Tuesday, March 4, 2008

Rating ULBs and corporates

The recent volatility in the Municipal Bond market (Munis) has spotlighted certain anomalies in the $2.6 trillion Munis market in the US. The NYT highlights how a complex system of credit ratings and insurance policies that Wall Street uses to set prices for municipal bonds makes borrowing needlessly expensive for many localities.

The turmoil in the US munis market is the best example of how standard credit rating models fail to accurately reflect the credit-worthiness of cities. It is widely acknowledged that states and cities rarely dishonour their debts and are therefore much safer than those issued by corporations. In fact, from 1970 to 2006, lower-rated, single-A municipal bonds defaulted 17 times less frequently than triple-A corporate debt. And even when they default, investors get all or most of their money back, unlike the case of corporate bankruptcies. Despite all these, there have been numerous instances of ratings firms assigning municipal borrowers low credit scores compared with private corporations.

California, one of the largest issuers of Municipal Bonds in the US and one of the safest investment options in the debt market, is rated A instead of AAA. Because of their relatively weak credit scores, more than half of all municipal borrowers buy insurance policies that safeguard their bonds in the unlikely event that they fail to pay the debt. California, for instance, paid $102 million to insure more than $9 billion in general obligation debt between 2003 and 2007. Ratings agencies like Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are then paid a second time to evaluate the insured bonds.

The lower rating also imposes another cost in the form of high bond insurance premiums. Municipal issuers with lower ratings paid $2.5 billion in premiums for bond insurance last year alone. Bond insurance companies like MBIA and the Ambac Financial Group, which together guarantee interest and principal payments on $733 billion in municipal debt, have been facing pressures on the sub-prime mortagage backed securities insured by them.

A vicious cycle gets generated - credit rating agencies give cities lower ratings, necessitating insurance at higher premiums, thereby increasing the cost of capital and straining municipal finances, and ultimately lowering their credit worthiness. The lower rating acts as an entry barrier for cities in accessing the municipal debt market by making investors wary of lending and cities reluctant to access debt.

Update 1
Moody's has decided to change its rating system so as to ensure that Municipalities are rated on the same standards as corporates.

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