In “States and Cities Start Rebelling on Bond Ratings,” the New York Times attempts to make the case that municipalities can lead a revolt against Wall Street:
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…..
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.
It’s a bit late to come to that realization. The horse hasn’t just left the barn, it’s in another county by now. As Bloomberg tells us in “Auction Supply `Tsunami’ Foreshadows Deeper Municipal Losses,” issuers of auction rate securities, already hosed by market failures and the resulting spike-up in rates, are going to take a second beating when they try to secure longer-term funding due to a massive supply/demand imbalance:
U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities….The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989….
“It’s a supply tsunami,” said Robert Fuller, principal of Capital Markets Management LLC in Hopewell, New Jersey, a financial adviser to municipalities. “All of that is going to be redone and it’s going to be redone fast,” he said of auction-rate bonds.
Now the New York Times piece, on page one, is no doubt intended for a broad audience, so it explains (without giving comparative default rates, which would have been useful), that rating agencies grade muni bonds more harshly than corporates:
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….. 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.
However, the piece notes rather blandly the central conflict of interest: that rating agencies have good reason to have established and perpetuated this double standard. When less than AAA municipalities go to buy bond insurance, they are paid again to issue the second rating.
Despite noting this large economic incentive, the Times makes no attempt to obtain or develop estimates of what these second ratings might be worth in financial terms to the rating agencies. One has to assume that these second ratings are highly profitable; there’s just about no effort involved in rubber-stamping a bond insurer policy.
While journalists can’t be as pointed as commentators, the lack of critical thinking, as exhibited in failure to question the pablum fed the author, is striking. Consider this section:
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.
And pray tell, who assumed that the municipalities should pay for new ratings? All that these hapless issuers (and allied state attorney generals) are asking for is for their self-serving grading scales to be recalibrated. They can do that using their existing data. The notion that they’d extract another fee for this is preposterous.
And the rating agencies are resorting to bald-face lies to defend their practices:
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.
Well, of course the rating agencies and bond insurers defend the system; it’s a meal ticket. And some investors might like it because it creates market inefficiencies.
But contrary to their sudden protestations otherwise, ratings were always supposed to mean the same thing, in terms of default risk, not matter what was being rated. That was the rating agencies’ own position on the matter. From Joshua Rosner and Joseph. Mason’s “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions“:
Credit rating agencies (CRAs) have long argued that the ratings scales they employed were consistent across assets and markets. Not long ago Moody’s stated “The need for a unified rating system is also reflected in the growing importance of modern portfolio management techniques, which require consistent quantitative inputs across a wide range of financial instruments, and the increased use of specific rating thresholds in financial market regulation, which are applied uniformly without regard to the bond market sector.” In a similar pronouncement in 2001 Standard & Poor’s stated their “approach, in both policy and practice, is intended to provide a consistent framework for risk assessment that builds reasonable ratings consistency within and across sectors and geographies”.
However, the willingness of ratings agencies to lie in public should come as no surprise. Moody’s, in testimony before the Senate Banking Committee last September, maintained that it played not role in structuring or designing structured securities. They dare make statements like that despite the fact that numerous industry textbooks, as well as documents at the SEC, describe the process of creating structured finance instruments, and frequently describe, in some detail, the active participation of the rating agencies. If this practice is so well known that it shows up in textbooks, it would be trivial to get industry participants to confirm it.
But of course, the rating agencies have a huge incentive to try to snooker anyone who can’t be bothered to dig deeper. Admitting to their well-known role in structured finance transactions could open them to liability by virtue of being an underwriter (now they are suit-proof by virtue of being able to hide successfully behind the First Amendment). So in keeping with their fierce attention to their bottom line, they’ll also defend their municipal bond sham as long as they can get away with it.