MuniLand

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.

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.

Know your debt load

A quick and dirty way to evaluate the credit quality of a borrower is to look at his debt load relative to revenues. It’s not a perfect measure — it doesn’t take into account whether that debt is repaid over many years or whether it’s all due at once, for instance — but it suggests why investors view some states as better risks than others. I’ve made a set of charts so we can compare debt loads and revenues for the states in a simple, visual way. The amount of debt load is indicated by the full height of the bar. (Please note the vertical scales of the charts vary. California is the highest borrower by far.)

I’ll do another series of charts that includes pension liabilities and other post-employment benefits, and I’m warning you now: that set will look scary. Here is a link to these data and charts in interactive format. Feel free to embed and use them elsewhere (crediting Reuters of course).

Tax collection data is from the U.S. Census Bureau and debt load data is from Standard and Poor’s.

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