Overview of Ratings

RATING AGENCIES, RATING SYSTEMS AND MUNICIPAL CREDIT

OVERVIEW

Ratings of municipal bonds (or other issues or entities for that matter) are a system for grading a bond based on its relative investment merit. Ratings are opinions about the ability and willingness of the issuer to meet its debt obligations. Bonds and other debts are rated by organizations known as rating agencies. The three leading rating agencies in the United States are Standard and Poor's, Moody's Investor Service and Fitch Ratings (Fitch is a distant third in size).

Rating agencies issue ratings on a scale from the best quality credit to the lowest. An issuer that wishes to have its issuance rated has to apply for a rating to one or more rating agencies. The issuer has to pay a fee to the rating agency for conducting the necessary analysis for issuing a rating.

Credit ratings (and consequently rating agencies) are important because they affect the cost of borrowing, i.e., the interest rate that the issuer will pay the investor for buying the bonds. Conversely, the interest rate is what the investor earns for buying the bonds, and so the rating affects the interest income of the investor. In the long run, an issuer can save or incur significant additional costs in interests over the life of a bond because of its credit rating.

Issuers with good credit ratings are able borrow at low cost (i.e., they pay low interest rates). As a result, bonds with good ratings will have low interests and low yields for investors. In other words, the yield is an indicator of credit worthiness; the higher the yield the higher the risk.

Ratings are assigned on the basis of a number of economic, financial, institutional and political factors. But for most municipal bonds, the basic process usually involves three fundamental steps:

First, the rating agency will identify the specific streams of revenue that is available for debt service payments ( taxes, fees etc.).

Second, the total expected revenue stream is calculated over the life of the project.

Third, the total costs of debt service are compared to total expected revenues. If total debt service costs are predicted to be low compared to total expected revenues, the credit rating will be high. Conversely, if expected revenues are less than the costs of debt service -- that is, if revenues are insufficient compared to debt service costs -- the rating will, in all likelihood, be low.

When the rating of a bond is lowered, its price may decline. Prices may also move up or down based on anticipated changes in ratings. However, price movements in response to ratings changes are not common unless it involves a series of downgrades. In such a situation, investors may have reasons for concern. Price movements in response to changes in interest rate levels are more normal.

It is important to remember that forecasting revenues over the life of an issue is not a precise science; the further the prediction into the future, the higher the degree of uncertainty. Over time, the changes in rating can be significant because of changes in circumstances.
In December 2003, two of the three leading rating agencies downgraded California's credit rating by three notches. A widening budget gap and plans for a $15 billion deficit bond were cited as reasons for the downgrade.

RATINGS AND THE POWER OF RATING AGENCIES

Credit ratings are critical because they affect borrowing costs (i.e., interest rates) and the ability to borrow. If an entity or an issue has a poor credit rating, its cost of borrowing could become prohibitive and impair its ability to borrow. As a result, credit rating agencies wield a tremendous amount of power.

In 1975 the U.S. Securities and Exchange Commission granted the three leading rating agencies status as nationally recognized statistical rating organizations (NRSROs). The top three exercise a lot of influence because of their dominant position. But they are not legally accountable for their ratings and are exempt from "expert liability" or negligence standards under securities laws.

Ratings are important to municipal bond issuers, underwriters, traders and investors. A bond with a good rating from one or more of the established rating agencies will be favored by investors as it implies that it is a good investment based on an assessment of the issuer's ability and willingness to pay. Issuers want a good rating so that they can attract investors to buy the bonds. Underwriters and traders will usually prefer bonds with good ratings, as they may be more marketable and/or tradable.


CONTROVERSIES ABOUT THE TOP THREE RATING AGENCIES
Controversies about credit ratings and rating agencies include allegations¹ of:

Anti-competitive practices by the big three rating agencies.
Potential conflicts of interest, such as getting paid by issuers for ratings and direct contact between rating analysts and subscribers.
Inadequate disclosure about how their ratings are determined.
Insufficient oversight by the SEC.

These issues came to the forefront after the Enron scandal because the three rating agencies had given investment grade ratings to the company just four days before it filed for bankruptcy.

In January 2003, the SEC, which has also been under fire for its lack of action on these issues, put out a report on the role of credit rating agencies pursuant to a provision of the Sarbanes-Oxley Act of 2002. The report investigated the controversies surrounding the practices of the leading rating agencies and recommended that the SEC explore the issues further.

A number of other ratings firms that want NRSRO recognition have complained that the SEC's designation process should be more transparent.

Some rating agencies also maintain that because their ratings are published opinions, the SEC would encroach on their First Amendment rights if it tried to regulate them.

In 1997, the Jefferson County School District of Colorado lost a case against Moody's when a federal judge ruled that the school district could not sue the rating agency because its opinions were protected by the First Amendment. The suit, filed by the school district in October 1995, alleged that the rating agency committed "fraud, malice, willful and wanton conduct" in retaliation for not being hired by the district to rate a $110.3 million refunding in 1993.² The agency's unsolicited opinion resulted in a loss of at least $769,000 to the district and required underwriters to reprice the refunding.³

NOTES

1. Lynne Hume, "Rating Agencies: SEC to Study Need for More Oversight, Other Issues in New Concept Release," The Bond Buyer, January 28, 2003. 2. Angela Shah, " Moody's Reiterates Request to Throw Out Fraud Lawsuit on First Amendment Grounds," The Bond Buyer, April 3, 1996. 3. Angela Shah, "Moody's Invokes Constitution in Response to Suit Challenging Unsolicited Rating," The Bond Buyer, February 26, 1996.