Sunday, June 22, 2008

Moody's Global Scale: The last remnants of the old ratings have been swept away

Bowing to significant political pressure, Moody's is set to change the way they rate municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different than other bond categories. For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10-years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district, or state) there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has admitted that their municipal ratings aren't comparable to corporate or ABS ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York, and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

However, recent stress in the municipal bond market has brought politics into the discussion. From auction-rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in hears past. Bond insurance and bank letters-of-credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

Politicians, lead by Congressman Barney Frank and California Treasurer Bill Lockyer have been pressing the credit ratings agencies to rate municipal bonds based on expected loss only. A June 12 press release from the California Treasurer's office reflects the argument proffered by the issuers: "Lower ratings [for municipal bonds] have cost taxpayers billions of dollars in higher interest rates and bond insurance premiums." The theory is that there is a direct correlation between the ratings and the interest rate paid by the issuer.

At the same time, Moody's and Standard & Poors are facing serious (and well-founded) claims of conflict of interest relating to CDO ratings. Moody's seems to have made a political calculation: it can't go back and re-rate CDOs, but it can give Barney Frank what he wants with municipals.

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping. (The complete report is available here, requires a free registration.)

That should be a near-term positive, especially for middle-rated credits. There is significantly more demand for A and Aa-rated bonds than for Baa-rated securities, owing largely to legal or policy restrictions. There might not be much immediate effect, particularly until S&P follows Moody's lead. But over time, expect liquidity and the spread for the upgraded bonds to improve. Also, expect S&P to follow suit. S&P faces the same political pressure as Moody's, and now that Moody's has made the move, S&P will be all but forced to acquiesce.

There is a likely negative, however. The high ratings standards for municipals encourages some measure of fiscal conservatism. This is especially true for Aaa-rated credits, where loss of the rating would be politically embarrassing. Of course, municipalities are downgraded all the time, but clearly local politicians would rather maintain their rating than not. If the overwhelming majority of general obligation issuers are going to be rated Aaa anyway, that incentive is greatly reduced. In other words, a state like Georgia (rated Aaa) is currently incented to maintain its austerity. But if they could slide all the way down to California's level (currently A1) and still be rated Aaa, they'll probably do it.


Gringcorp said...

And presumably with the muni scale goes a large part of the monolines' business, unless there's an appreciable spread gap between, say Bershire Hathway Assurance and California.

Was there a lot of evidence that single- and double-A munis weren't getting access to the more conservative accounts?

Daniel Newby said...

So the solution to our risk underrating meltdown is ... upgrades for everybody! Oh, dear.

gringcorp: As far as I can tell, muni insurance exists so that unsophisticated investors can be protected against total loss of capital. They lack the knowledge to diversify effectively, but can be trained to check for insurance before buying. There should still be some demand for insurance.

Anonymous said...

daniel, a loss of capital is a total loss of capital, it's still painful whether or not you are a sophisticated or unsophisticated investor or diversified or not. FYI, muni insurance exists partly because of the difficulty in obtaining timely financial statements from the municipality. One muni bond I own is the City of Vancouver, Washington and the relevant financials arn't ready until August of the following year. That's worse than financial reporting from corporations in the 3rd world all around the globe!

Anonymous said...

This really does make a huge difference in California -- the state constitution mandates repayment of bonds. Period. It's not really clear to me why the full faith and credit of the state of California is appreciably different than the Federal government. I suppose the California state constitution could be amended, the same way congress could abolish the FDIC. Neither seems likely, however, given the enormous repercussions. Otherwise, there is not a situation where a California bond will not be repaid while there is a state of California.

Sivaram V said...

Good post as usual...

I have a question about ratings of foreign "muni" bonds (European, Japanese, or developing countries). That is, what scale is used to rate those public-private partnership/foreign municipalities/etc bonds right now?

Anonymous said...

Whatever Moody's decides to do, it'll definitely determine a lot...I like this quote by Bethany McLean: "If the rating agencies act too rashly, they could be accused of causing a bankruptcy. Yet if they deliberate too long, they'll simply be stating what everyone already knows."

Anonymous said...

Congress is getting involved and bullying the ratings agencies into giving higher ratings...

Unlike history on which this bullying is "based", today's municipalities face:
- unmanageable pension costs made by sloppy politicians in the past ten years
- bloated payrolls
- a crumbling infrastructure that will require increased spending
- falling home prices, which will curtail revenue growth
- an electorate that is fed up with taxes rising faster than their incomes

I feel very confident in predicting that this is going to end badly

Anonymous said...

This is off topic, but I am posting anyway... Citibank has fallen back on the lazy CEO's standard response to weakness by announcing thousands of layoffs.

If growth could be achieved by layoffs, why not go the next step and lay off ALL the employees... then growth would be huge, right?

A competent CEO might do layoffs as part of a broad STRATEGIC restructuring, but that would require some thinking and ability to articulate plans for the future -- two things that CEOs are not very good at, especially financial CEOs

Sooner or later, AI and other portfolio managers are going to have to admit the problems on Wall Street are way deeper than some liquidity issue.

The Fed made a huge mistake trying to fight a mismanagement problem with excess liquidity.

Anonymous said...

There's a very large difference between the Federal Government and the State of California. The Federal Government can print money.

