Rating Agency Conflicts in Munis Coming Under Fire

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.

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  1. Ginger Yellow

    “”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?”

    I don’t think that’s what they’re saying. I think the point is that even if in general munis should be on the same scale as corporates, it doesn’t make sense to upgrade them when they’re under severe fiscal pressure.

  2. Yves Smith

    Ginger Yellow.

    I still beg to differ. If the rating agencies are merely rescaling their current grades, which is all that the municipalities are calling for, all ratings would go up. If you accept the inch/metric example that the Moody’s source claimed, this would be a mere changing of the mark to make it mean what it is supposed to mean. The municipalities are asking for a rescaling, not a rerating. And it’s reasonable for them to ask for it. They should have asked for it years ago, however.

    The problem, which is not acknowledged, is you have some sophisticated buyers (funds) but even they have rating constraints (often AAA/AA), and retail buyers who are very ratings driven. And the ratings as they stand are way too tough.

    The disparity in grade is often over a full grade based on expected defaults.

    If the ratings are too high systemically, on whatever scale, that says the rating agencies aren’t doing their job, But of course, we know that already.

    And in this case, the rating agencies have no statistical basis, none, nada, for how to rate munis with this much stress in the housing market. Better to re-rate now, or anytime in the next six months. The agencies have a very very well established history of not downgrading until well after the markets have already treated the paper as if it’s downgraded.

    After the wreckage they have caused via the bond insurer mess, there is no way the rating agencies are going to be aggressive in their estimates of default risk (except those few high profile basket cases like Jefferson County in Alabama). They maintained a politically and financially expedient fiction via their affirmation of AAAs for MBIA and Ambac. They’ll do so again with the munis.

  3. Anonymous

    Rating agencies have no credibility left. The muni issuers should abandon the insurance scam, which by the way didn’t exist until 1971. States have the ability to raise taxes to cover potential deficits, plus there is a lot of fat that can be cut from state governments. That’s why there have been such a scarcity of defaults in munis. The issuers may still need ratings, but the point is that munis get systematically underrated by the agencies. That has to stop.

  4. RK

    Here is a question for which I don’t have an answer.
    Perhaps some reader may. If municipal bonds as a class have been UNDER RATED relative to their long
    term performance by the rating agencies, so that they pay a higher interest rate than they should, does that not imply that corporates of the same ratings grade have been OVER RATED? And if this is true, does it not logically follow that corporate credits have paid a lower rate than they otherwise would have, as a result of this free rider effect?

  5. Ginger Yellow

    I’m not saying it’s right. I’m just saying that’s what the argument is. It’s not about paying for a new rating, it’s about upgrading a deteriorating credit. You can see why they’d be wary of doing that, even if it’s a systematic upgrade of a sector.

  6. Francois

    I’m not a credit expert, nor a CPA, just a taxpayer who’d like to know why in the world should the munis let Wall Street and compadres collect fees on top of fees that will end up costing me more in taxes.

    Can someone help me with some nagging questions I have?

    The data appears to show a far less probability of default for municipalities than corporations, all things being equal. Then:

    1)Why do investors anchor themselves to those stupid ratings in the first place? They need someone to discharge themselves from due diligence or what?

    2) What is this thing about “…they are suit-proof by virtue of being able to hide successfully behind the First Amendment”? I was not aware that First Amendment protection gave anyone permission to lie and cheat, nor that it allow anyone to engage into dereliction of fiduciary duty.

    3) Why don’t the municipalities form a non-profit institution that would record and monitor their credit history and performance,thus helping investors doing their own diligence?

  7. Ginger Yellow

    1) Basically, yes. Retail investors are big buyers of muni-bonds, and they can hardly be expected to do detailed credit analysis. More worryingly, however, this crisis has revealed the extent to which large institutional investors, who should be doing their own due diligence, were looking only at rating and yield.

