Credit rating agency Moody’s labels California’s general obligation bonds as Aa3, among the four lowest-rated state bonds in the country. The other large rating agencies, Fitch and Standard & Poor’s, have bestowed similarly low ratings on California issues. However, the California constitution makes debt service senior to everything in the budget except education spending. This means that the state, by law, would have to zero out all spending on prisons, health care and virtually everything else before defaulting one dollar on a general obligation bond.
Even in bad budget years — and the state is currently running a surplus — this would be unthinkable and impossible, given available revenue streams. Yet the low credit ratings translate into higher financing costs, ultimately paid by state taxpayers. The rating agencies have attributed a particular risk of default to California, where, practically speaking, none exists.
California is not alone; states like New Jersey, Illinois, Pennsylvania and Connecticut also have been hit with relatively low credit ratings on their general obligation bonds. But no state has defaulted on general obligation bonds in 80 years, since the Great Depression. Similarly, numerous municipalities have low credit ratings, making it challenging to secure affordable financing to run government operations. But the expected wave of state and local government defaults, predicted by the likes of financial analyst Meredith Whitney and others, never really materialized. City bankruptcies like Detroit and San Bernardino get the headlines, but they are rare rather than regular events.
Incredibly, rating agencies, which use a “jury-style” process of analyst discussions along with computer models to rate municipal bonds, appear to still be using statistical analyses informed by the wave of state and local bankruptcies during the Depression, an era before deposit insurance and other safeguards. Public finance ratings have really never been the same since, systematically under-rated in a way that costs taxpayers and benefits various financiers on Wall Street.
In March, former rating agency official Marc Joffe, who now runs a competing computer model-based rating agency called Public Sector Credit, pointed out that the overall default rate among government bond issuers has been no more than .03 percent throughout the post-recession period. However, Fitch downgraded twice as many government bonds in 2013 as they upgraded, showing no signs of accounting for an improving state and local government budget picture. Downgrades based on speculation, like when states have problems passing a budget or securing pension reforms, rarely get met with immediate upgrades when the outlook brightens.
Meanwhile, Moody’s recently changed their rating model as it relates to pensions, using a different discount rate that increases the perceived size of future pension liabilities. This has made Moody’s gloomier about municipal finance, even though nothing has changed in the municipalities themselves, only their yardstick. “I do think Moody’s has gone overboard in their treatment of public debt,” said economist Dean Baker.
States have fought this issue in the past. In 2008, Connecticut Attorney General Richard Blumenthal (now a U.S. senator) sued the leading rating agencies, alleging differences between the rating scales for municipal bonds and corporate bonds. “We are holding the credit rating agencies accountable for a secret Wall Street tax on Main Street — millions of dollars illegally exacted from Connecticut taxpayers,” Blumenthal said at the time.
The lawsuit eventually settled, giving Connecticut just $900,000 in credits for future ratings services, without an admission of guilt. But changes to industry models were supposed to result, aligning all bonds under a standard rating system that measures the actual risk of default. While this appeared to work temporarily, many observers believe problems of systematic under-rating persist.
Because rating agencies are often the only information source for investors in municipal finance, their ratings carry significant weight. Jess Cornaggia of Georgetown University’s McDonough School of Business estimated in a paper this March that municipalities pay roughly $1 billion annually in excess interest due to the under-rating of municipal bonds. While this is a drop in the bucket for the $3.7 trillion muni bond market, it presents a legitimate burden on taxpayers despite a questionable rationale. And states pay even more; Illinois spent up to $500 million more than AAA-rated counterparts in debt financing last year.
Certainly the standards for downgrading municipal debt do not match the standards for corporate debt or other structured finance deals. Another report from Jess Cornaggia looked at Moody’s ratings from 1980-2010, and found that structured securities received twice as many AAA ratings over the period, but 20 percent of those AAA structured securities had to be drastically downgraded, while none — repeat: none — of the AAA municipal bonds did.
Section 938 of the Dodd-Frank financial reform law mandated that rating agencies apply ratings “in a manner that is consistent for all types of securities and money market instruments for which the symbol is used.” But the law also says rating agencies can use distinct sets of ratings for different bonds, defeating the purpose of consistency. “So you have AAA tiny subscript M for munis, and AAA tiny subscript S for securities,” said Marcus Stanley, policy director for Americans for Financial Reform. “They’re not applying a consistent scale based on default rates, just jiggering the symbols.” Standard and Poors has admitted this on its website, saying explicitly that its ratings “are designed primarily to provide relative rankings among issuers” and “are not measures of absolute default probability.”
Municipal finance suffers from individual biases far more than corporate finance. “A few years ago, the Harry & David gift basket company went bankrupt,” said former rating agency official Marc Joffe. “Does anyone believe that means all corporations will go bankrupt? No. Yet Detroit is supposed to be some kind of harbinger for everything that's going to happen.”
Marcus Stanley of Americans for Financial Reform believes the issuer-pays model of compensating rating agencies plays a role. “The economics of structured securities are dominated by a few players who can direct a lot of repeat business your way,” Stanley said.
While taxpayers experience harm from under-rating, multiple financial industry participants benefit. The rating agencies create an air of authority by differentiating ratings on state general obligation bonds where virtually none should exist. This assumed expertise allows the rating agencies to charge a high price for their services. “There’s a lot of money in being seen as an expert on state and local fiscal issues,” said AFR’s Marcus Stanley.
Monoline insurance companies also make out as a major winner. Before the financial crisis, municipalities bought bond insurance from these companies to improve their credit ratings. These insurers were no help in the Great Recession of 2008 because the biggest ones, like Ambac and FGIC, collapsed due to severe under-capitalization (despite AAA ratings from the rating agencies, mind you). Yet the industry has recently made a comeback, collecting significant sums from municipal bond insurance, money that could be spent in local communities. “They make up a gap in ratings that shouldn’t exist in the first place,” noted Marcus Stanley.
Incidentally, Ambac is in the midst of litigation from two counties in California, alleging that they and other bond insurers “colluded with the rating agencies to perpetuate a ‘dual rating system,’” in which rating agencies “rated the debt obligations of municipal issuers differently from corporate debt obligations, thereby keeping municipal ratings artificially low relative to corporate ratings.”
Congress has not held hearings on this problem in several years. The tools exist — through Dodd-Frank Section 938, reforms to rating agency compensation and the enactment of real penalties for abuse of the rating process — to end this two-tiered dynamic, where corporate debt is over-rated and municipal debt under-rated. But until the Securities and Exchange Commission actually makes some changes, any state or local government needing financing for road construction, education or health care will pay a steep price to prop up financial institutions.
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