California is on the roof

Municipal bonds should not be switched to the corporate credit ratings scale. The current scale provides a level of discipline to state and local governments, as the California's periodic credit concerns demonstrate.
S&P downgraded the State of California’s note rating yesterday from SP-1 to SP-2, affecting $5 billion in revenue anticipation notes (RANs). At the same time, the long term rating on California’s $46.6 billion general obligation bonds (G.O.s) and $7.8 billion of general fund lease appropriation obligations was put back on CreditWatch with negative implications. Cal G.O.s had been taken off of CreditWatch and reaffirmed at A+ with a “Stable” outlook at the end of October, after being put on Negative CreditWatch in the beginning of that month.

I have always thought that the ratings agencies’ short term note ratings scales were the model of admirable brevity and pith, relaying information clearly and succinctly. Here are the definitions of the various ratings, from S&P

SP-1: Strong capacity to pay principal and interest. An issue determined to possess a very strong capacity to pay debt service is given a plus (+) designation.
SP-2: Satisfactory capacity to pay principal and interest, with some vulnerability to adverse financial and economic changes over the term of the notes.
SP-3: Speculative capacity to pay principal and interest

In others words things are either: 1) good to very good, 2) not great, but o.k., or 3) time to worry. This befits the short term nature of the investment—not a lot of time of fine distinctions, am I going to get paid in a few months or not?

The CreditWatch process for long term debt, on the other hand, always reminds me of the “Cat’s on the roof…”
joke. You kind of get the feeling that the rating agency knows something and just trying to let the bondholders down easy. On top of that, the ratings for different types of bonds are not comparable—a AA corporation is much more likely to default (i.e., actually miss a payment) over the ten years after receiving the rating than a AA municipal issuer.

This process has its virtues, however, in that it provides an effective balance of the concerns from public officials to not have anything bad said about them and bondholders needs to have a critical eye cast on their debtors. The process ensures that there is a feedback mechanism where government borrowers are given encouragement to keep their finances in a semblance of order. Often this is a very important source of discipline for the not very disciplined budget processes in the various states. This was certainly true during California’s most recent fiscal crisis, which helped bring Gov. Schwarzenegger to office. The state’s G.O.s were rated AA in September, 2000, saw their rating dropped steadily to BBB in August of 2003 as the dot com bubble burst, the Enron energy crisis and the post 9/11 recession hit the state. Similarly the budget crisis under Gov. Wilson in the early 1990s saw the state’s S&P rating plummet from AAA in 1991 to A+ by the end of 1992.

I do not suggest that California’s, or any state’s, lawmakers were not sincerely working with the best interests of their state in mind during these crises and would regardless of the ratings. But the fact is that in both of the instances cited, all the participants were often working at cross purposes—communications broke down and political processes threatened to impact the state’s ability to make timely payments of principal and interest. The ratings on California’s bonds are the best measurement, published for all to see, of how those political processes were unfolding, and therefore provide a primary source of discipline.

It’s true that in each case the market was ahead of ratings, even when still A-rated, California G.O.s traded at BBB levels in 2002 and 2003—I remember one colleague noting just before the downgrade that if the bonds were still investment grade after the rating action, they should rally. However, we’ve seen how easy it is for government officials, or corporate managers for that matter, to dismiss the workings of the market as the manipulations of evil speculators and even be emboldened by tilting against against it.

Now, California’s Treasurer Bill Lockyer has been a
vocal proponent of having the ratings agencies adjust the standards they use to rate municipal bonds to be equivalent to the standards for corporate bonds. The result of this would be that California and virtually all the other states (except Louisiana), would become AAA. There are strong arguments in favor of this. Bond insurance would never have become as prevalent if these standards would have been in place over the past twenty years. (An alternative history exercise: the monolines don’t grow to cover over half of all muni bonds issued in the late 1990s and early 2000s; they don’t grow to have massive balance sheets and then don’t get pressured by the rating agencies to diversify their business; therefore they don’t start aggressively writing protection on super-senior CDOs, which the rating agencies push to rate AAA; sub-prime lenders don’t have one of the sources of funding that enabled them; broker-dealers don’t enter into the negative basis trade, laying off risk to the AA rated monoline insurers; the current credit crisis becomes a minor blip.)

There is another alternative, move corporate ratings to the muni standards. In this case a host of financial companies probably move to junk status and Berkshire Hathaway may be at best a weak AA-. The benefits of this would be be that same as for state and local governments, forcing management to focus on the problems at hand, and it might just be a way for the rating agencies to start to rehabilitate their reputations. Mass upgrades of the state’s credit ratings in the midst of a economic crisis, even if warranted and logical, would probably not do much for those reputations. (I’d also venture that my alternative history scenario above would still hold. The ridiculousness of buying credit enhancement on California from MBIA in 2003 should have been obvious to all of us.)

In the meantime, with much more looming than the political/fiscal crises that it has endured in the past, “Cal is on the roof…”

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