MuniLand

The swirl of ratings and CDS

The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.

The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.

The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.

Muniland is shrinking

Although municipal tax revenues have rebounded in the last few quarters, the declines of prior years have hit state and local employment hard.  In the chart above Matt Yglesias shows the collapse of state and local revenues; with the collapse of revenues we’ve seen the loss of many muniland jobs. Now the story is pivoting to large potential job losses at the federal level.

The New York Times is reporting that:

The financially strapped U.S. Postal Service is considering cutting as many as 120,000 jobs.

Facing a second year of losses totaling $8 billion or more, the agency also wants to pull its workers out of the retirement and health benefits plans covering federal workers and set up its own benefit systems.

Are raters accurate?

Credit markets are about taking risk to earn more return.

A way to think of this on a personal level is if you loan $1,000 to a steady, well-employed neighbor, you are likely to get it back because they have cash flow to repay the loan. Since the steady neighbor could likely borrow from many others, you can’t command a high interest rate. But if your chronically-broke, unemployed, woman-chasing neighbor wants to borrow $1,000 from you to fix his motorcycle, you could demand a higher interest rate to compensate for the risk. Maybe you’re the only one willing to loan to the risky neighbor.

The risk is that the broke neighbor might take your loan, fix his bike and ride off into the sunset and you may not get the money back. Bond markets call this type of borrower “speculative grade” because you are speculating that you will get your money back. The steady, settled neighbor would be called “investment grade” because you are investing your money with high likelihood of being repaid.

If you have a good sum of money to lend out, but not too much time, you probably would have to have some group investigate your neighbors and give you some feedback on their ability and willingness to pay. In the fixed-income markets this is what credit rating agencies do. They are very powerful because they have collected decades of data on issuers and their borrowing and repayment habits. It’s this process of monitoring and evaluating the creditworthiness of borrowers that makes raters central gatekeepers for bond markets. They are always watching the neighbors so you are relieved of the trouble.

Jon Stewart dives into raterville

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Jon Stewart’s Daily Show interview with Columbia law professor John Coffee is great. To have credit rating agencies discussed on a popular national comedy show is fantastic. The more the public knows about these powerful agencies, the better.

I generally agree with Professor Coffee but disagree with his statement that raters were the primary culprits in the financial crisis. The investment banks that created the subprime dreck and pimped the agencies to assign AAA ratings — they are the main culprits. Raters were just well-paid handmaidens to the banks which packaged mortgages. Banks also made the most profit from creating the crisis. He does identify investment banks as bad actors later in the video. Overall, an impressive performance by Professor Coffee.

Rater bashing

I may be the first blogger to defend the rating agencies this week. After I studied them and helped shape the rules which regulate them, I think this is a watershed moment. Standard & Poor’s took one of the bravest actions that I’ve ever seen a rater take when it downgraded the United States one notch. Furthermore, this marks a new beginning for accurate credit analysis and truth in fixed-income markets. Keep speaking the truth, S&P. Stand up and sing it out!

It’s been somewhat disconcerting to see the river of recent articles bashing the credit rating agencies after the downgrade. Raters aren’t perfect — after all they did prostitute themselves with their structured finance ratings that lead up to the August 2007 crash. For that, they deserve criticism. Strict new rules have been put in place since then that regulate them. Regardless, almost every article about the U.S. downgrade huffs and puffs about the legitimacy and fairness of a private company assigning an opinion about the creditworthiness of a sovereign entity.

S&P initially assigned their top rating of AAA to the United States in 1941 and had left it unchanged until last Friday. S&P is not paid for rating the United States. Even so, the decision to downgrade has been mocked as anti-American and uninformed. Unfortunately almost every person writing about this action couldn’t tell you how ratings are created, what they are used for or how raters are regulated. The lack of understanding is stunning.

Why the little guys can be on top

Here is a brilliant map from the Tax Foundation (via WPRI.com). The percentages on the map indicate the amount of each state’s annual budget that goes to pay off interest on their debt. Massachusetts leads the pack in this statistic with 9.58% of their budget going towards interest payments, much higher than the average. It’s important to note that this is not a map of relative ranking of debt loads as that would look quite a bit different and have California in the lead.

After seeing this map, S&P’s announcement that cities and states can keep their AAA rating despite the U.S.’s downgrade makes more sense. The National League of Cities said the following in response to Standard & Poors’ statement:

Standard & Poor’s announcement that cities and states may keep their AAA bond ratings despite the recent downgrade of the U.S. federal government demonstrates the difference between U.S. federal debt and the municipal bond market.