    2) The argument, which has held up so far in court, is that the rating agencies are just providing an opinion on credit quality, not a recommendation to buy. The courts have held they have no fiduciary duty. Whether that’s appropriate is another matter.

    3) Well, there would be a pretty clear incentive for them to distort those figures, even more so than for the rating agencies.

  8. Anonymous

    I hope every city in America comes to terms with the corruption out there, but obviously a lot of corruption is also at the local level. I live in a small town that just had to get into the game of building big box stores and expanding the city infrastructure to meet the demand of all the great min wage jobs that would flood in along with the crime that has followed. The people that ran the city acted like the same mafia we see in washington, and with The Fed, rating agencies, banks, derivatives, etc.

    Wmt and the big boxes have helped set a tone for discretionary abuses of local policy, so dont be too fast to think that local small town manipulators will be less greedy than someone with a larger market share.

    The only good thing about distribution at a small scale, is that voters can now address this abuse by looking at the accounting and staying on top of local accounting, budgets and the issue of bonds, which may the way this is solved!!!

  9. Anonymous

    In regard to the above comment, I want to offer some Katrina-like spin on this topic of collusion as it relates to politics. Our Fed is now obviously run by idiots, but the same thing is happening at lower levels within society, where nepotism has taken root and like a pernicious weed spread like wildfire. How does one control this fire? How do we take back America from these retarded zombies that turn everything they touch into piles of feces? I hope at a local level people question bonds, pensions, structure, growth and those in charge. As with any weed taking over, one must be vigilant!!!

    Example of trickle down economics as we await hyperinflation):

    Fed Nominees Pressed on Political Ties
    Questions Raised Over Their Service in Administration, but Confirmation Is Likely
    By Nell Henderson
    Washington Post Staff Writer
Wednesday, February 15, 2006; Page D03


    President Bush’s decision to elevate three former administration economic advisers to the Federal Reserve Board prompted questions yesterday about whether they would be able to steer the economy independently of the White House they have served.
    “This is inevitably going to create the impression that the board is more political than in the past,” Schlesinger said. “This creates more of a burden on Bernanke and company to prove they’re not taking their cues from [White House Deputy Chief of Staff] Karl Rove.”
    Warsh, 35, who has served on Bush’s National Economic Council for the past four years, is a special assistant to the president for economic policy.

    See Also: Jane Lauder is joining the migration of the well-heeled from their traditional breeding ground east of Central Park to the treeless precincts of Lower Manhattan.

She plans to occupy a newly purchased $12.63 million penthouse triplex with a terrace in a recently converted building in NoLIta.

Ms. Lauder, 31, the daughter of Ronald Lauder and the granddaughter of the cosmetics pioneer Estée Lauder, is vice president for marketing for the Estée Lauder brands American Beauty and Flirt! She is married to Kevin M. Warsh, 35, who works in the White House as a special assistant to the president for economic policy. Mr. Warsh has his primary residence in Washington, according to the White House press office.


  10. Anonymous

    Wow, The Fed’s youngest son has a great brother-in-law too!

    The Lauter family changed their surname to “Lauder” in the late 1930s. Her older son, Leonard Lauder, was chief executive of Estée Lauder and is now chairman of the board. Her younger son, Ronald Lauder, is a prominent philanthropist, a Republican political appointee in the Reagan administration, and developer of property in Berlin, among other endeavors.

  11. Anonymous

    OT, but worth a peek under the hood???

    SPRINGFIELD, Mo. — The Freedom Financial Group, a subprime auto finance company that primarily purchases contracts via independent dealers, recently announced it has signed a $15 million, two-year, revolving credit facility with ReMark Capital Group, which is an affiliate of the Goldman Sachs Group.

    According to officials, the facility is secured by auto receivables originated by Freedom Financial.

    Basically, Freedom Financial specializes in the acquisition, collection and servicing of subprime auto loans that are purchased primarily from independent dealers.

    “We serve as an alternative credit source of financing for dealers who sell vehicles to customers who have past credit problems or might not be able to secure financing from traditional sources,” Fenstermaker indicated.

