WASHINGTON - Fitch Ratings yesterday proposed changes in its municipal ratings framework that would result in one- to two-notch upgrades on most general obligation bonds and debt backed by broad-based taxes, following a four-month review of the sector.
The announcement came one day after Fitch and competitors Moody's Investors Service and Standard & Poor's were sued by Connecticut Attorney General Richard Blumenthal for allegedly rating municipal credits lower than merited.
Meanwhile, a Securities Industry and Financial Markets Association task force unveiled a dozen recommendations for improving the disclosures and transparency of credit rating agencies. The group embraced the push to "harmonize" municipal and other ratings scales, but said this should be done globally over a period of several years.
In its reassessment of its muni ratings framework, Fitch proposed to recalibrate its municipal ratings "so that they denote a comparable level of credit risk as its international rating scale for corporate, sovereign, and other entities."
Under the new scale, "ratings will typically be revised up by two notches if the GO or senior revenue bonds of the issuer are rated between BBB and A," Fitch said.
Fitch said its proposed changes were based in part on the favorable municipal credit characteristics of GO, tax-supported and water and sewer utility debt, especially the tax- and rate-setting powers. In addition, it cited the low overall default experience in municipal securities, the existing rating distribution, and the economic challenges of the housing crisis and weakening tax collections facing public finance credits as contributing to the new framework.
The agency's proposal also seeks to maintain some of the "granularity" sought largely by the investors that participated in the roundtable discussions Fitch held with municipal market participants ahead of making this proposal.
Initial reaction to the proposal was mixed.
Matt Fabian, managing director at Municipal Market Advisors, noted that Fitch's proposed upgrades might not result in muni ratings that are as high as their relative default risk would warrant. However, he said the agency's taking into account the ongoing economic stress and its impact on issuers was "pretty reasonable."
Richard Larkin, senior vice president and director of research at Herbert J. Sims & Co. and a former Fitch managing director, said some of the proposal was positive. Specifically he said the decision by the agency to maintain California's rating at AA-minus under the new framework, up from the current A-plus on watch for possible downgrade was better than suggesting it be raised to AAA.
However, he questioned the upgrade because the "state's financial problems are so large that any upgrade at this time may not be advisable. In Fitch's case, it is curious that they would consider any upgrade on California, when the current California rating of A-plus is on negative watch for a downgrade."
He also questioned the wisdom of using a "formulaic approach" for the recalibration.
"I think Fitch is better advised to review each rating individually, rather than use a mechanical broad brush approach," Larkin said in a comment on Fitch's proposal.
Overall Fitch's proposed changes would mean that the percentage of state and local GO ratings in the AA and AAA categories would rise to about 85% from the current 58%, Fitch said. Fitch also said it would subsequently review other public finance sectors, such as tax-exempt housing, public power, higher education, health care, and solid waste, plus debt backed by more narrow tax categories, as appropriate.
Fitch is seeking feedback on the proposal and its implementation by Aug. 29.
"We need to make sure that there's harmonization across groups, so that a corporate triple-A rating versus a municipal triple-A rating versus a structured finance triple-A rating versus some sort of a sovereign debt triple-A rating doesn't mean different things," Deborah Cunningham, co-chair of the task force and chief investment officer at Federated Investors, said in a teleconference with reporters yesterday. "This would need to be accomplished over a several-year time period, not certainly overnight, to avoid market disruptions and promote greater understanding of the process."
Boyce Greer, the task force's other co-chair and president of fixed income and asset allocation at Fidelity, said the recommendations are geared toward giving investors greater disclosure of the ratings process, and spurring credit rating agencies to share more fully the information they use in determining their ratings.
"Investors' ability to better understand the credit rating agency inputs and methodology will allow investors to incorporate ratings appropriately in their own internal risk assessments and investment decision analytics," Greer said. "This, in turn, is a key element of strengthening the securitized credit markets."
Specifically, the task force called for more specific disclosures, rather than the release of "additional large quantities of raw information," in "pre-sale reports." It also called for rating agencies to provide more disclosure of information on underlying assets that are securitized, as well as better explanations of the extent to which it or any other entity performed due diligence on the underlying assets on the securities they rate.
Though the task force embraces the general aims of legislation approved Wednesday by the House Financial Services Committee that would require credit rating agencies to rate all securities on the same scale and based on the likelihood of repayment, Cunningham said that the task force favors a more deliberative response and is concerned about the unintended consequences of passing such legislation and immediately implementing it.
The bill, which was introduced last month by committee chairman Rep. Barney Frank, D-Mass., could be voted on by the full House this fall, but it is unclear if there is any interest in the Senate for such a measure.
Harmonization "won't happen immediately, and obviously we wouldn't want it to - we think it would cause disruptions in the marketplace," Cunningham said.
Tim Ryan, president and chief executive officer of SIFMA, stressed that the industry group is asking American and European regulators to address credit rating changes in a collaborative, global effort, rather than through piecemeal measures.
"The key objective is uniformity," he said. "These are global markets and we need convergence, not just uncoordinated decisions in different parts of the world," he told reporters.
One of the report's lengthiest section revolves around so-called ratings modifiers, which regulators in both Europe and the United States have suggested should be used to help investors differentiate between different securities products. For instance, a triple-A structured finance product would be designated "AAA.SF," under such proposals.
While the task force strongly supports enhanced transparency and disclosure, it is concerned that such modifiers are "cosmetic" and could "further damage our already unsettled capital markets, impair capital raising (for student loans, auto loans, credit cards, mortgages, and the like), and lead to the sudden sale of structured finance securities at fire-sale prices, into an already highly illiquid market, at a time when our financial markets can ill afford such an unnecessary shock to their system," the report said.
It added that modifiers could also lead to a number of unintended consequences, including the possibility that asset manages working within carefully worded investment guidelines that mandate that purchases consist of particularly rated securities, such as "AAA" securities, would be forced to sell off structured finance securities suddenly rated under a new symbol "into an already illiquid market."
David Weinfurter, a spokesman for Fitch Ratings, said that it generally supports the findings and recommendations of the SIFMA task force. Fitch, he said, has already implemented a wide range of analytical and organizational initiatives designed to ensure the reliability of its ratings and to enhance transparency.
He added that Fitch does not agree with the suggestions that rating agencies have the primary responsibility for disclosing to the market information on underlying assets that are securitized. In addition, Fitch expects that the primary responsibility for due diligence falls on the originators or arrangers of the underlying assets.
The rating agencies took issue with some of SIFMA's proposals.
"While Moody's recognizes that additional measures that enhance rating quality are appropriate, we do not support certain recommendations and statements in SIFMA's report and the views expressed in that report should not be taken to represent Moody's views," the agency said. "We are working with other credit rating agencies, authorities and market participants on measures to restore confidence in the credit rating process."
Standard & Poor's said: "As part of our ongoing commitment to openness and transparency, S&P has worked - and will continue to work - closely with market participants to identify ways we can strengthen the ratings process and help restore confidence in the markets. That said, we do not agree with a number of the conclusions in the SIFMA report. In February, we announced a number of actions that focus on the same issues identified in the SIFMA recommendations, including obtaining additional loan level data from issuers, disclosing our ratings scenarios and assumptions and increasing investor understanding of the role of ratings in the investment research process."
