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.
Ratings firms, bond insurance companies and some bond investors defend the separate ratings scales, arguing that it allows investors to make distinctions among various debt and, ultimately, set appropriate interest rates. Defenders of the current system say that sophisticated investors understand that the letter grades assigned to corporate bonds and municipal debt mean different things.
Gail Sussman, the Moody’s executive in charge of public finance ratings, likened the firm’s dual ratings scale to a ruler that measures in inches on one side and centimeters on the other.
“The distance between point A and point B is the same” whether it is measured in inches of centimeters, Ms. Sussman said.
Moody’s says it is willing to discuss changing its scale; so far few local and state officials have asked for a change, Ms. Sussman said. And when Moody’s asked for comments on the issue several years ago, investors, bankers and insurers overwhelmingly favored the status quo, she said.
Executives at S.& P., however, say they use a single global rating scale to measure all kinds of debt. Colleen Woodell, chief quality officer for public finance, acknowledged that municipal debt had defaulted at lower rates than corporate issues, but she noted that the data covered a relatively benign 20-year period.
Ms. Woodell said the disparity was “within a tolerable band” and would diminish over time. She said the firm upgraded a number of municipalities after it finished its first default study in 2000. (Data on S.& P.-rated municipal and corporate debt from the early 1980s to 2006 show similar differences in default rates as those rated by Moody’s.)
Some sophisticated bond investors say that if municipalities were rated on the same scale as corporations, it would be harder to distinguish the relative riskiness of various cities, states and school districts, and mutual fund companies would have to evaluate bonds issue by issue.
“If you rate 95 percent of the issues the same, the ratings cease to be useful, and investors need and utilize these ratings to differentiate credits,” said John Miller, chief investment officer at Nuveen Asset Management in Chicago, which manages about $65 billion in mostly tax-exempt bonds.
But local and state officials counter that a universal rating system would emphasize the relative safety of their debt against other bonds, arguably attracting more investors. In periods of stress like now more ready buyers would help reduce instability and help keep borrowing costs low.
So far, Mr. Lockyer has won support for his plan from half a dozen states, including Connecticut, Oregon and Washington, as well as from numerous cities and local authorities. They plan to send a letter to the three ratings agencies early this week calling for action.
Other public finance officials, including those for New York City, said that while they agreed municipal bonds were underrated, they would not sign the letter. New York City’s bond rating is double A.
The Government Finance Officers Association of the United States and Canada, which represents 17,200 local and state governments, is weighing whether it wants to take a stand on the issue before its annual conference in June.
The debate is not new. It has been pushed to the forefront because of the recent concern about the strength of bond insurance companies like MBIA and the Ambac Financial Group, which together guarantee interest and principal payments on $733 billion in municipal debt.
The insurers are themselves rated triple A — on the corporate scale — by Moody’s and S.& P., and essentially transfer those gilt-edged ratings to municipal issuers through the policies they sell. Municipal issuers with lower ratings paid $2.5 billion in premiums for bond insurance last year alone. In exchange, they typically pay lower interest rates on their debt than they would without the insurance.
Robert G. Shoback, a senior managing director of public finance at Ambac, said bond insurance lowered the cost of borrowing money, especially for smaller municipalities and school districts that might not be well known on Wall Street. Investors have relied on insurance for “comfort, confidence and stability,” he said.
But this year investors effectively stripped away the premium they placed on insured municipal bonds because they feared the bond insurers would lose their top ratings and, as a result, the bonds those companies insured would be downgraded, too.
“The industry is at a significant point now in how it views itself, how it interprets risk and how it will use insurance going forward,” said Thomas Doe, chief executive of Municipal Market Advisors, a research firm.
Mr. Blumenthal, the Connecticut attorney general, said the recent turmoil had allowed municipalities to voice long-held frustrations that they did not feel comfortable expressing earlier, fearful that ratings firms would refuse to rate them or give them low ratings.
The California group and other municipalities say there may be some middle ground where the two sides could compromise. Investors could still have finer delineations among bonds if rating agencies added suffixes to the newly triple-A-rated bonds, like Aaa1, Aaa2, and so on, said Roger L. Anderson, executive director for the New Jersey Education Facilities Authority, who has agreed to sign California’s letter.
Ms. Sussman, of Moody’s, said the firm would be wary about adding qualifiers to triple-A ratings, which the company regards as “gilt-edged.”