Are Credit Ratings Reflecting True Risk?
More than two years ago, MuniNet published a five-part series on Assessing the Credit Quality of America’s Cities, intended to examine and create a framework to analyze the financial health of cities. With this first installment, MuniNet updates that study with an updated look at bond ratings assigned my Moody’s and Standard & Poor’s.
In the aftermath of Detroit’s bankruptcy, Merritt Research Services tapped its vast database of credit statistics to assess how close to the fiscal edge are America’s cities. The initial study focused heavily on long-term liabilities, including public pensions and other types of debt and obligations owed by cities, that weigh on cities for many years, often decades. With that in mind, we thought MuniNet visitors may find it useful to update those primer pieces with updated information.
Bond Ratings as the “Standard” for Assessing Risk
As a first step to examine the health of America’s cities, we took a look at their bond ratings. The two biggest municipal bond rating agencies – Standard and Poor’s (S&P) and Moody’s, were used in this study.
As a measure of credit quality, municipal bond ratings are popularly viewed as the official source of judgment that indicates the strength of a state or local government’s ability and willingness to pay its bonded indebtedness. Their respective opinions are based on standardized criteria set by each rating agency, that considers matters of relative affordability, legal protections, historical experience, and foreseeable projections.
To accomplish their mission, they rely on standard methodologies, using key metrics to measure performance over time. The question is whether city ratings measure up evenly to the statistics which are largely used to assess them.
According to the analysis, based on ratings applicable and available as of June 19, 2017 75% of the 1,525 U.S. cities in the study (all cities with more than 30,000 persons as well as 602 randomly selected cities with populations below 30,000 persons) had at least one rating in the two highest rating brackets on their own merits (excluding insured ratings), AA or AAA, with fine-tuning symbols of “+”, “-“, 1, 2, and 3 ignored, by S&P or Moody’s. In general, as city population size became larger, ratings became higher.
The concentration of highly rated cities is a recent occurrence, which ironically came to fruition mostly after the credit crisis
Eighty four percent of the ratings for cities with populations over 100,000 we at least AA3 or AA- (S&P: 88% and Moody’s: 83%).
Eighty five percent of the ratings associated with the nation’s biggest cities whose populations equaled at least 500,000 fell in the two top brackets. The breakdown for each rating agency was 81% for S&P, and 91% for Moody’s.
The heavy percentage of highly rated cities suggests that the official evaluators of credit risk are content with the prospects for city credit quality. Since ratings are supposed to reflect risk over the life of the bonds through their maturity, rating agencies are suggesting that perceived risks are manageable for the next 20 to 30 years.
The concentration of highly rated cities is a recent occurrence, which ironically came to fruition mostly after the credit crisis, when criteria changes were adopted by the rating agencies related to state and local general obligation bonds. Encouraged by federal and state officials, who felt that municipal ratings were overly punitive given their post-Depression default rates, rating agencies embraced the concept of recalibrating ratings in tune with global
In 2010, a massive recalibration by Moody’s and Fitch revised upward the majority of city credit ratings, as well as other state and local issues – often by as much as two rating grade notches. The primary justification for the higher bond ratings was largely attributed to the historically low municipal bond default rates on general obligation and essential purpose revenue bonds, compared to all other types of fixed income bonds, referred to as the global credit scale. While S&P didn’t technically recalibrate U.S. local government ratings en masse, it was already engaged in a more gradual upgrade approach, based on similar rationale-adjusted criteria, which began around the onset of the new millennium.
Many fiscal experts, including the rating agencies, view Detroit as a combination of fiscal mismanagement as well as being a victim of its dramatic structural deterioration in its economic base. The cities that filed bankruptcy in California (Vallejo, Stockton, and San Bernardino) suggest a potentially broader risk due to a confluence of rather sudden escalating costs and liabilities associated with boom-and-bust conditions. Whether their challenges are not necessarily representative of the majority of cities across the country is not the issue so much as the fact that high liability cities, that lack the flexibility to respond to sudden or prolonged adverse conditions, pose the risk of insolvency and default.
Whether the preponderance of high-grade city ratings is warranted leaves plenty of room for debate, especially in light of the still-heavy burden of long-term liabilities, particularly retirement costs.
At the time of Moody’s and Fitch’s ratings recalibrations in 2010, municipal governments were facing their most challenging financial conditions since the Great Depression. When the agencies announced the proposed recalibrations two years prior to their implementation, I voiced my concerns in an article entitled, “Been There, Done That: Municipal Bond Ratings and the Move to Restructure the Rating Scale.”
In the piece, I took issue with the proposed recalibrations, by recalling that the last time city ratings were so highly concentrated at the top rating grades was in 1929. Thereafter, so many cities defaulted during the Depression that the experience led to a downward shift for city ratings that lasted over the next seven decades. Among other reasons for concern, I warned:
“Existing debt levels, pent-up infrastructure demands, pension and other post-employment benefit obligations have the potential to weigh down government balance sheets for years to come, especially in places and regions whose local economic bases are likely to grow much slower than in years past.”
Now, more than six years later, the numbers indicate that most cities have rebounded from the credit crisis, particularly in relation to current operations and are in little danger of a near-term fiscal crisis.
Still, the long-term outlook is less sanguine, as the Achilles heel for many cities remains the escalating burden of the dollars that they owe to pay existing and future retirees. In addition, many cities have deferred infrastructure financing to the extent that it creates a less conspicuous balance sheet liability, despite the intergenerational burden to taxpayers and ratepayers. From that perspective, today’s high concentration of city ratings in the upper two brackets paints too rosy a picture for a number of cities whose categorical legal protections, including those associated with a general obligation bond, earn them better ratings than their fundamental characteristics deserve. Accordingly, these cities may be less motivated to correct their deficiencies or resize their governments than if they were more accurately distinguished by the rating agencies or the market.
Richard A. Ciccarone is a Co-Publisher of MuniNet Guide. He is also President and Chief Executive Officer of Merritt Research Services, a municipal bond credit database and research company that primarily serves institutional investors, investment dealers, and bankers.