Sunday, June 22, 2008

Moody's global scale for municipals

(Accrued Interest) Bowing to significant political pressure, Moody's is set to change the way they rate municipal bonds. The change will result in thousands of upgrades, some perhaps many letter grades higher.

Historically, Moody's municipal bond ratings talked and walked like its ratings for other types of bonds: corporates, asset-backeds, etc. The top rating was Aaa, the lowest investment grade rating was Baa3, and so forth. But the default and recovery performance of municipals has been vastly different than other bond categories. For example, according to Moody's, between 1970 and 2006, about 1.3% of A-rated corporate bonds suffered a default within 10-years of issuance. However, only 0.03% of A-rated municipal bonds suffered defaults over the same time period. The ratings results were not even consistent within municipal bonds. Among Moody's rated general obligations (bonds backed by the full taxing power of a city, county, school district, or state) there was exactly one default from 1970 to 2006, whereas 0.4% of other municipal bond types defaulted.

Moody's has admitted that their municipal ratings aren't comparable to corporate or ABS ratings. However, in the past Moody's had contended that municipal bond investors appreciated the gradations of credit quality afforded by the municipal ratings scale. If Moody's used nothing but default expectation, virtually all general obligation municipals would be rated Aaa. It stands to reason that municipal investors value the differential between A1-rated California, Aa3-rated New York, and Aaa-rated Virginia. Something would clearly be lost if all three were rated Aaa.

However, recent stress in the municipal bond market has brought politics into the discussion. From auction-rates to bond insurers, the perceived safety of municipals has taken a hit. The collapse of several tender-option bond programs (a popular hedge fund strategy involving municipals) has dented demand for munis. More behind the scenes, municipalities are finding Wall Street less hospitable than in hears past. Bond insurance and bank letters-of-credit have become considerably more expensive. Wall Street firms are not as willing to buy bonds for their own accounts, increasing the cost of issuance.

Politicians, lead by Congressman Barney Frank and California Treasurer Bill Lockyer have been pressing the credit ratings agencies to rate municipal bonds based on expected loss only. A June 12 press release from the California Treasurer's office reflects the argument proffered by the issuers: "Lower ratings [for municipal bonds] have cost taxpayers billions of dollars in higher interest rates and bond insurance premiums." The theory is that there is a direct correlation between the ratings and the interest rate paid by the issuer.

At the same time, Moody's and Standard & Poors are facing serious (and well-founded) claims of conflict of interest relating to CDO ratings. Moody's seems to have made a political calculation: it can't go back and re-rate CDOs, but it can give Barney Frank what he wants with municipals.

Investors should care for two reasons. First it appears that most municipal bonds will soon be upgraded by Moody's. It is not currently clear what the timing of the ratings revisions will be, but Moody's has previously published a guide to "mapping" municipal credits to the Global Scale. For direct obligations of States, anything rated A1 or higher on the muni scale would be Aaa on the Global Scale. That means every state would be Aaa except Louisiana. For other general obligations, including cities and counties, anything rated Aa3 or better would be upgraded to Aaa. A general obligation bond rated Baa3 would be upgraded to Aa3. Even riskier credits like hospitals would enjoy at least a 1-2 notch upgrade, according to Moody's mapping. (The complete report is available here, requires a free registration.)

That should be a near-term positive, especially for middle-rated credits. There is significantly more demand for A and Aa-rated bonds than for Baa-rated securities, owing largely to legal or policy restrictions. There might not be much immediate effect, particularly until S&P follows Moody's lead. But over time, expect liquidity and the spread for the upgraded bonds to improve. Also, expect S&P to follow suit. S&P faces the same political pressure as Moody's, and now that Moody's has made the move, S&P will be all but forced to acquiesce.

There is a likely negative, however. The high ratings standards for municipals encourages some measure of fiscal conservatism. This is especially true for Aaa-rated credits, where loss of the rating would be politically embarrassing. Of course, municipalities are downgraded all the time, but clearly local politicians would rather maintain their rating than not. If the overwhelming majority of general obligation issuers are going to be rated Aaa anyway, that incentive is greatly reduced. In other words, a state like Georgia (rated Aaa) is currently incented to maintain its austerity. But if they could slide all the way down to California's level (currently A1) and still be rated Aaa, they'll probably do it.

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