Unlike the federal government, municipal debt is typically not used to finance day-to-day operations. Local and state governments use municipal bonds to finance infrastructure projects. Nearly all local and state borrowing is longer-term (20 or 30 years) and debt service payments are predictable (usually the same amount each year). Additionally, local and state debt levels are low, about 16 percent of GDP, and usually representing a relatively small portion of local and state budgets, about 5 percent on average.

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“The great difficulty with politics is that there are no established principles.” - Napoleon Bonaparte (1769-1821)

Oh, America! It’s time to reinvent you. You are mired in a deep and prolonged slump. Economic activity keeps slowing. Our political class has been viciously testing the boundaries of their adversaries. We are faced with a lot of bills coming due and we are broke. What can be done?

Wall Street’s deepest muniland fear

Wall Street’s deepest muniland fear

Although credit rating downgrades for municipal bonds are grabbing the headlines, that is not a real worry for Wall Street. Underwriters and traders are used to adjusting their models and formulas for changes in ratings and interest rates; after all, they are extremely skilled at that. However, forces are taking aim at the way they are compensated, and that is Wall Street’s deepest muniland fear. It’s all about how they are paid to underwrite municipal bonds, and the state of Maine is leading the charge.

When states or municipalities issue bonds they use Wall Street banks to underwrite them. Wall Street banks or dealers either compete against each other for these mandates in a competitive process or one bank or dealer privately negotiates the terms of the bond offering with the issuer. A privately negotiated underwriting happens in approximately 80% of municipal bond deals. This often costs municipalities and states more in fees. Bloomberg has an outstanding piece about how the state of Maine is choosing the competitive style of bond underwriting and the political struggle that happened to get there:

Banks promote negotiated sales as letting them offer the lowest cost by tailoring the debt to specific types of investors. Yet academic studies of the municipal market show such sales often raise costs by as much as $4.80 on every $1,000 borrowed, according to Mark D. Robbins and Bill Simonsen of the University of Connecticut in West Hartford.

“Muniland a quiet backwater today”

Muniland was quiet today as market participants confined the bloodbath to the equity markets. Investors mainly sat on the sidelines and benchmark yields were unchanged. The Thomson Reuters Municipal Market Data 10-Year AAA Scale closed at 2.38%, unchanged from Friday. Reported volumes were light.

The worst muniland event of the day occurred when Moody’s announced that they had cut Puerto Rico’s general obligation debt rating to Baa1, a level close to the bottom of the investment grade scale. Because it is a territory, Puerto Rico has the unique distinction of enjoying national exemption from local and state taxes, so its debt is widely held across America. It is also among the cheapest municipal bonds available because the market believes it has some likelihood of default due to high levels of debt and unfunded pension liabilities.

The muniland non-story that commanded headlines was the expected downgrade of state and local bonds due to the Standard & Poor’s downgrade of the United States. Chris Mauro of RBC Capital Markets has some very good analysis about the arcana of this market and how the headlines are wildly overblown:

Because most municipal bonds are structured with serial and term maturities, the $2.9 trillion municipal bond market contains about 1.2 million individual CUSIPs, compared to about 75,000, for example for the US corporate bond market. As a result, S&P’s anticipated downgrade of pre-refunded municipal bonds and other directly linked bonds will, in the aggregate, produce a very attention-getting headline number.

We anticipate that most media outlets will run with this figure and highlight “thousands of municipal bond downgrades” in their headlines. We note, for example, that Moody’s, in its July 13, 2011 report on the potential implications of a US rating downgrade, identified 7,000 directly linked municipal ratings with approximately $130 billion in par value. Our immediate concern is that these kinds of headlines will prompt retail investors to engage in another wave of mutual fund selling.

Muniland likely resilient to U.S. downgrade

It’s a little frustrating to hear commentators outside of muniland bash all municipal bonds as though they were a homogenous asset class. AOL’s Daily Finance ran a quote from the top regulator at the Municipal Securities Rulemaking Board, who is pushing back on this idea:

“It is important to remember that only four to six [defaults] make headlines, but 45,000 others are doing OK,” Lynnette Kelly Hotchkiss, executive director of the Municipal Securities Regulation Board, tells DailyFinance. “Remember that every issuer is unique and needs to be analyzed on its own merit.”

Reuters is running with the meme that the municipal bond market will likely be resilient in the face of Standard & Poor’s downgrade of the United States. Bloomberg is sailing in the opposite direction with a gloomy view of the prospect of downgrades for munis after S&P’s action. The Bond Buyer reports that low expected issuance should help buoy yields. And the Wall Street Journal details how muniland has passed a critical threshhold in the second quarter as municipalities were able to renew and renegotiate their bank backstop agreements: