The House Financial Services Committee Thursday will hold hearings on four key areas of the municipal bond market. Two of the proposals are targeted to restoring municipal government access to reasonably priced capital: liquidity and bond insurance. A third is an effort to increase government oversight of financial advisers. The fourth, however, has a different tone. The proposed legislation is titled the "Municipal Bond Fairness Act" and seems designed to push rating agencies to upgrade municipal bond ratings.
Indignation by public officials against "Wall Street" for creating the current financial mess appears to be driving this legislation. A number of years ago Moody's Investors Service published a municipal default study that showed investment-grade corporate bonds had significantly higher probability of default than municipal bonds of the same rating level.
Moody's ultimately provided a mapping of municipal ratings onto a corporate scale. Since then public officials have been pressuring the rating agencies to upgrade municipals. To a large extent the agencies have complied, upgrading muni ratings bit by bit.
The finding that corporate securities are far more likely to default than municipals at the same rating level could easily lead to a very different conclusion: that corporate ratings are too high. The popular solution among state and local officials is raise most municipal ratings higher to put them on par with corporate ratings. A wholesale recalibration that pushes corporate ratings downward would be rating agency suicide, not to mention the damage this action would do to corporate bond portfolios.
There is nothing wrong with the rating scale itself, but how useful is it to investors to have ratings squeezed into a band that accommodates a 30-times differential in the probability of default? Moody's study showed a cumulative 10-year corporate default rate for investment-grade securities of 2.09%. The comparable municipal rate was found to be 0.07%.
There is nothing wrong with using probability of default as an approach to ratings. The default research itself has some missing parts, but generally reflects relative risk between municipal and corporate sectors. What is missing is a spectrum of ratings on a single scale that accurately reflects the default research - municipals at the higher end of the scale with corporate ratings further down - in line with their relative risk.
At least two factors point towards caution in making major changes to the municipal rating process at this point in history. First, the period for Moody's default study period was 1970 to 2006, a time of relative prosperity that also coincides with the rise of bond insurance. Defaults on insured bonds were not included in the study. (While there were not too many of these, there were some notable claims, such as the Washington Public Power and Supply System, whose insured bondholders were paid.)
Second, we really don't know how many muni bonds are likely to default in the current downturn. We do know, according to George Hempel's landmark study, that around 15% of all municipal debt went into default in the Great Depression. The economy today continues to sour. Municipal revenues - particularly property taxes - tend to be lagging indicators during a downturn. It sometimes takes a year or longer to see downturns in property values and losses.
Chrysler and General Motors announced the closing or non-renewal of 1,900 dealer contracts last week. The communities where these dealers reside will begin to see the property tax loss in the next taxing cycle. Employment income losses show up right away and sales taxes, of course, have already shown the drop in purchases. Some communities that tax personal property will see losses in the tax value of inventory as well. GM has agreed to take back unsold inventory from their dealerships, removing this source from the local tax base. This is just one example.
There are some major structural differences between government and corporate borrowers that should be taken into account. Government has the ability to raise revenue in many ways: property taxes, sales taxes, income taxes, user charges for services provided, fees and fines, to name a few. Government assets cannot be liquidated and sold off in bankruptcy, as corporate assets can. Municipal governments cannot be forced into involuntary bankruptcy. Many states watch over their local governments and school districts carefully and have early intervention and aid programs.
On the other hand, municipalities do not have a post-bankruptcy financing mechanism like "debtor in possession" on the corporate side. It is difficult to impossible for a troubled municipality to access to capital markets. Creating a DIP mechanism for municipal governments would help create liquidity for those in trouble.
Finally, we cannot achieve fairness between municipal and corporate ratings without resolving the disclosure issue. Many municipal market participants do not file timely or robust financial information and management information is often scanty. An investor anywhere in the world who wants to buy a U.S. corporate bond can gain access to frequent filings through the Internet, free of charge.
There have been calls lately to revise the Tower Amendment and allow the Securities and Exchange Commission to directly require information from government borrowers. Government's counter-argument is that it is too costly and burdensome to comply with this demand, especially for smaller borrowers (many of the same ones that are having difficulty entering today's markets with reasonable pricing).
We need to take this ongoing (and real) argument off the table. I suggest a small fee be charged on every public municipal capital market borrowing to fund a skilled state-of-the-art technology service (government or private) to help reduce cost, create reporting efficiencies and limit the burden of providing timely information to the market.
If there is any lesson learned from the current financial mess it is that rating agencies need to be independent and free of influence from vested interests on any side of the table. Ratings methodology and rating agency analysts should be no more influenced by bankers eager to market their "triple-A" structured mortgage-backed securities, than by public officials.
The rating scale is a good one. The problem is that ratings should be honestly laid out along the entire scale in reflection of relative risk between municipal and corporate securities based on impartial research. The voices of credit analysts should be included in this discussion, both in the board room and in the discussions among congressional committees and regulatory agencies. After all, isn't credit risk what we are talking about?
Natalie R. Cohen is founder of National Municipal Research, an independent consulting and research firm focused on state and local governments. She previously authored the "Fiscal Stress Monitor," an independent newsletter, and has worked for bond insurers and re-insurers, a rating agency, and local government. She can be reached at firstname.lastname@example.org.