While some vocal state and local government officials have suggested an overhaul of the municipal bond rating system, calling for a broad scale upgrade of municipal securities, not everyone is so quick to jump on that bandwagon.
The Government Finance Officers Association (GFOA) has announced its support of Moody’s Global Scale Rating, which aims to further enhance transparency and comparability between corporate and municipal rating scales. The GFOA letter of support is posted on the California State Treasurer’s Office web site, in a section devoted specifically to Municipal Bond Rating Reform.
Those pushing for a sweeping upgrade of municipal bond ratings point to low default rate studies that have been done since the 1970s, along with a need to provide a global equivalent scale for grading corporate and municipal bonds.
However, there are some that say that these studies may be incomplete.
In a recent report entitled, “Been There, Done That: Municipal Ratings and the Move to Restructure the Rating Scale,” Richard Ciccarone, Managing Director and Chief Research Officer of McDonnell Investment Management, says that the reasons for the current rating differentials – which have a strong foundation based on the total 20th century default records – should be carefully considered. He cautions against making changes to the system too quickly, particularly as we embark on a period of economic uncertainty.
“This appears to be an odd time for a wholesale upgrade due to the enormous uncertainty in the credit markets, economy and real estate,” he says.
Ciccarone refers to the genesis of current rating system, which dates back to the Depression. He points to the Postwar Quality of State and Local Debt study, published by the National Bureau of Economic Research, which provides historical default rates for municipal bonds, based on a study by George Hempel. According to the study, more than 3,200 municipal bonds were in default at the peak of the Depression in 1935. Of these defaulting issues, almost half carried a triple-A rating in 1929, and more than three-quarters were rated double-A or higher.
While the good news is that government debt that defaulted had a high recovery rate, the defaults led to more stringent criteria by the rating agencies.
“Proponents of the upgrades are making a push based on assumptions that may be too narrowly defined, based solely on historical default rates since the 1970s. And while there have certainly been some “bumps in the road” since then, these have generally been prosperous times, marked by a healthy overall economy.”
But increased debt levels, infrastructure demands, pension and other post-employment benefits all have the potential to impose a significant negative weight on credit quality going forward, making this an untimely period for a mass upgrade.
Ciccarone explains that today’s rating system has its foundation based on a longer record than just the default history from the past thirty years. The ratings process was revised after the Depression for reasons that should be strongly considered today.
In a position statement issued in early May, the National Federation of Municipal Analysts (NFMA) urges market participants to participate in the debate “in a reasoned and thoughtful manner.” While it doesn’t specifically choose sides, the organization expresses its concern that “recent statements advocating radical and sudden changes to the municipal rating scale could threaten the restoration of a smoothly functioning market.”
How likely is a change in the ratings system? We are probably going to see some sort of compromise on the horizon, with a gradual increase in ratings upgrades. In fact, both Standard & Poor’s and Fitch have already begun to move in that direction. Moody’s and Fitch are both considering a global equivalent rating system, based on default rates for all types of fixed income instruments. This system is currently under review for possible implementation.