All three rating agencies saw their ratio of upgrades to downgrades fall in the fourth quarter of 2008 as the weakening economic conditions begin to reflect the increasing pressure put on municipal issuers.
Moody's Investors Service's upgrade ratio stood at 1.1 to 1 in the fourth quarter, its lowest level since the first quarter of 2003, following the previous recession.
Fitch Ratingse_SSRq upgrade ratio fell to 1.15 to 1 in the fourth quarter from 2.9 to 1 in the third quarter, and the ratio by par value fell to 0.19 to 1, under one for the first time since the fourth quarter of 2005, following Hurricane Katrina.
Even Standard & Poor's, which upgraded thousands of credits last year as the result of a ratings "recalibration," saw its upgrade-to-downgrade ratio fall to 16.2 to 1 in the fourth quarter from 21.4 to 1 in the third quarter. In the state and local government sector, where it upgraded 629 credits and downgraded just seven, the changes to rating criteria as the result of a recent default study drove almost all the upgrades, Standard & Poor's said.
The rating agencies took note of the economy's impact in their quarterly reports.
"The current recession originated from the housing sector but became more widespread, culminating in the severe credit and liquidity crisis experienced in fall 2008," Moody's wrote. "The prior year's favorable economic growth allowed municipal issuers to maintain their credit quality for the first three quarters of 2008, but credit deterioration became more acute in the fourth quarter, particularly in the health care and housing sectors."
Even in cases where credit quality has not necessarily been hurt, many municipal issuers are facing difficult challenges as the economy weakens. Eighty-four percent of cities reported facing fiscal difficulties in a recent survey conducted by the National League of Cities, the highest percentage since the survey began in 1985. In addition, 92% of cities "expected to have trouble meeting their city needs during this year," according to the survey.
Standard & Poor's noted in its report that in municipal credit analysis it's important to differentiate between fiscal challenges and actual stress. Although governments may have to make difficult and unpopular decisions, the agency said: "They can and will take the necessary actions to remain in control of their own destiny - making them better off relative to corporate and nonprofit issuers who are more dependent on markets and the demand for their goods and services."
Standard & Poor's has increased the weight it gives management analysis in its ratings and taken negative rating action against tax-backed issuers that delayed or forestalled "timely corrective action of these conditions."
All three credit agencies came under pressure from critics early last year that said dual-rating scales that systemically rated municipal debt lower than corporate debt with similar or high rates of default led to higher costs for issuers through higher interest rates and the need for credit enhancement. Moody's and Fitch both rolled out proposals to move to a global scale last year, but postponed them in October amid the global financial crisis.
Standard & Poor's has maintained it has always had just one scale for corporate and municipal debt, but upgraded 2,073 credits last year while downgrading just 128 credits, citing its updated municipal default study. The revisions to criteria in certain sectors have already led to a "sustained upgrade trend overall several years" and its reviews of other sectors are ongoing.
Its most recent upgrades were related to its conclusion that rural and small credits were "not more vulnerable to the current environment than larger, more urban or suburban credits with other similar credit factors at the highest rating level."
Fiscal stress and recovery for public finance issues tends to a lagging indicator of the economy, said Standard & Poor's, which downgraded just seven state and local government credits in the fourth quarter. At Fitch, upgrades exceeded downgrades in the fourth quarter, but the ratio of credits with positive outlooks to credits with negative outlooks fell to 0.63 to 1, continuing its steady fall from the end of 2007.
Although widespread downgrades have yet to occur for state and local governments, other sectors, including health care, have seen pressure. Standard & Poor's downgraded 28 health care credits while upgrading just seven in the fourth quarter, and Moody's downgraded 29 compared to four upgrades. Both said the number of downgrades has not been seen since the fallout from the 1997 passage of the Balanced Budget Act, which cut Medicare reimbursements to hospitals.
In addition, Standard & Poor's downgraded 23 housing credits and upgraded 16, while Moody's downgraded 22 without any upgrades. The downgrades, however, were in many cases linked to changes in the credit ratings of counterparties, the rating agencies said.
"Despite the rising mortgage defaults and a housing market downturn, credit quality in the public finance housing sector remains relatively stable," Standard & Poor's said. "At the end of the fourth quarter, more than 86% of our ratings were AA or better, a slight decline from the third quarter when 90% of ratings were AA or better. The actions were mostly driven by our assessment of changes in the ratings on counterparties, who provide investment agreements or guaranteed investment contracts, and financial performance."