By: Anthony Rainey
Anthony Rainey is treasurer and CFO of Hyattsville, MD.
GOVERNMENT SECURITIES—Governmental securities are debt
obligations issued by states, cities, counties, and other governmental entities
to raise money to build schools, highways, hospitals and sewer systems, as
well as many other projects for the public good. Municipal securities are the
most important way that U.S. state and local governments borrow money to
finance their capital investment and cash flow needs. An important
distinguishing characteristic of the municipal securities market is the
exemption of interest on most municipal bonds from federal income taxes. The
implicit subsidy provided by the federal government permits municipal issuers
to compete effectively for capital in the domestic securities market. There is
currently in excess of $2.67 trillion in outstanding municipal debt. One of the
requirements of the past was for a government to obtain a credit rating.
CREDIT RATINGS—In its simplest sense, a credit rating is an independent opinion by specialist on the
chances that a government borrower will repay its debt as promised—on time, in full. It is an
opinion based on an assessment of a government’s creditworthiness, which is the
likelihood of making repayment, or conversely the risk of default, on
a debt. The
credit opinion, summarized in the form of a rating, is prepared by
someone who understands the operations and environment of the government—a suitably qualified rating agency
that investors will trust. It enables potential investors to decide whether
to invest in the government’s issuance of debts, based on the level of risk they are willing to take and the likely
reward associated with that risk.
Each credit rating indicated to the
government considering borrowing the rate of return it
would need to offer to an
investor, in the light of the level of risk assessed by the rating agency. There is
a range of ratings – from very secure through to very risky—and the higher the rating the lower the interest rate a borrower would need to
pay to attract an investment. Ratings could have many gradations, but rating scales
typically had a
break-point above which the ratings were classed as “investment grade.” This was for the benefit of those
who only wanted
relatively risk-free investments, such as pension fund administrators. However, some
investors weree
interested in borrowers below investment grade (normally
known as “speculative”), since they may have wished to include a higher return (but higher risk) investment
within their portfolio (that is, their collection of investments with a
spread or mix of risk/return opportunities).
In the past issuers that met certain credit criteria could
purchase bond insurance policies from private companies. Insurance guaranteed
the payment of principal and interest on a bond issue if the issuer defaulted.
Bond ratings were based upon the credit of the insurer rather than on the
underlying credit of the issuer. The bond insurance mechanism began in 1971.
Since then, the number of insured issues
expanded exponentially from only 3 percent of bond issues in 1980. Moody’s Standard & Poor’s
Fitch IBCA Duff & Phelps Interpretation
The credibility of credit rating agencies has been
questioned (a result of how they rated subprime mortgage securities), municipal
bond issuers have taken them to
task for upholding them to a higher standard than corporate issuers, although
they are less likely to default. Higher ratings mean less bond issuance costs,
with the municipal bond insurer avenue to the same goal being affected by the
credibility question as well in the credit crunch era of today. Some have noted
that the crisis with the quality of credit ratings is rooted in the change in
the incentive structure within the rating agencies. During the early 1970s, it
was pointed out that the credit rating agencies abandoned their long-held
practice of charging investors for subscriptions, and instead began charging
issuers for ratings based upon the size of the issue. The failure of the rating
agencies to keep abreast of market reality has been blamed by some commentators
on the fact that this created a conflict of interest and a bias in favor of
issuers over investors. Ironically, the old payment model also produced a
similar result in 1929.
An
important feature of ratings was that they helped
investors maintain a diverse portfolio without in-depth knowledge of each
of their holdings because the rating agency maintained surveillance over individual borrowers.
Thus, the rating agency helped “pool” market knowledge, which made tracking of a large
number of investments much easier and less expensive.
While the historic risk involved
in municipal bond investment has been negligible (the municipal default rate is about 20 times
lower than investment grade securities in the corporate sector), local governments that issued municipal bonds often choose to
purchase "bond
insurance" to enhance the security of the bond
to bond purchasers and because of the exceptional ratings of bond insurers lower their
borrowing costs. For example, a bond that was insured would have a higher credit rating than a non-insured
bond. The higher credit rating (AAA for example) enabled local governments to pay a lower
interest rate on the bonds when they are sold.
Q1. Do you
know what the credit ratings are for the state and municipality that you
reside?
Q2. Do you
think that the financial bubbles of past and present times led the rating
agencies to become lax in their vigilance when they should have been extra
vigilant in their scrutiny?
Q3. Should
rating agencies for state and municipal debt issues be regulated?
BOND
INSURANCE—While the
purchase of bond insurance by local governments has been a routine practice to
lower the cost of borrowing and fund critical local projects, this practice
has been severely impacted by the subprime mortgage crisis.
Nearly all of the bond insurance companies that local governments relied on to provide
highly rated insurance are the same institutions that also guaranteed the payments on
securities backed by subprime loans. As a result those insurance companies have seen a downgrading
of their investment rating or have ceased business operations entirely. Thus, the
benefits of insurers' bond insurance are lost and the cost of borrowing for local governments
utilizing bond financing increases. Further, with few highly rated insurance providers
available, local governments, who are already facing severe budget constraints and fewer investors in
the marketplace, must now assume increased borrowing costs.
SOLUTIONS
A. One
solution is for the U.S.
Department of Treasury to act as a temporary guarantor of municipal
bonds exercising authority granted to Treasury under the Emergency Economic Stabilization
Act of 2008 (P.L. 110-343)
B. Another solution is the
creation of a mutual guarantor for municipal bonds. The new entity could insure new,
fixed-rate securities covering general obligation bonds and revenue bonds
issued by cities, ccounties
and school districts and revenue bonds sold to finance essential governmental services
such as water and sewer facilities. Such a voluntary, national mutual insurance company
owned and operated by local governments would have many advantages. It would be
mission-driven rather than profit-motivated with the objective of minimizing
borrowing costs paid by its members. Federal capital support would be needed to
establish such a guarantor.
C. Another solution is to provide
bond security in place of highly rated bond insurance is a letter of credit
(LOC). Under this arrangement, a bank providing a LOC lends its own credit
rating to the bond issuer. However there is only one bank (Union
Bank of California) that will extend a LOC and they will only provide such a
letter to cities and counties with a Moody's Investment Grade
rating or better. However
this would mean that a
number of local governments—in many instances those with the
greatest need for bond financing assistance—would not be extended support. In addition,
costs will be higher for those cities and counties that are able to
participate, as the cost of obtaining a LOC versus securing bond insurance is
higher.
Q4. How
should we resolve these issues?
Whether you
are a municipal, state or federal government employee, the answers to these
questions will affect you.