California is acting like it can, but will find out that it can't. Perhaps this won't matter (if the dollar dies first).

Anonymous said...

Perhaps someone can explain to me exactly how California could default on a bond measure (excluding a state constitutional amendment, which would have a long lead-time). The state supreme court must follow the state constitution, and States cannot declare bankruptcy to wipe out there debts. The state of California is not an incorporated municipality. So, why should the taxpayers of California, who are legally on the hook no matter what, pay for risk that doesn't exist? California can't print money but must pay off the bonds, even if it comes at the cost of all other state services.

I guess I answered my question -- California could default on the bonds if the state was unable to levy sufficient taxes to cover the interest, which has the state treasury's top payment priority. That's going to happen how?

Anonymous said...

AI: there was only one municipal default since 1970... (paraphrased)

Come on tddg, are you going to argue about what the definition of "is" is next?

Without even going past the defaults that made major headlines, we know New York City defaulted in the 70s, Orange County defaulted (a result of the classic municipal function trading the yield curve), then there was the state of California a few years back leading to the Gubernator replacing the old governor. Oh, and only a few weeks ago the city of Valleho, CA declared bankruptcy.

I know, you are going to split hairs and say these entities eventually got around to paying bond holders, just a little late. News flash: that's technically a default.

And New York City nullified some of its debt, and restructured other debt -- but only debt held by banks (little old lady's and rich people were spared). Nullifying debt is a formal default. Restructuring debt with different rates and longer maturities is also a default.

If you don't pay back your debt at the time you said you would, after paying the interest you said you would -- its a default. No one wants to hear your lawyer split hairs and weasel out on a technicality. You either kept your promises 100% and in full -- or you didn't.

Wall Street's mentality of "close enough" is how the banks got themselves into the mess they are in.

The situation won't get better until everyone on Wall Street, including AI, stop enabling this nonsense. You are all like a bunch of alcoholics, lying to everyone including yourselves.

And BTW, if Uncle Sam pays back "our" debts with worthless currency, that is also a default, even if your lawyer thinks he found a loophole.

Anonymous said...

Anon 10:26

You basically answered your own question.

The state Constitution is just a bunch of words. They mean whatever the people of California decide they mean.

Quite simply, California has promised a lot of people far more than the state can raise via taxes.

Various propositions over the years have shown that, even in a fairly liberal state, even in a wealthy state, even in a large economy (California would be the 6th largest economy in the world if it was a country) -- there are limits to how high taxes can be raised.

California WILL default on its promises. Its only a question of which promises. Municipal employee pensions are an obvious cut back, as they received massive "raises" the last 5-10 years without any funding to back those raises.

But even assuming 100% of those pension changes are rolled back, California still has a bloated payroll, out of control spending, infrastructure problems, etc.

Municipalities are in basically the same position as GM was in the early 1970s. Bloated payroll, overpaid union workers that don't care, management that isn't paying attention to the big picture, and a "product" that is hopelessly out of date.

Can government provide useful services? Of course, just like Honda and Toyota and BMW can all operate car manufacturing plants right here in the U.S. while GM makes most of its cars in Mexico and Canada.

AI is telling us that municipals can never go wrong... sounds a lot like the CEO of GM telling us that "as GM goes, so goes the American economy".

Municipalities have been mismanaged for decades and are in serious serious trouble.

Leave it to Wall Street and the losers in Congress to insist on ratings system that is stuck in the past.

Anonymous said...

Anon 10:26

sorry, I got off on a tangent...

The state constitution is a bunch of words that are only as good as the word of the people who wrote the words.

If California really intended to pay back its debts, it would have raised taxes to match the increased spending.

No matter how much the lawyers and politicians try to spin things, they either had to increase revenue to match increased spending (which obviously did NOT happen) -- or else the promise in the Constitution ranks right up there with "Read my lips, I did not have sex with my intern".

Accrued Interest said...

There has only been one general obligation default in the universe of Moody's rated bonds. And I'm not excusing late payments of interest. Every one has remained current on GO debt except one. Orange County didn't default on any general obligation debt. Neither has Vallejo or Jefferson County.

Even if you consider all the defaults and near defaults you mention, that still makes municipal defaults pretty rare. I mean, you have five or six major near defaults. We get that many major corporate defaults every year!

Anyway, I wasn't trying to say GO's can't default, merely that its very rare historically. It is an undeniable truth that municipalities probably face a more difficult fund raising environment now than any time in recent history. So Moody's move may come at exactly the wrong time.

And for the love of everything holy, I never ever said our only problem was liquidity! I've also said the liquidity crisis is over and we're now just dealing with the shitty economy.

Anonymous said...

Just looking at historical data on growth rates in debt. State and muni YoY increase has ranged from 8.8 to 10.2% since 2001. Suggest that nominal tax/fee collection rates have probably not tracked that rate

capitalhill said...

The issue boils down to this. The historical default/loss performance of municipal bonds in a particular rating category is much better than that of corporates, sovereigns, etc. in the same category. Shouldn't the expected loss performance of, say, Aa-rated munis roughly reflect that of Aa-rated corporates and other debt products? The change Moody's has announced with result in more comparable credit comparisons within rating categories across product sectors. Makes sense to me.