Sell Side

Ratings Reflect Turmoil

Although all three rating agencies upgraded more public finance credits than they downgraded in the third quarter of 2008, some actions have already started to reflect the pressures that will weigh on issuers from the weakening economy and market turmoil.

Noting the stress on the municipal market, Moody's Investors Service had its lowest ratios of upgrades to downgrades in more than two years, upgrading 2.6 credits to every downgrade it made in the third quarter, compared to 3.8-to-1 in the second. Fitch Ratings upgraded 2.91 credits to every downgrade in the third quarter compared to 1.4-to-1 in the second, but also had more credits with negative outlooks than positive outlooks for the second consecutive quarter.

"As far back as our 2003 default study, we've noted that changes in municipal credits tend to be lagging economic indicators," Fitch managing director David Litvack said. "So I think actually the slight uptick in negative rating outlooks presents a more indicative view of medium- to long-term credit concerns, with lower housing values and economic pressures causing vulnerability to tax revenues while [other post-employment benefits] and other pension problems create additional pressures."

Standard & Poor's continued to upgrade hundreds of credits during the quarter, citing a recent re-benchmarking based on its updated default studies that showed overall creditworthiness improving over the past 25 years. Excluding housing, the agency upgraded 21.4 credits for every public finance downgrade in the third quarter, compared to 22.1-to-1 in the second.

Standard & Poor's said its efforts to review its U.S. public finance criteria to keep in line with its goal of maintaining a single scale for all sectors has led to a sustained trend of upgrades over the past several years. In just the past two quarters, it has upgraded thousands of public finance credits despite the weakening economy. The agency boosted 579 credits in the third quarter and 619 in the second, compared to a quarterly average of 106 since 1986.

Standard & Poor's said it recognizes the impact of the current turmoil, and the weakening economy has not been fully reflected in its ratio of upgrades to downgrades. The agency said it will continue to closely monitor these factors. It said near-term market conditions will be "very challenging" for some issuers, especially those that rely on borrowing to meet cash-flow needs.

In the state and local government sector, Standard & Poor's upgraded 560 credits and downgraded just seven. Municipalities and school districts continue to have strong revenues and fund balances, the agency said. In addition, sound financial management practices have "better positioned" many issuers "to deal with any declines in revenue due to an economic downturn, and to whether the other issues facing the municipal market."

Standard & Poor's said market conditions have increased the role management quality will play in determining credit ratings. It noted, for instance, that it upgraded to AAA the ratings on a number of credits in states hit particularly hard by the current crisis.

"Our rating and criteria actions thus far in 2008 reflect our conclusion that many governments are increasingly prepared to adjust their fiscal positions as economic downturns or cost pressures affect financial stability," it said in the report. "Accordingly, we have re-benchmarked key government ratios. While we believe this adjustment suggests that a number of governments may have adequate resources from a credit perspective, even taking into account expected deterioration in the current economic downturn, whether they will use them is an important question."

Although Standard & Poor's maintains it only has one scale for ratings across asset classes, Citi managing director and fixed-income strategist George Friedlander wrote earlier this year that the volume of upgrades with no subsequent change in credit strength suggested some form of mapping had occurred. Under pressure from lawmakers and others, Fitch and Moody's have said they will also convert to a global ratings scale, although both put those plans on hold following turmoil in the market and the deteriorating economy.

Moody's said in its report that the weakening overall economy will likely mean a "continued softening" in its upgrade-to-downgrade ratios. Its 2.6 upgrade-to-downgrade ratio fell well below the 6-to-1 ratio in the third quarter of last year. Its outlook on the states remains negative to reflect the weakening economy.

"Credit quality in the municipal market began to show signs of stress related to the economic downturn during the third quarter of 2008 and we expect this to continue - even though upgrades for the quarter exceed downgrades," Moody's wrote.

The credit crisis has already hit the housing sector hard. Moody's downgraded eight credits and upgraded just two in the third quarter, while Standard & Poor's downgraded 31 credits and upgraded four. The agency noted that its actions mostly reflected changes to the ratings of financial counterparties that provided investment agreements and that the quality of the underlying credits in the sector remains stable.

Rating actions by Moody's and Standard & Poor's also said the not-for-profit health care sector has faced continued operational and financial strains. Moody's downgraded 10 credits and upgraded seven, and Standard & Poor's downgraded 19 and upgraded four.

"In our view, the pressure seems to be focused heavily on already lower-rated hospitals that are demonstrating operation and financial stress," Standard & Poor's said.


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