In the most conclusive sign yet that the apocalypse is upon us, the lead story in today’s New York Times is about municipal bond ratings. Apparently a few state treasurers are getting mad about the fact that their bonds are graded differently than corporate bonds–Moody’s, for example, gives five different grades for munis that all would get a Aaa corporate rating. From the Times article:
“Taxpayers are paying billions of dollars in increased costs because of the dual standard used by the rating bureaus,” said Bill Lockyer, treasurer of California, who is leading a nationwide campaign to change the way the bonds are rated. California, one of the largest issuers of municipal bonds, is rated A; Mr. Lockyer said the state should be triple A.
The state is soliciting support from other municipalities for a letter it intends to send to the ratings agencies, arguing that municipal bonds should be rated on the same scale as the one used for corporate bonds.
The article never gets around to mentioning, though, that muni bonds have an entirely different customer base than corporate bonds. Munis are exempt from federal income taxation, and pay lower yields than equivalent corporate bonds because of this. Pension funds, college endowments, the mutual funds offered in 401(k) plans, and foreign investors can’t take advantage of the tax break, so they don’t buy munis. Banks can only get the tax break on certain (“bank qualified”) munis, and steer clear of the rest of the muni market. Which mostly leaves just wealthy American individuals and a few muni bond mutual funds that cater to them. It’s a weird, inefficient little market, with all sorts of unique customs–the different ratings scale among them.
So it’s not as if somebody’s going to pass on a California revenue bond in favor of a corporate bond just because the rating is different. They’re simply not part of the same market.
The real issue is that the added gradations in the muni market create a built-in business for bond insurers. Muni issuers that get an Aa1, Aa2, Aa3 or A1 rating from Moody’s all have incentive to pay for insurance that brings their rating up to AAA. And then they have to pay to get rerated. The argument for the multiple gradations in the muni market is that munis are generally less risky than corporate bonds, and there’s an appetite among muni investors for finer distinctions at the safe end of the risk scale. And one would assume that if all the munis from AAA to A1 were simply rerated AAA, the muni issuers now at the top of the risk scale would pay higher interest rates. But the whole bond-insurance connection is unsettling.
Jesse Eisinger said something fascinating about this in Felix Salmon’s blog last week:
When I asked Moody’s they said that the market likes to have fine distinctions in their muni ratings. Ok, so why does muni bond insurance need to exist, which makes every insured bond Triple A? Because, Moody’s told me, the market likes the “commoditization” in the ratings that bond insurance brings. Hmmm. So which is it?