitted last Tuesday. “The trustee is reviewing the implications of this agreement with its counsel,” the notice read.
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The trustee also reported that last Wednesday it learned Mamtek had assigned its assets to Development Specialists Inc. to be liquidated and distributed to creditors. The trustee is reviewing the “implications of this assignment,” it wrote.
So a principal from the soon-to-be-liquidated firm, Mamtek, has rushed off to form a new corporate entity and wants to continue the project supposedly by acquiring the assets of the bankrupt company. The AP adds that the principal investors of Mamtek formed the successor company.
It really doesn’t get much richer than this. The important question for Moberly taxpayers is who will pay off the bonds. Assuming that the reconfigured corporate entity can pull it off on the second round may be foolhardy. The project has almost $39 million of municipal bonds outstanding and it’s not clear who is going to make those bond payments.
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.
Beyond understanding the structure of a specific bond most investors want to review the health of its issuer. The Bond Buyer describes what information investors need to access to:
Investors will need to understand the issuer’s underlying finance structure, sources and uses of cash, and the cost structure of an issuer’s budget, as well as their own economic and legal rights as investors — in and out of court — in the event of a bond default.
Several regulatory changes in the last few years have increased the flow of information about issuers in muniland. With the full implementation of the Municipal Securities Rulemaking Board’s EMMA system, investors now have near real-time disclosure of the offering details of bonds and continuing disclosure of the financial condition of bond issuers.
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.
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Bashing a rater for truth-telling is like punishing a child for speaking an unpleasant truth. It creates incentive to shade the truth, and the harsh truth is what is needed now more than ever.
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.
The most widely-used measure of credit risk for municipal bonds is the Thomson Reuters Municipal Market Data (MMD) AAA GO Scale. MMD’s Daniel Berger in his daily note talks about how New Jersey bonds got riskier and cheaper ahead of the downgrade and suggests that cash-bond selling started happening ahead of the Fitch downgrade.
New Jersey has approximately $31 bln of appropriation backed-debt and $2.6 bln in GO [general obligation] debt. The spread of New Jersey’s 10yr GO bonds has steadily risen this past week and closed last night at +47bps to MMD’s AAA GO scale. Last Friday this spread was +40bps.
It looks as if traders were anticipating this move by Fitch and this confirms our thesis that spreads are a leading indicator of credit. For the latest 12-month period this spread averaged +56.3bps which ranks sixth highest among the states actively monitored by MMD.
The MMD chart perfectly shows how traders and investors responded to rating downgrades and how they demanded higher interest rates starting September 22, 1010. This was the date that Moody’s put New Jersey on “negative outlook,” the advance notice of a possible downgrade. The long, flat, tabletop-like area is the period of market confusion following Meredith Whitney’s pronouncement of default doom. Markets settled down after that with a decline in New Jersey’s risk profile before turning up again ahead of Fitch’s downgrade.
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.
“Quite frankly, we just don’t want to be associated with [Standard & Poor’s] anymore based on that decision. We think it was irresponsible and just excessive,” Thomas Juarez, the city’s chief investment officer and assistant treasurer, told The Bond Buyer.
S&P gave an honest opinion and is getting cut out of business. That is how the “paid for opinion” business works. If the entity paying for the rating doesn’t like it, then they don’t pay.
Rhode Island enhances financial disclosure for bond offerings
The Providence Journal reports that the Securities and Exchange Commission has been scrutinizing the state of Rhode Island about their financial disclosures associated with new municipal-bond offerings. As a consequence the state has expanded the level of detail that they are disclosing in their bond-offering documents. This increased transparency is critical for muniland. From the Providence Journal:
The swirl of ratings and CDS
The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.
The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.
The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.
Raters should incorporate every type of information available to them. Markets want hot, accurate information. Raters create reputations for themselves for good analysis, and reputations rise and fall on good predictive ability. Information is money, and markets want to make money.
It’s a well known phenomenon in fixed-income markets that once a bond falls into the junk or speculative category that its rating becomes murkier for predicting default. So maybe credit ratings are more useful for investment-grade bonds and CDS are more useful for junk-grade securities? If there are any academic studies on the subject that you know of, please add them in the comments.
An interesting thing about muniland is that all states are rated investment grade. California has the lowest rating for a state at A-. See it on the last line in the great chart above from Stateline. S&P has adjusted California’s rating 7 times in the last ten years, which is pretty active for rating change on a major issuer. But the CDS on California is moving every day!
The state becomes the guarantor
Jefferson County, Alabama is getting a lot of attention as it negotiates with the holders of $3 billion of sewer bonds. The county would like to pay $2 billion to settle the $3 billion of bonds outstanding and limit the rate increases county residents would have to pay. This arrangement would pay bondholders (led by JP Morgan) 66 cents on the dollar — not a great recovery but not outrageous either. Bondholders want the state to guarantee this new arrangement and stand ready to pay in the event of another default.
There is an alternative option for settling the matter: a Chapter 9 municipal bankruptcy. The county is now prepared to go that route if necessary and have hired an expert attorney to lead them through the process if they so choose.
The county accumulated this sewer debt over a number of years to fund the development of an EPA-mandated sewer system. Its construction was laced with delays, cost overruns and corruption. It’s the poster child for disastrous public works and bad dealing by Wall Street. The credit rating for this debt started out as AAA in 1997 when it was issued. The bond insurer FGIC stood behind the debt and helped raise the credit to the highest level, AAA, from Baa1. In the chart above you can see the rating move in February 1997 as the insurer came in and pledged to repay bondholders if default occurred.
Jefferson County issued another very large amount of bonds in 2003 to pay for project overruns. This caused the rating on these earlier 1997 bonds to be lowered. This is due to the Jefferson County now having a heavier debt load to service. Credit ratings are a reflection of an issuer’s ability to carry and service the debt they have outstanding.
The financial crisis of 2008 decimated the bond insurer and caused Jefferson County’s rating to plunge. The rating briefly spiked in March 2008 as the guarantor briefly recapitalized their business. Since then the rating has been sinking lower and reflects that these bonds are near default.
The state of Alabama could be a good guarantor of the bonds for Jefferson County, and there appears to some political willingness to do this. The rating agency Standard and Poor’s rates the state as AA and says (emphasis mine):
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Resident Muniland expert
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