Where Every Child Is Above Average, and Every Issuer Is Rated Triple-A

The charge on the Bloomberg News wire this morning was explosive:  The credit rating agencies cost U.S. taxpayers $3.6 billion "on bonds sold in 2006" by maintaining separate rating scales for municipal and corporate credits, even though studies show municipals are far less likely to default. [free article]

I think it's also false.  Here are my arguments.  I'd love to hear yours -- pro and con.

• The vast majority of tax-exempt bond investors use ratings to help them choose among tax-exempt bonds -- the rating scales for municipals and corporate may be apples and oranges, but so are the underlying securities.  "A triple-A should be a triple-A" is a nice populist rallying cry, but it doesn't reflect actual investor behavior.
       Right now, "natural" triple-As, like Maryland and North Carolina receive a comparative pricing advantage over lower-rated states like Michigan or Connecticut.  If the corporate scale was applied and a significantly larger number of states, cities, and other issuers were awarded triple-As, the dynamics of that advantage would shift:  Michigan and Connecticut could see lower yields, and Maryland and North Carolina would suffer.  But taxpayers in the aggregate would not benefit.
  
  
• The municipal bond ratings system is more finely calibrated than the ratings scales for corporate debt, but that is something to be celebrated, not criticized.  Adapting corporate scales to municipals would mean eliminating many of the current rating distinctions among municipal issuers, and would actually be a boon to sophisticated investors (who can invest in their own research to identify the relatively stronger credits) at the expense of individuals (who would have less information available to help them distinguish among credits). 
  
  
• Default is not the only risk that can harm investors.  One argument for the higher corporate-equivalent ratings for U.S. municipals is because of the likelihood of a taxpayer bailout when trouble strikes.  But the political road to those bailouts can be rutted and perilous -- just ask holders of bonds from Nassau County or New York City who tried to sell their bonds on the open market during the depths of those issuers' fiscal crises, before their taxpayer bailouts were organized.  They suffered real economic losses.  Those unique risks deserve a unique credit scale that can at least hint at the risk of such disruptions over the life of a bond issue.
       And avoiding disruptions like those are exactly why many investors prefer to buy triple-A insured bonds -- the insurance policy guards not only against default, but also insures the bonds will have liquidity during any periods of fiscal stress at the issuer level.  There's real value in that -- it's not evidence that "insurers are insuring bonds that don't need it."
  
  
• Finally, from a public-policy standpoint, the more finely calibrated municipal ratings encourage marginal but important improvements in governance and fiscal policy by issuers -- an outcome that does benefit taxpayers.  Wider distribution of  triple-A ratings would create complacency, giving rise to a "moral hazard" that, ironically, would actually increase the incidence of fiscal stress among municipalities.

Far from being accused of some vaguely nefarious "double talk," Moody's should be celebrated for shedding light on the discrepancies and providing the tools for investors to make their own judgments.  The process is not finished -- as "non-traditional buyers" become a more important influence on U.S. munis (weighing them directly against taxable securities rated on other scales), the importance of my first argument could be eroded.  And there are a lot of arguments to be made about whether the municipal market is as efficient as it could be (or if there are better alternatives).  But there is no evidence that the current rating methodologies alone are costing taxpayers billions, and it's damaging to contend otherwise.

-- Mike Stanton, Publisher (Michael dot Stanton at sourcemedia dot com)