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Don’t Trust Municipal Bond Credit Ratings

A municipal bond's Official Statement is a Kafkaesque nightmare of blind alleys and rabbit holes.

This blog post continues my series on municipal bond risks faced by ultra-high net worth investors in Manhattan.  My previous post can be found here.

No individual investor I’ve met has possessed the capabilities needed to evaluate municipal bond risk.  Worse, very few advisors I have known have the capabilities to evaluate municipal bond risk.

Why?

Because if you go one level deeper than the bond description, you’re in a Kafkaesque nightmare of blind alleys and rabbit holes otherwise known as the issues Official Statement.

Because of this complexity, the heuristic of individuals and professionals alike quickly becomes: rely on the credit ratings.

This is a spectacularly bad idea for anyone, and a violation of the Municipal Securities Rulemaking Board (“MSRB”) rules for a broker.  Indeed, brokers are required to undertake meaningful analysis and to not rely on a bond’s credit rating:[1]

Dealers are reminded that the obligation arising under Rule G-19 in connection with a recommended transaction requires a meaningful analysis, taking into consideration the information obtained about the customer and the security, which establishes the reasonable grounds for believing that the recommendation is suitable…

To meet those (due diligence) requirements, firms must perform an independent analysis of the bonds they sell, and may not rely solely on a bond’s credit rating.  (Emphasis added)

The MSRB is right.  Buying bonds requires a meaningful, independent analysis which must not rely on a bond’s credit rating.  Unfortunately, very few investors or professionals are equipped to undertake these analyses.  The result is that a lot of uncompensated risk is taken, and these risks are building daily.

Ratings Agencies

Relying on the credit ratings of a bond is simply relying on the agency that creates the rating.

In theory, the ratings agencies exist to inform investors about the credit worthiness of the bonds they own or are considering buying.  In reality, they work for bond issuers and operate the most conflicted business model on Wall Street.

Municipal (and corporate) bond ratings operate under what is known as the issuer-pays model, where the ratings agencies are paid by the bond issuer to rate their bonds.  This is a terminally conflicted model.  However, it was not always this way:[2]

When John Moody began issuing credit ratings for railroad companies in 1909, both Moody’s and S&P generated revenue by selling ratings directly to investors.  This investor-pay model was free of any conflicts of interest and helped build both agencies’ reputations for integrity.  However, in 1968, S&P began charging municipalities for ratings.  Two years later, Moody’s adopted an issuer-pay model for both corporate and municipal bond issuers.  In 1974, S&P followed suit and began charging issuers for corporate bond ratings.

Chart 1: Timeline of Moody’s and S&P’s Change in Revenue Model[3]

 

municipal bond ratings chart

In a statistical analysis of the period when Moody’s and S&P switched from an investor-pay to issuer-pay business model, authors Jiang et. al. show that an issuer-pay model leads to higher credit ratings, finding:[4]

… when S&P charges investors and Moody’s charges issuers, S&P’s ratings are lower than Moody’s.  Once S&P adopts issuer-pay, its ratings increase and no longer differ from Moody’s.  More importantly, S&P only assigns higher ratings for bonds that are subject to greater conflicts of interest, measured by higher expected rating fees or lower credit quality.  (Emphasis added)

In short, the ability for municipal bond issuers to shop their rates leads to credit rating inflation and the bigger the conflict, the higher the inflation.

A second problem at the ratings agencies is the talent gap.  Wall Street banks and broker-dealers are hiring the best talent from the best schools every year.  Working for a ratings agency is like playing offensive line on your high school football team – it’s the last stop.

Wall Street firms use their superior talent to weaponize complexity to their (and their issuer clients) advantage.  The overmatched ratings agencies are left playing a continual game of catch up.  (For those keeping score, Wall Street is undefeated in the head-to-head.)

If you think my critique of the ratings agencies is harsh, don’t.  I’m merely reiterating their own opinion of themselves.

In the litigation that followed the Global Financial Crisis, the ratings agencies were sued for their AAA ratings on CDOs with underlying sub-prime mortgages.  In a fraud case brought against S&P by the U.S. Justice Department, the S&P defense team argued:[5]

S&P’s self-description(s) as ‘the world’s leading provider of independent opinions and analysis on the debt and equity markets… (and) the world’s foremost provider of independent credit ratings, indices, risk evaluation and investment research’ were not actionable because they were ‘classic puffery’.

‘A reasonable investor’ would not rely on the statements in deciding whether to trust S&P’s ratings, according to the agency.  (Emphasis added)

The translation is that S&P is biased and incompetent and only a fool would rely on their ratings.

I take them at their word and so should you.

Municipal Bond Risks

As I have written about here, the risks are rising for municipal bonds in general, and New York City issuers in particular.  Some of those risks include:

  • pension deficits;
  • rising health care costs;
  • out-migration;
  • environmental, and;
  • structural deficits

I will address these risks in more detail in subsequent posts.

Bantam Financial Planning Services

We offer completely personalized, professionally designed and bound Family Strategy Books, which evaluate municipal bond risks and go miles beyond what is commonly referred to as “financial planning”.

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Notes:

[1]       MSRB Rule G-17; Quoted from An Ill Wind Blows Through Municipal Finance; Jack Duval (2016); 23-24.  Available at: http://bant.am/wp-content/uploads/2018/01/An-Ill-Wind-Blows-Through-Municipal-Finance-Jack-Duval.pdf;  Accessed May 10, 2018.

[2]       Jiang, Stanford, and Xie; Does it Matter Who Pays for Bond Ratings? Historical Evidence; Journal of Financial Economics; April 1, 2012; 3.  Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.363.3392&rep=rep1&type=pdf; Accessed May 10, 2018.

[3]       Id. at 3.

[4]       Id. at 1.

[5]       Paul M. Barrett; S&P’s Outrageous, Clever Fraud Defense; Bloomberg; April 23, 2013; Available at: http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.363.3392&rep=rep1&type=pdf;  Accessed May 10, 2018.

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