In an historic move toward greater transparency Moody’s, the New York-based credit rating service, plans to release a description of its surveillance process for rating local government debt this fall. Despite Moody’s claim that there will be no changes to its methodology, there will be plenty of eyes on this document when it is released.
In general, Moody’s has noticed an “increasing demand for more frequent and robust disclosure in the marketplace,” says Gail Sussman, group managing director for U.S. Public Finance and a 26 year employee of the company. Referring to the document as a “description of our process,” Sussman says, “People are interested in how we do it.”
That could be the classic understatement of the recent meltdown, for which the agencies also have, in part at least, been blamed. There remains no doubt on the Hill that regulators want to end the current external credit rating structure, of which Moody’s is a leader.
FDIC Chair Sheila Bair is no longer debating whether they should exist. Last Tuesday, August 10, the issue for her was the “task of replacing the agencies,” which she predicted “will not be simple.” In following the directive laid out in the new Dodd-Frank Wall St. Reform & Consumer Protection Act to limit the powers of external credit rating services, Comptroller of the Currency John C. Dugan, also on Tuesday, issued the report, which suggests ways banks can avoid using external credit rating services.
The procedures agencies are operating under are rife with conflicts. For the past two years, Elizabeth Warren, chair of the Congressional Oversight Panel and favored to head the new Federal Consumer Financial Protection Agency, has railed against what she calls a revolving door between major rating companies and Wall Street. She has followed ratings employees’ movements to jobs for the same investment houses who used the rating company for their investment instruments.
SEC Chair Mary Schapiro worked last year to find ways to stop firms from “rating shopping,” whereby the prospective client can find out the rating the bureau will give them before they decide if they’ll buy it from that service. Moody’s own 17-year veteran-executive-turned critic, Jerome Fons, now with ratings start up Kroll Bond Ratings, wrote in an March 16, 2009 New York Times op-ed that “regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.”
Judging by these examples, which represent a tiny sample of the tide of criticisms and outrage being publicly expressed, it’s safe to say people are not only interested in how the agencies process, crunch, interpret and finally choose the labels they affix to investments, but are likely intent on learning how they’ve gotten away with those practices so long.
Rather than waiting for the new report, readers impatient to learn more about these methods can simply dive into Moody’s 28-page opus from October 2009, entitled, “U.S. Finance: General Obligation Bonds Issued by U.S. Local Governments.”
Once as worry-free as Treasury bonds, municipal debt can no longer be seen as safe as houses. City revenue streams — squeezed by declining home values, unsold and foreclosed real estate, delinquent or appealed taxes, dwindling state financial support, climbing health care premiums, rising school costs, energy bills, retirement payouts and pensions — now come with highly variable rates of risk. Moody’s tackles these myriad considerations with a nationwide staff of 165, headed by four managing directors reporting to Sussman. They rate the local government credits, about 9,400 annually, using four factors: economic strength (40 percent), financial strength (30 percent), management and governance (20 percent) and debt profile (10 percent).
Considerations for peer comparisons and other exceptions aside, the ratings are dominated by the above factors — and Moody’s throws 70 percent of its weighting to economic and financial strength which, in the case of municipalities, Moody’s has (possibly to its detriment) largely equated with real estate growth. According to its guidelines, Moody’s viewed building permits, for new residential and commercial construction preferable, less “economically volatile” than existing properties, as late as its October 2009 paper. This, together with a weighting for debt of just 10 percent, could have proved irresistible for towns struggling to meet budgets swelling from public employee health, pension and retirement payments — on top of growing debt service costs.
Moody’s methodology states that the weighted average provides one input into Moody’s credit analysis. It depends on “where the credit lies on the rating scale and the degree to which it is an outlier on a given factor.” There are many such variable factors.
When governments are limited by caps from raising property taxes to satisfy debt service, they may resort to a special levy — another property tax — to secure debt. Some states provide exceptions under the cap for tax increases for debt service. Moody’s says that it considers a city’s limited or unlimited status on a case by case basis. It considers mitigating factors in these cases to be a strong financial position and steady tax base growth, again property tax revenue to keep pace with expenditure growth.
Another factor that is favorably perceived is state fiscal oversight, including a state’s willingness to allow cities to raise additional taxes to meet debt service. “Strong oversight at the state or local level is viewed as a positive factor, limiting the likelihood of a local government developing serious financial stress under a property tax limit,” the policy states. Oversight panels are also cited as “a positive rating factor... Moody’s believes that they ensure consistent standards of financial integrity.”
Two examples of these positive rating factors cited are New Jersey and North Carolina. The Local Government Commission in North Carolina is composed of nine unpaid members; four are state employees, one is an academic, one is a county commissioner, and three are attorneys, one of whom is also a former mayor. Aside from the four employees, three are appointed by the Governor, one by the Speaker of the House and one by the President Pro Tem of the Senate.
In New Jersey, the Local Finance Board is comprised of eight appointees of the Governor with the advice and consent of the Senate, who are paid $12,000 a year. The majority of the current panel hold no professional positions in finance. They are predominantly either elected officials or have served in some public capacity through political appointment. The board is under the Department of Community Affairs, whose former director was asked by then-Governor Jon Corzine to step down last year after the FBI raided his home and office as part of a sting operation.
Investors Can Check Muni Bond Ratings on the Web
As part if its effort to make its credit analysis more transparent to investors, Moody’s maintains a public interface on its Website, Moodys.com. In addition to rating changes, which are publicly announced via press release, visitors to the site can view outlooks and ratings by looking them up with the CUSIP number of the bond. From there, they can check Moody’s ratings list.
To assess a municipality’s debts, Moody’s relies on the audited financial reports prepared by the municipalities themselves. At least 85 percent are independently audited, the company says. Additional obligations owed by a city to issuing authorities also are disclosed by the governments. While ratings are public, Moody’s doesn’t share the municipality’s financial reports or audits, because they feel it’s not the agency’s place. However, municipalities are required to file financial statements with the Electronic Municipal Market Access (EMMA) , which is run by the Municipal Securities Rulemaking Board (MSRB), which the public can access at www.emma.msrb.org.
