Municipality Ratings Lead to the Questioning of Credit Rating Methodologies

Today’s post reacts to the interesting article published recently in the Bond Buyer, entitled ‘How the coronavirus is impacting perceptions of municipal credit, ratings’. The article raises some very interesting points regarding the usefulness of credit ratings in the ‘muni’ marketplace, and also the impact that regulations on the disclosure and following of public methodologies may be having upon the position of the agencies.

‘Municipal bonds’ are simply bonds issues by a state, municipality, or county in order to finance any of its capital expenditure; this is similar to the process of generating sovereign bonds for countries, for example. However, with a number of major US muni issuers being hit with rating downgrades recently – including Illinois, New York, New Jersey, Connecticut, and the New York Metropolitan Transportation Authority – there are questions being raised as to how valuable these downgrades actually are. That concept is based on the understanding that a. these issuers are naturally going to be impacted by the pandemic in terms of lost revenue, but that b. they will not fail. The article discusses how municipal bonds are second to that of US Treasury bonds; the major difference between the two, as noted in the article, is that the US does not, really, need to worry about ‘balancing its books’ – it is currently in a deficit of nearly $4 trillion – however, whilst the muni-issuers do need to balance their books, the likelihood of them being allowed to fail by the Federal Government is extraordinarily low. This provides them with a protection that is particularly valuable and utilised by investors.

For this reason, a number of experts cited by the article essentially ask the same question: if this is the case, then what value does a muni downgrade have for investors? A former Moody’s analyst, Lisa Washburn, begins the analysis by suggesting that the rating agencies are using pre-pandemic rating methodologies, which are not able to usefully factor in the pandemic-related crisis and its particular intricacies. As the near-future is likely to be very unstable, the mass downgrades that are apparently coming (in all sectors, including the CLO market) are both uninformative for investors, as the argument goes, and also runs the risk for the rating agencies (and the market as a result) of the ratings overstating default risk, unnecessarily. Data is derived in the article from the Great Depression, which witnessed the same phenomenon. This issue is confirmed by the article which states that ‘none of the rating agencies have changed their methodologies due to the coronavirus’. However, the agencies have defended themselves. The Big Three and Kroll Bond Rating Agency are cited in the article as arguing that their methodologies look ‘through the crisis’, as well as being forward-looking (a consistent argument of the agencies against methodological criticism). The agencies have also argued that they a. review their methodologies regularly, b. that they are aiming to look through the crisis and then rank bonds in an orderly manner afterwards, and c. that the usage of tools like ‘outlooks’ and ‘opinions’ allow the rating process and methodological development to be ‘flexible’. Yet, the article raises the point that, on account of the Dodd-Frank Act of 2010, the wide-ranging legislation requires the rating agencies to both develop and most crucially adhere to publicly disclosed rating methodologies, and also to apply rating symbols universally. This is slightly misleading because, in that vein, the rating agencies are absolutely free to amend their methodologies in light of the crisis, but that they then must stick to them. Washburn wonders whether new rating symbols are needed for very short-term issues; she speaks about the New York MTA being dropped by two notches as representing ‘neither the opinion that there is an imminent risk to the issuer’s solvency nor that it is too big and important to fail and thus will receive the extraordinary support needed’. Whilst this sentiment may be unique to the muni market, it could perhaps be extrapolated to other markets, like the elite banking market for example – surely they are also ‘too big to fail’? The argument for more rating symbols pushes for the agencies to be more reactionary to short-term issues, and also injects more complexity into a process which is paradoxically extremely complicated yet mostly useful for its simple and easy-to-assimilate outputs (letter-based ratings). New and more rating symbols is likely not the way to go.

However, the negativity surrounding the rating agencies’ assessments of muni bonds is not universal. George Friedlander argues that the ratings in this market are quite important for a number of reasons. He rightly notes that the agencies have access to both masses of information, but also direct access to the issuer, which institutional investors do not have. Also, the agencies are specialists, with vast resources dedicated to analysing all of that available data. As the rating industry increases in size and continues to devour other industries – I have argued consistently that its natural progression is to devour the ESG rating market next – this concept will only become more appropriate. He also argues that ‘quite simply, in an environment in which the agency rating process did not exist, municipal bonds would be vastly more illiquid and difficult to price. Ratings provide a baseline from which institutional investors can adjust, higher or lower, and make changes over time as more information becomes available’.

This reminds me of a subject that arose whilst I was constructing an article that will be published shortly. I wondered ‘what do investors want from rating agencies?’ and quickly realised that finding one answer for that question is impossible. Of course, this is reflective of the dynamic and varied nature of the investor base, but it is telling that the agencies are coming in for criticism for many things which they have been historically been accused of not doing. For example, many critics have argued that the ratings are too reactive, but now people are arguing for a new set of symbols to show that the agencies are reacting quick enough, and for a short period in an exceptional era. If the agencies do not act – whether in downgrading or upgrading – they are criticised, but in this case they have downgraded and critics subsequently argue that downgrading is pointless because of the subject – does that mean municipals should not be rated at all? If a downgrade is applied but it does not take the bond into ‘junk’ status, is it really worthless? Friedlander has argued that it affects the pricing of that bond, which is a key part of the process and investing system.

Ultimately, the rating agencies will likely not care that much because their revenues and profits are consistently increasing, even after the post-Crisis regulatory era which was supposed to be ground-breaking. The reality is that the process will continue. There are issues with the rating agencies which should always be remembered, however. One of which is the issuer-pays system, which the article rightly cites as being an inherent issue for the industry. I read an article recently in which a number of hedge funds were identified as responding to the incoming pandemic quicker than most and also, Pierre Andurand stated that ‘I thought a lot of people were in denial about the potential for a pandemic and its knock-on effects… it was clear to me from February that it was going to spread to the rest of the world, that it was contagious, and that the potential death toll meant there was no other way than to have a lockdown’; this was interesting because he stated that he spent two weeks researching it, before taking the relevant actions with the money in his fund. The question then is why were rating agencies not doing the same thing? Could the rating agencies had downgraded much earlier, based upon the same ‘forward-looking’ analysis conducted by the leading hedge fund managers? Rather cynically, I wonder whether the answer lies in the answer to another question – what separates hedge fund managers and rating agencies? One answer to that question is that the hedge fund managers meet their profit-based objectives by foreseeing these trends and exploiting them, whilst rating agencies derive their profits from issuers, who would certainly react strongly to being downgraded weeks or months earlier than we have seen in the current crisis. Perhaps the whole rating industry issue, with all of the criticism that is attached to it, simply boils down to ‘how do you earn your money?’

Keywords – credit rating agencies, municipality ratings, methodology, @finregmatters