When I was a high school athlete, preparing for "away" wrestling matches I remember there were always one or two schools that had a reputation for tweaking their scales for the pre-match weigh-in.
For those unfamiliar with the sport, each wrestler has to weigh in before each match to confirm they are under the weight for each wrestling class. For example, a wrestler that grappled in the 145-pound class had to weigh 145 pounds or less just prior to the match. I suspected some unscrupulous schools would make sure all of its wrestlers were well under the prescribed weight and then adjust their scales to trap the visiting team.
Just the possibility of this would force us to arrive at least one pound underweight - naturally putting us at a disadvantage, whether the scale was fair or not. It became clear to me that familiarity with the scale allowed for an advantage.
Now that I am much older, and possibly a little wiser, I look back and realize that maybe the schools with the bad reputations were not really cheating. It's possible there was just natural error that occurred from scale to scale. Maybe they did not re-calibrate their scales frequently enough. Many of the scales were very old, and most of the floors were a bit uneven. There was definitely room for error that may not necessarily mean there was intent to cheat. Or maybe I am just being naive and there really was rampant cheating.
Either way, I cannot help but compare my thoughts on wrestling to the current dilemma in the municipal bond market. The rating agencies acknowledge having a different scale for rating corporate bonds than they use for rating municipal bonds. I would like to believe this calibration served a well-intended purpose at some point, but currently the scale used to rate munis is at the heart of a potential collapse in the funding markets for municipalities and must be changed. By rating municipal debt on a more burdensome scale than virtually any other type of debt in the world, rating agencies are inadvertently causing the potential for a liquidity crisis in the U.S. municipal bond market.
The key to understanding the problem lies with the realization that bond ratings are extraordinarily important. When investors look at a bond they are often completely dependant on the rating. Given a choice between a corporate bond with a rating of double-A and a municipal bond with a rating of single-A, it is likely the majority of investors will believe the corporate bond is stronger as analyzed by the rating agency.
In the municipal bond market, where there are over 50,000 unique issuers of debt (100 times the number of companies in the S&P 500 stock index), it is virtually impossible for any investor to employ a staff that is able to continuously oversee the credit quality of each of these issuers, leaving the market dependant on the services of the rating agencies. This makes for the perfect business relationship - in essence, all municipal bond investors outsource their research to the rating agencies, so we need to know the ratings are proper, relevant, and up to date.
Furthermore, and most important, mutual funds and money market funds have developed large and successful businesses based on ratings. Money markets, the foundation of the liquidity of the U.S. dollar, invest based on rules that revolve around ratings. Under the current draconian system, when providing a muni bond a rating of single-A, the rating agencies are giving a rating that is not generally eligible for a money market investment under SEC Rule 2a-7.
In order to move the rating up to a level that is consistent with money market eligibility, the issuer would need to pay a bond insurer to enhance the rating. This seems to be an unfair consequence that has significant, if unintended, financial penalties. The A-rated municipal would likely be eligible for money markets on its own merit if debt was rated equally across all asset classes.
It seems strange that double-A corporate debt is money-market eligible, while single-A municipal is not, even though the cumulative default rate for double-A corporate debt is approximately 10 times that of single-A municipal debt. Though the rating agencies have carved out a unique scale to rate municipal bonds, the general public and the SEC do not recognize it.
Until recently, the solution to normalize muni ratings between the municipal rating scale and the 2a-7 regulation was the use of bond insurance, which provided the municipalities and money market funds with the ultimate show of strength, a triple-A rating. Over the last year, bond insurance has become increasingly irrelevant as many investors, along with the rating agencies, are coming to realize that the majority of bond insurers may lack the financial capability to sustain triple-A or even double-A ratings perpetually.
That is why this is precisely the correct time to make a change in the rating scale. Adjusting municipal ratings to be on parity with corporate ratings would level the playing field. It would allow municipalities to operate fairly within a marketplace that is inclusive of all debt issuers, and will end the system that currently leaves municipalities paying approximately $2 billion a year to buy credit enhancement just to increase their debt ratings to where they would be rated without the prejudice of the current methodology.
Maybe I am being naive now, but I would like to hope the difference in rating scales is nothing more than an oversight that needs to be resolved, an overdue need to re-calibrate. I would hate to revert back to my distrustful youthful thoughts where I might wonder if the rating agencies are acting deliberately to hold municipal ratings down on behalf of their largest clients - the bond insurers. By using two different scales, the visiting team - in this case municipal governments - are playing at a consistent disadvantage.
Jon Fiebach is managing director at Duration Capital.