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Thursday, Nov 30, 2023

Global Rating Scale Needed for Public Sector Debt

In March 2008, the California state treasurer asked California businesses to respond to a request for comment from Moody’s Investor Services on potential changes to their U.S. Public Finance rating scale. The following letter, from Westlake Village-based Montague, DeRose and Associates mirrored that of most of the 150 respondents to that request. Earlier this month, Moody’s stated that they would soon be adopting a global rating scale that will grade public-sector debt on the same criteria as private-sector debt. Montague DeRose & Associates, LLC strongly supports implementing a Global Rating Scale for municipal debt (taxable and tax-exempt). It is critical that municipalities are rated on a scale that is accurate in measuring risk and consistent with the global market. Underlying ratings drive market yields as well as the cost of credit enhancement, thus greatly influencing an issuer’s cost of borrowing. Implementing an accurate scale that reflects the strong credit profile of municipal issuers will improve capital market access and reduce borrowing costs which should result in significant taxpayer savings. Further, establishing this system is a necessary step in improving market confidence and efficiency. We believe that these results will have broad-reaching benefits for municipal entities in the U.S. We recognize and appreciate the research and oversight provided by the rating agencies. We believe the rating agencies will continue to play an integral role in the municipal finance process. However, we believe municipal ratings must reflect the low probability of default and/or loss and should be readily comparable to their corporate and international counterparts. This is essential to both the issuer and investor community. We applaud Moody’s for taking steps to correct the current rating system that has penalized municipalities for decades. Municipal bonds have historically demonstrated a level of credit strength that is second only to federal securities. As your default study recognizes, municipalities have continued to make timely principal and interest payments to investors even in periods of severe economic downturn, natural disaster, and political pressure. Despite demonstrated credit strength, the conservative application of municipal ratings has led investors to seek additional yield to compensate for perceived risk. The municipal rating scale has also created an artificial need for bond insurance, further increasing the costs of issuance and (in recent months) the volatility in the marketplace. This has also led to the illogical and perverse situation in which the risk of default is actually much greater for the higher rated corporate bond insurer than the lower rated municipal issuer that is having its debt issuance credit enhanced. Correcting the discrepancy between the perceived default rates and the actual default rates will align municipal ratings with the existing global market, which should provide significant benefits to the entire financial marketplace. The investor community will also benefit from a more transparent and symmetric rating scale. Because their investment guidelines are primarily tied to the corporate scale ratings of credit and liquidity support providers, money market and hedge funds as well as tender option bond programs have been forced to liquidate portions of their portfolios, buy insurance in the secondary market, or terminate programs at a loss. The resultant sell-off had detrimental effects on investors and issuers as the glut of supply pushed overall yields upward. Applying a global scale could avoid another sell-off of that magnitude, improving stability in the overall market. A consistent rating scale is not only important for the “traditional and alternative” institutional investors, but also for the “mom and pop” retail investors. Many retail investors may not have access to adequate research materials to determine the credit worthiness of municipal securities relative to their corporate counterparts. The mixed use of municipal ratings for issuers and corporate ratings for credit enhancers in the municipal market only adds to this confusion. A GSR will foster greater transparency and reduce confusion in the municipal market place. We believe GSRs will standardize documents and ensure better consistency in negotiating terms during a financing. Derivative documents, in particular will benefit because bilateral credit terms will now be more meaningful as both parties will be rated on the same scale. We believe the following should be considered in applying global scale ratings: – GSRs should be universally applied. – For existing debt that has been rated by Moody’s we believe a GSR should be applied retroactively to lessen market volatility and increase the supply of money market eligible paper. – Obtaining a GSR should not be cost prohibitive. The prior practice of charging additional fees for the corporate equivalent rating creates a barrier to participation. Further, the Moody’s 2007 report indicated that GSRs will capture the true default risk for municipal securities. With that in mind, the GSR should be the primary rating and thus the only rating paid for by the issuer. If investors desire an additional municipal rating for comparative purposes, this should be provided at no cost to the issuer. – Investor education is increasingly important. We believe continued dialogue with investors and the general market is crucial to emphasize the safety of municipal debt and provide comfort with the GSR. – Moody’s should consider expanding the AAA GSR rating category to include additional gradations. This would help in distinguishing between the credit strength of issuers in what will become a very large universe of AAA municipal and corporate credits. In conclusion, we believe a global scale will greatly benefit the taxpayers and ratepayers throughout the country. Municipalities should not be penalized relative to their corporate counterparts. Establishing a fair rating scale will ensure continued progress on critical capital projects which benefit not only local economies but the greater economic environment. We appreciate Moody’s efforts to act as a market leader in enacting such crucial changes. Douglas Montague is a principal in Montague, DeRose and Associates, LLC. The company primarily provides independent financial advice to government entities in the Western U.S. on the issuance of debt. Since its founding in 1995, the firm has advised on the issuance of over $80 billion in debt.

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