Ratings Agencies and the Municipal Market

In this article, we review our thoughts on the value of credit ratings within the municipal market. Even though ratings agencies appear to have misjudged the credit worthiness of some mortgage-backed securities leading up to the financial crisis of 2007–2009, we believe their ratings are still of importance in assessing the default risk of municipal bonds. We have received numerous questions recently about the usefulness of municipal bond credit ratings given the default rates of subprime mortgage-backed securities, which were highly rated prior to the recent financial crisis. While there clearly are some flaws with the ratings model that exists today (such as bond issuers paying the ratings agencies for the ratings), we believe there are fundamental differences between rating municipal bonds and rating mortgage-backed securities. Further, we have been discussing the usefulness of municipal bond credit ratings with municipal credit analysts and money managers and researching the history of credit ratings and defaults within the municipal market. These discussions and research have given us additional comfort that municipal market credit ratings, especially when combined with market pricing, have value in separating out those bonds with higher default risk.

Rating Subprime Mortgage-Backed Securities

The process of rating mortgage-backed securities with credit risk is far from easy. Most mortgage-backed securities consist of a large number of mortgage loans given to people with varying levels of credit worthiness, ages, socioeconomic statuses and homes in different geographic locations. Determining the level of default risk in the securities is a tricky proposition.

Compounding the problem is that you have to project the degree to which housing prices could drop and the likelihood of other people defaulting on their mortgages if one person defaults. Needless to say, establishing a rating (even if done properly) is very complicated. In hindsight, it is clear that the model used for how far housing prices could fall was not calibrated correctly, and the likelihood of a wave of defaults was not foreseen.

Rating Municipal Bonds

Rating municipal bonds is nothing like the process described above. General obligation bonds are backed by the full faith and credit and taxing power of the issuing entity. Some of the key factors that help determine the credit rating of the issuer are:

• Unreserved general fund levels — This is essentially money set aside that could be used to cover revenue shortfalls. Issuers with substantial amounts of money set aside are considered to be of better credit worthiness.
• Market value per capita — This is the total market value of all property within a given jurisdiction divided by total population. A higher level of market value generally indicates lower credit risk.
• Taxpayer concentration — This metric gives an indication of what proportion of tax revenues come from a small number of taxpayers. A more concentrated tax base generally means higher credit risk.
• Debt burden — This is the overall level of debt divided by the population within that municipality or the number of households in that municipality. Debt burdens below $1,000 are considered low.

For essential service revenue bonds, some of the key metrics are:

• Debt service coverage — This term refers to the amount of revenues in place to cover debt payments. Generally, a coverage percentage of 150 percent would be considered strong.
• Liquidity — This typically relates to the amount of days of working capital cash on hand. Entities with 120 days or more of cash on hand would be considered very liquid.
• Revenue concentration — This is similar to the concept of taxpayer concentration noted above for general obligation bonds. It refers to the percentage of total revenues that come from a certain number of customers.

These metrics highlight a fundamental difference in the process of assigning credit ratings to mortgage-backed securities versus municipal bonds. The former is largely a model-driven process (such as the likelihood home prices could fall by 10 percent), while the latter is grounded in known financial data.

Historical Default Rates of Municipal Bonds

Historical default rates over the period of 1970–2009 also confirm the usefulness of the ratings in terms of predicting default rates. As the table below shows, lower-rated bonds have defaulted at a higher rate than higher-rated bonds.¹ This is exactly what one would hope to see.