A new study by the Kroll Bond Rating Agency on municipal bond defaults dating back to the Great Depression casts a positive light on the muni industry, saying there will be “no material increase” in defaults over the next three to five years.
“Our study finds that widespread municipal bond defaults have not been a feature of the most recent downturn and we do not expect a sharp increase in defaults over the foreseeable future,” wrote Jerome Fons, executive vice president for strategy, and Tom Randazzo, managing director, co-authors of “An Analysis of Historical Municipal Bond Defaults.”
Released earlier this week, the study is a precursor to the fledgling rating agency’s foray into the municipal bond industry.
The firm, which is a nationally recognized statistical rating agency that was established in 2010, has rated five issuer-paid commercial mortgage-backed securities, and also assigns issuer-level ratings to thousands of institutions, mainly banks, thrifts and credit unions through its subscription service.
Fons said the firm decided to publish the report — and subsequently enter the municipal industry — as a means of uncovering and understanding the causes of 8,500 municipal defaults occurring between 1929 and 2010 to educate investors and issuers.
“Clearly the stress the municipal market has been under has been of interest,” Fons said in an interview. He explained that with plans to establish municipal exposure, the firm needed to develop the proper methodology to rating individual issues before it launches its muni rating service out of its New York City office in early 2012. The seven-month study, Randazzo said, was “the best way to survey the historical performance in order to determine what caused stress in this sector in the past.”
Between 1929 and 1939, 4,816 issuers defaulted on their obligations, affecting nearly $6.5 billion in outstanding debt, the study shows.
The defaults were concentrated in a small number of states with little control over local issuers. Therefore, several large defaults by major cities accounted for a wide margin of the defaults, followed by school districts, counties, agricultural projects, and municipal special assessment districts, the study pointed out.
The study looks at how pre-war defaults affected the market and how today’s issuers can learn from past mistakes. It also contradicts claims that the market volatility over the past three years will lead to massive municipal bankruptcies and widespread defaults.
It includes in-depth case studies on several large states and cities, including New York City, Texas and California, among others.
Among other publications and resources, The Bond Buyer was a primary source of data for the study, as Kroll analysts used daily and weekly editions of the newspaper to research defaults — particularly over a 22-year period from 1920 to 1942.
The firm looked at demographic factors, including tax revenues and population changes, among other factors, to assess the Depression-era bankruptcies.
The defaults resulted from various factors such as the rapid buildup of debt stemming from major road and infrastructure financings, as well as significant bank failures, holidays, and closings, which caused many municipalities and states to miss bond payments.
The study also analyzes and compares the important structural differences between the pre-war era and today’s market.
“During the Great Depression, rapid growth in the volume of municipal bonds was spurred by the inception of the personal income tax, demand for paved roads accompanying the popularization of automobile travel, and the relaxation of World War I controls on issuance,” the study states.
To make matters worse, Fons said there was an unjustified amount of triple-A ratings distributed prior to the Great Depression and those credits could not withstand the financial strain.
Of the 3,943 municipal issues outstanding in 1929, for instance, 55% were rated Aaa by Moody’s Investors Service — the only large rating agency covering U.S. muni bonds before 1941, according to the report.
When the ratings performed poorly following the Depression, Moody’s reacted by downgrading and withdrawing ratings, and by 1939, the number of rated issues returned to 1929 levels, but only 1% of issues were rated Aaa, and 14% were Aa, the study showed.
In the report, Fons and Randazzo suggest that the legacy rating agencies have “misread” history and have “yet to adjust their methodologies to account for recent structural changes in the municipal market.” As Kroll embarks on its new endeavor, the team said it plans to incorporate lessons learned from the study into its new rating methodologies.
Among the lessons are the ability of a municipal entity to effectively navigate increasing expenditures on social services, fluctuating revenues, an expected decrease in federal stimulus spending, long-term pension obligations for public workers, and the need for increased infrastructure spending.
“We hope to have a firmer footing when making distinctions between the issues … we hope to do a more careful job and treat the sector more carefully,” Fons said.
More recent problematic bond issues, the report noted, have been concentrated in the industrial revenue, health care and housing sectors.
But large defaults, such as the Washington Public Power Supply System in 1983, Orange County, Calif., in 1994, and Jefferson County, Ala., which defaulted in 2008 but officially filed for bankruptcy last week, have had a minimal impact on aggregate default rates.
Meanwhile, the study provides a positive forecast for the municipal bond market going forward based on a number of criteria. Chief among them are the elimination of a large number of small taxing districts that contributed to defaults, more diversified revenue sources, and the use of federal safety nets to protect a large portion of the deposits of municipal issuers.
“Because the majority of Depression-era conditions do not apply today — and have not applied for some time — municipal bonds are significantly safer than some commentators have reported,” Fons and Randazzo wrote.
Despite competition in a market dominated by Moody’s, Standard & Poor’s, and Fitch Ratings, Kroll believes it will have a good success rate based on its previous experience, its research into the sector’s default history, and positive feedback from issuers and investors.
“There are significance barriers to entering this business, and it’s going to take something different and special” to compete, Fons said. He added that the firm plans to differentiate itself based on heavy surveillance and monitoring of issues — both big and small.
“States are high on the list and we will go down from there,” he explained. “We don’t want to be seen as a company rating the weakest issue or lowest-rated issue that no one else will touch. We want to rate high-profile issuers.”
To staff its team, the new agency is now in the process of recruiting prospects, training new hires and meeting with market players to begin building a book of business before rating its first bond issue in the new year, according to Randazzo.
“We’re leveraging our reputation and contacts and using word of mouth to meet with market intermediaries, and presenting our story to investors and issuers,” he said. The report can be accessed at
