States and Cities Start Rebelling on Bond Ratings

Does Wall Street underrate Main Street?

A growing number of states and cities say yes. If they are right, billions of taxpayers’ dollars — money that could be used to build schools, pave roads and repair bridges — are being siphoned off in the financial markets, where the recent tumult has driven up borrowing costs for many communities.

A complex system of credit ratings and insurance policies that Wall Street uses to set prices for municipal bonds makes borrowing needlessly expensive for many localities, some officials say. States and cities have begun to fight back, saying they can no longer afford the status quo given the slackening economy and recent market turmoil.

Municipal bonds, often considered among the safest investments, sank along with stocks last week, darkening the already grim mood in the markets. Several big hedge funds unloaded bonds as banks further tightened credit to contain the damage from mounting losses on home mortgages and other loans.

States and cities rarely dishonor their debts. The bonds they sell to investors are generally tax-free and much safer than those issued by corporations. But some officials complain that ratings firms assign municipal borrowers low credit scores compared with corporations. Taxpayers ultimately pay the price, the officials say, in the form of higher fees and interest costs on public debt.

“Taxpayers are paying billions of dollars in increased costs because of the dual standard used by the rating bureaus,” said Bill Lockyer, treasurer of California, who is leading a nationwide campaign to change the way the bonds are rated. California, one of the largest issuers of municipal bonds, is rated A; Mr. Lockyer said the state should be triple A.

The state is soliciting support from other municipalities for a letter it intends to send to the ratings agencies, arguing that municipal bonds should be rated on the same scale as the one used for corporate bonds.

Because of their relatively weak credit scores, more than half of all municipal borrowers buy insurance policies that safeguard their bonds in the unlikely event that they fail to pay the debt. California, for instance, paid $102 million to insure more than $9 billion in general obligation debt between 2003 and 2007.

Ratings agencies like Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are paid a second time to evaluate the insured bonds.

Officials at ratings firms and bond insurance companies defend the system, saying it gives investors the information they need to buy bonds with confidence. The recent turmoil, they say, highlights the need for insurance. They further add that rating municipal bonds like corporate debt would not save taxpayers much money, if any.

The outcry in the municipal market comes at a difficult time for the ratings firms and bond insurers. S.& P., Moody’s and Fitch Ratings have drawn criticism for assigning their highest grades to securities tied to subprime mortgages, only to downgrade them later as defaults surged and the investments tumbled in value.

The plunging fortunes of bond guarantors, meantime, have cast doubt over the value of the insurance policies municipalities buy.

“We are learning essentially that the emperor may have no clothes, that there is no real reason to require these towns to have insurance in many instances,” said Richard Blumenthal, the attorney general of Connecticut, who is investigating the ratings firms on antitrust grounds. “And it simply serves the bottom lines of the ratings agencies, the insurers or both.”

The House Financial Services Committee plans to examine how municipal bonds are rated at a hearing on March 12.

At every rating, municipal bonds default less often than similarly rated corporate bonds, according to Moody’s. In fact, since 1970, A-rated municipal bonds have defaulted far less frequently than corporate bonds with top triple-A ratings. Furthermore, when municipalities do default, investors usually receive some — or even all — of their money back, unlike in most corporate bankruptcies.

But critics like Mr. Lockyer and Mr. Blumenthal face an uphill battle to change the Wall Street system. Upgrading municipal ratings would dramatically alter the landscape of the $2.6 trillion market; Moody’s estimates that more than half of the market would be rated triple A or double A using the corporate scale. Triple-A securities are considered nearly as safe as Treasury bonds issued by the federal government.

Moreover, some bond specialists caution that this is the wrong time to rerate municipal bonds. The slowing economy and faltering housing market are squeezing state and city tax revenue. At the same time, public pension liabilities keep rising. Facing budget shortfalls, states like California, New Jersey and Arizona are cutting services.

CONTINUED : States and Cities Start Rebelling on Bond Ratings

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