A recent article in The Bond Buyer reports that investors are gravitating toward longer maturities (“Investors Going out Longer,” Aug. 31). Yet in spite of the longer focus of investors, the pillars of credit analysis and ratings continue to be largely based on analysis of what can be seen in the rear-view mirror.
A recent podcast on Knowledge@Wharton, the online business journal of the Wharton School, discusses the “New Role of Risk Management — Rebuilding the Model.” The point was that “risk technology” has traditionally modeled risk using statistical analysis of historical data to predict the future.
The discussion centers on the obvious fact that these models did not predict the future — that going forward, it is critical for risk analysts to gather “forward information.”
Since statistical modeling missed factors that could have predicted the mortgage meltdown and the resulting crisis in the financial sector, risk managers are asking themselves what needs to be done to avoid a relapse. The new vanguard in municipal credit analysis faces the same question.
Much is made of the low default histories of municipalities as the basis for the conclusion that the muni market is “systemically low-risk.”
But is this data a reliable predictor? The data could be skewed, as some contend, by the bond insurance industry’s active risk-containment efforts — which is still going on, despite lack of new business.
Furthermore, historically, municipalities and not-for-profit issuers have been able to “refinance out” of problems and difficulties through refundings that in some cases are tantamount to debt restructuring.
Over the past 30 years, these were abetted by the easy market access derived from bond insurance and thin credit spreads. The dearth of bond insurance, a newly risk-averse bond market, and debt capacity constraints make the refunding tool a lot more limited and available to fewer borrowers.
The following are just a few prominent examples in which debt has played an important role in relieving municipal fiscal stress:
In the early 1990s, New York City refunded significant portions of debt, solving a budget problem by granting itself a debt service “respite” in the process.
In 2005, California refunded its Golden State enhanced tobacco bonds, paying itself $525 million out of the proceeds to help balance its budget.
In 2000, the Nassau County, N.Y., Interim Financing Authority issued more than $400 million of bonds, some to provide debt relief and restructure outstanding debt.
Earlier this year, Wisconsin’s tobacco bond restructuring freed up reserves and provided sufficient up-front savings to help close a large state budget gap.
These events occur often in the municipal market without the drama and headlines of a bankruptcy. Often in the past, credit enhancement in the form of letters of credit, bond insurance, or federal and state assistance facilitated the process. Is this quiet workout tool still available, and if not, what will municipalities that hit the wall in the face of declining revenues and increasing needs do?
True enough, the vast majority of municipal issuers have the wherewithal and flexibility to manage through tough times, but does this mean we can rest easy and assume there are no sleeping, unsolvable crises on the municipal horizon? And if we accept that predictive analysis would be desirable, can the concept of forward information be applied to a market as idiosyncratic and disparate as the muni market? What data is needed to conduct predictive analysis and where will it come from?
Municipal analysts often point to diversity as an indicator of fiscal health, but they need to avoid the trap that this is indeed a predictive measure. The big “miss” for structured finance credits was that diversity descended into correlation when real estate values declined. In a down market, that phenomenon carries over to the municipal market. Once lost, regaining diversification may be a long time coming.
In order to add a predictive element, traditional historical trend analysis will need to be supplemented by stress-testing. Sophisticated stress analysis is currently applied to municipal credits on a limited basis — project finance, transportation — or simplistically, even randomly.
For example, a stress test on a tax revenue bond may examine the impact of the loss of a large taxpayer — a revenue decline of 10%, perhaps. Whether this is a logical stress scenario or even a likely one is largely beside the point. It’s one thing to talk about running stress tests on more generic credits, but identifying the proper data, obtaining it, and running meaningful tests is harder than it seems. Stress-testing needs to be used more widely but the framework for doing so needs to be in place before this can be done.
Scholars everywhere are focused on sustainability — we have concerns about agricultural sustainability, energy sustainability, and environmental sustainability. Add “fiscal sustainability” to the list.
In June, the Government Accounting Standards Board issued a report that stated in part: “The GASB has been studying the importance of the notion of fiscal sustainability to the users of state and local government financial reports and the kinds of information they use to assess it. The GASB will consider whether a project should be added to its current technical agenda to better address economic condition and fiscal sustainability reporting.”
The report goes on to state: “In keeping with the GASB’s goals of improving transparency and providing better accountability, citizens and other users of financial statements ought to be able to look at financial reports and be able to discern the fiscal path a government is on.”
The impact this could have on local governments and other issuers is likely to be large and encounter resistance. GASB will need to move slowly to assure that all constituencies are fairly served.
Meanwhile, major paradigm-shift trends loom on the horizon — reduced geographic mobility, growing educational and income disparities, aging populations, and rising suburban poverty. Identifying accurate data and gathering it into relevant units is one of the bigger challenges.
But if properly assembled, presented, monitored, and marshaled, these variables could become useful tools in predicting long-term credit conditions, and could even help issuers maintain credit quality as forward analysis becomes a tool that can help guide governmental policy and planning decisions.
There are 366 metropolitan statistical areas and 574 “micropolitan” areas in the U.S. and over 50,000 municipal and not-for-profit entities that have bonds outstanding. Each of them carries a unique set of demographic and economic drivers.
Testing these entities against a framework for long-term financial health is good practice but a pretty daunting exercise. Developing a credit philosophy that incorporates fiscal sustainability is an important next step in analytical thinking and depends on the availability of reliable data and meaningful deployment of that data.
The attention being given to this by GASB and others is encouraging. On Sept. 25, the Municipal Analysts Group of New York will host Christopher Mier of Loop Capital Analytical Services Group and proffessor Matthew Drennan of UCLA, who will share their thoughts and findings on forward-looking analysis. It’s time to start talking more about our future.
Debra Saunders is planning co-chairman of MAGNY and was formerly a credit analyst and manager of the western region at Ambac Assurance Corp.