A $6.54 billion sale of California bonds March 24 has revived a debate about the fairness of the way that the nation's three credit rating agencies evaluate tax-free bonds sold by state and local governments compared to those dealt by private companies.
Four days after one of the agencies, Fitch Ratings , downgraded California's bond rating to the worst in the country based on the state's struggling economy, California put together what state officials said was one of the largest long-term general obligation bond sales in U.S. history. The money will be spent on infrastructure projects.
State Treasurer Bill Lockyer said the sale, which exceeded the original goal of $4 billion, proved that the ratings the agencies assign to state bonds are dubious, because as far as the municipal bond buyers were concerned, "investors stepped up and showed their confidence in California."
Lockyer and other state treasurers say these same agencies gave top ratings to AIG and Lehman Brothers, private companies whose problems helped cause the Wall Street collapse last fall. The state officials say the ratings firms should give states higher credit scores that are more comparable to those assigned to corporations.
Like a family buying a house or car, states borrow money for expensive projects such as roads and schools that they can't pay for out of day-to-day operating funds. Voters must first approve such sales because it's their tax money that guarantees the debt will be paid, with interest.
The ratings firms evaluate the likelihood the state will repay the bonds in a timely way-information that investors rely on to decide whether to buy the bonds. They assign letter ratings, with triple-A the highest and anything below triple-B considered risky. ( Moody's Investors Service applies a combination of letters and numbers.)
Such ratings are crucial to state governments because they can add millions of dollars to the cost of a bond sale: The lower the rating, the higher the cost in interest and insurance. California's demotion from A-plus to A added about $213 million to the cost of the bond sale, Lockyer's office estimated. The state has a backlog of $61 billion in tax-free bonds, which, if sold with the lower rating, would add about $2 billion in interest costs, officials said.
No wonder states with the highest ratings boast about them. When Standard & Poor's raised Iowa's bond rating to the highest possible ranking last fall, Gov. Chet Culver (D) cited it as proof that he was an excellent manager. He used the triple-A rating to propose a $700 million borrowing plan for state infrastructure projects in January.
Lockyer has been leading an effort in the last year to get Fitch, Standard & Poor's and Moody's to create a new system to rate state and local government debt. He has been joined by his counterparts in Connecticut, Idaho, Iowa, New Mexico, Maine, Oregon, Nevada, Rhode Island, New Jersey and Washington. Iowa's treasurer, Michael Fitzgerald , said that despite his state's high rating, states are treated unfairly by the rating agencies. "We're sovereign entities. We can raise taxes to repay debt if we have to. No state has not paid its bonds since Mississippi after the Civil War," he said.
Connecticut Attorney General Richard Blumenthal sued the agencies in a state court last summer seeking to overturn the current rating system, which he said results in higher interest rates and pricey bond insurance premiums.
Congress jumped in last year. U.S. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, sponsored the Municipal Bond Fairness Act , which sets a single rating system for municipal and corporate bonds. It cleared the committee but got lost in the flurry of activity after the Wall Street collapse in September and the fall election campaign. "We are bringing this legislation back, and we expect to have it done soon within the next few weeks," Frank's spokesman said March 27.
Frank, Lockyer and others are focusing on the disparity between how the agencies rate municipal and corporate bonds. They want the firms to be more consistent, arguing that municipal bonds usually are rated lower than commercial bonds despite the fact that governments rarely default compared to corporations, according to data supplied by Moody's and Standard & Poor's.
"We want the rating agencies to rate municipal bonds essentially by the same criteria that they rate corporate bonds," Frank said before last year's committee vote.
Bond insurance fees required for lower-rated states to avoid the higher interest costs can be costly. California paid $102 million from 2003-2007 for its bond insurance, Lockyer said. The insurance would not be needed if a state's bond ratings were higher.
Blumenthal, the Connecticut attorney general, called the costs of bond insurance and higher interest rates "a secret Wall Street tax" on state and local governments that benefits the insurers and the ratings agencies. Lockyer's spokesman, Tom Dresslar, said the ratings firms engaged in "financial punishment" of California taxpayers in the recent bond sale. These same firms, he said, contributed to the Wall Street collapse by assigning high ratings to questionable corporate bond deals that collapsed.
"What they did was punish the taxpayers of California for a problem they helped produce," Dresslar said. "Every investor who has ever bought a California bond has received their money on time and in full. Given that history, why do the rating agencies insist on not giving us the highest grade?"
The ratings agencies say just because state and local governments hardly ever fail to pay their debt does not mean they should automatically receive high credit ratings. Economic assumptions vary from state to state, and bond ratings should reflect those differences, they say. California has a new $8 billion budget gap after closing a $40 billion deficit in February.
"The market looks to us to identify and analyze" the differences between state and local governments, Standard & Poor's said in a statement. "We believe our ratings do that."
Laura Levenstein, senior managing director of Moody's, told Congress last fall that if Moody's used the corporate scale, most of the municipal bonds would fall between AAA and AA. "This would eliminate the primary value that municipal investors have historically sought from ratings-the ability to differentiate" among various bonds, she said.
The ratings agencies say that although it is rare, governments do default, most recently in Vallejo, Calif., and Jefferson County, Ala.
Government and corporate operations differ substantially, the rating agencies say, which argues against a universal rating system. Corporations can move faster than governments can if they run into financial trouble by restructuring, refinancing, declaring bankruptcy, moving overseas or shutting down altogether. Governments must continue operating, even if they cannot repay their debt.
Spokesmen for Fitch and Standard & Poor's, which downgraded California bonds from A-plus to A in February, said the lower ratings reflected the state's precarious financial condition, especially its reliance on one-time revenue, temporary tax increases and borrowing to balance its budget in the next two fiscal years.
Dresslar said California officials are well aware of the state's financial difficulties, but those troubles don't mean the state can't honor its commitments. The state should have a triple-A rating, Lockyer says. "We know we have fiscal management problems," Dresslar said. "We don't need a rating agency to tell us that. Those problems are irrelevant to our ability to fulfill our promises to our bond investors."
Moody's said last year it would offer states the same rating system as corporations but shelved the plan after the financial crisis hit.
The criticism of the ratings agencies isn't confined to the United States. Russian Prime Minister Vladimir Putin, whose country's credit rating was recently downgraded by Fitch and Standard & Poor's, said in February he was so fed up with relying on the agencies' evaluations that Russia should create its own.
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