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.
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