  12. Smiff

    The whole muni/monoline thing is now barking mad

    QUICK: We also have talked an awful lot about what’s been happening with the bond insurers. You made a deal that you brought up on our air a couple of weeks ago, where you said you would take over the municipal bond portfolios for Ambac, for MBIA, for FGIC if they came to you. Did you hear from any of them? Did any of them take you up on that deal?

    BUFFETT: Well, we heard from them, but we tossed our hat in the ring, and they tossed the hat back. But fortunately–it’s been fortunate for us, because we’ve been writing business that they insured, and we’re getting a far better rate than we offered to take it over from them. So here–we’ve written 206 transactions in the last three weeks, and we have been paid an average of 3 1/2 percent to take on business that they wrote at 1 percent. But we don’t pay until they go broke. So in effect, the municipality has to quit paying, and over here I’ve got the bond insurers. And it’s just–it’s the three you named plus a few others. And they have to go broke, and then we pay. So we’re getting paid 3 1/2 percent to be in a secondary position when we offered to do it for 1 1/2 percent in a primary position.


  13. Anonymous

    Better get over here yves:


    Parts of the credit market remained largely dysfunctional, with asset-backed issuance volumes down, high-yield bond markets effectively closed, and large backlogs of leveraged loan deals still awaiting financing. Against this background, bank balance sheets continued to be under pressure and financial sector spreads saw renewed widening from mid-January, adding to perceptions of systemic risk.”

  14. Yves Smith

    Anon of 3:10 PM,

    Felix and I frequently disagree.

    The two agencies are merely making different statements about the same practice. S&P is trying to maintain the ratings are consistent, when they aren’t; Moody’s is being more candid, but putting a spin on it.

    I’ve seen tables, but I can’t recall the sources, which show the default rates across issuers and they are very similar for Moody’s & S&P. The articles in question (this long before the muni issue was hot) commented at some length about the highly inconsistent default results across issuers over prolonged periods. The agencies have been using strikingly tougher grading for munis, and lax standards for structured products, even before the recent problems.

    And of course, both those patterns are consistent with what served them financially.

    Aside from the fact that this had been their well-established policy, the reason that the agencies should have consistent marks across issuers is that in many cases, what credit quality of debt investors hold is restricted, either by regulation (capital charges, investment restrictions) or for fund managers, by their agreement with the investors), and those restrictions are defined in terms of rating agency ratings. Thus it’s important that an AAA (or BBB, same concept applies) mean the same thing across product, that’s been the regulatory assumption behind these rules.

    Why? Well, look what happened with structured products. If you have ratings that are too high, you create an incentive for investors to buy those products, It’s permitted under their charter, but will carry extra yield, because that AAA really ought to be an AA or A, so it carries a higher yield. Again, before the credit mess got acute, many structured products were carrying big spreads over Treasuries for their AAA tranche (I heard 270 bp last May, which is massive). You don’t get free lunches on AAA paper. The market knew bloody well this paper wasn’t what the rating agencies said it was.

  15. Francois

    Ginger Yellow 10:57AM:

    “The argument, which has held up so far in court, is that the rating agencies are just providing an opinion on credit quality, not a recommendation to buy. The courts have held they have no fiduciary duty. Whether that’s appropriate is another matter.”

    This is an eye-opener to me. I used to practice medicine and I was asked to provide an opinion every day on health and disease. The thing is, i had an “obligation of means” (do your best to guarantee a professional-grade effort and diligence) and a fiduciary duty to my patients.

    The courts have always held that health care professionals have a fiduciary duty, and rightly so. If the courts consider that rating agencies have no fiduciary duty in a line of work that can cost billions in investors AND taxpayers’ money, they are full of shit!

    Why Congress hasn’t addressed this blatant lunacy proves Mark Twain famous quote:
    “Say you are a member of Congress. Suppose also you were an idiot. But I repeat myself.”

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