Assessing the Credit Quality of America’s Cities – Part One: Focus on Bond Ratings
How close to the fiscal distress edge are America’s cities? This article, the first in a series, Assessing the Credit Quality of America’s Cities, examines the financial health of cities against a backdrop of high ratings issued by the three major credit rating agencies.
by Richard A. Ciccarone
Detroit’s Chapter 9 bankruptcy filing will likely earn a chapter or two in the municipal history books. In its aftermath, the role of credit quality has been reinforced and, to some extent, redefined.
Much like the impact that New York City’s default had on the municipal bond market in 1975, Detroit’s bankruptcy has refocused attention on the credit quality of America’s cities. While most experts and observers agree that Detroit’s path and condition are extraordinary, the question on many minds is: How close to the fiscal distress edge are America’s cities?
In order to address that question, Merritt Research Services, LLC conducted a comprehensive statistical analysis of important factors and benchmarks that portray the most serious challenges to the fiscal health of America’s cities now and in the future.
Bond Ratings as the “Standard” for Assessing Risk
As a first step to examine the health of America’s cities, we took a look at the bond ratings held by cities. The three biggest municipal bond rating agencies – Standard and Poor’s (S&P), Moody’s and Fitch – generally assign credit ratings based on a combination of three factors: the categorical default history of the specific security class (i.e., city general obligation), the strength of the issuer’s economic base and the individual merits of and risks to a particular city (e.g., debt, pensions, reserves, liquidity, management, etc.). To accomplish their mission, they rely on standard methodologies, using key metrics to measure performance over time. The question is whether city ratings measure up evenly to the statistics which are largely used to assess them.
According to the analysis, based on ratings applicable and available as of October 2014, 78% of the 1,800+ U.S. cities in the study had at least one of its ratings in the two highest rating brackets on their own merits (excluding insured ratings), AA or AAA by S&P, Moody’s or Fitch. The study showed a heavy concentration of city ratings in the top two rating brackets (i.e., AAA and AA with fine-tuning symbols of “+”, “-”, 1, 2, and 3 ignored). In general, as city population size became larger, ratings became higher.
About 80% of the ratings for cities with populations over 100,000 were at least AA3 or AA- (S&P: 80%, Moody’s: 84% and Fitch: 79%).
Close to 90% of the ratings associated with the nation’s biggest cities whose populations equaled at least 500,000 fell in the two top brackets. The breakdown by percentage for each rating agency was as follows:
- S&P: 87%
- Moody’s: 90%
- Fitch: 88%
The heavy percentage of highly rated cities suggests that the official evaluators of credit risk are relatively content with the prospects for city credit quality. Since ratings are supposed to reflect the risk over the life of the bonds through their maturity, the rating agencies are suggesting that the perceived risks are manageable for the next 20 to 30 years.
The concentration of highly rated cities is more of a recent occurrence which, ironically, came to fruition mostly after the credit crisis when criteria changes were adopted by the rating agencies related to general obligation state and local general obligation bonds. Encouraged by federal and state officials, who felt that municipal ratings were overly punitive given their post-Depression default rates, rating agencies embraced the concept of recalibrating ratings in tune with global ratings in other credit markets.
Municipal Ratings Recalibration
In 2010, a massive recalibration by Moody’s and Fitch revised upward the majority of city credit ratings as well as other state and local issues – often by as much as two rating grade notches. The primary justification for the higher bond ratings was largely attributed to the historically low municipal bond default rates on general obligation and essential purpose revenue bonds compared to all other types of fixed income bonds, referred to as the global credit scale.
While S&P didn’t technically recalibrate U.S. local government ratings “en masse,” it was already engaged in a more gradual upgrade approach based on similar rationale adjusted criteria, which began sometime around the onset of the new millennium.
Most fiscal experts, including the rating agencies, view Detroit as an aberration of fiscal mismanagement as well as a victim of a dramatic structural deterioration in its economic base. The bankrupt cities in California suggest a potentially broader risk due to a confluence of negative events and factors, including escalating costs and liabilities associated with boom-and-bust conditions; however, their challenges are not necessarily representative of the majority of cities across the country.
The question of whether the preponderance of high-grade city ratings is warranted leaves plenty of room for debate, especially in light of the still-heavy burden of long-term liabilities, particularly retirement costs.
At the time of Moody’s and Fitch’s ratings recalibrations in 2010, municipal governments were facing their most challenging financial conditions since the Great Depression. When the agencies announced the proposed recalibrations two years prior to their implementation, I voiced my concerns in an article entitled, “Been There, Done That: Municipal Bond Ratings and the Move to Restructure the Rating Scale.”
In the piece, I took issue with the proposed recalibrations, by recalling that the last time city ratings were so highly concentrated at the top rating grades was in 1929. Thereafter, so many cities defaulted during the Depression that the experience led to a downward shift for city ratings that lasted over the next seven decades. Among other reasons for concern, I warned, “Existing debt levels, pent-up infrastructure demands, pension and other post-employment benefit obligations have the potential to weigh down government balance sheets for years to come, especially in places and regions whose local economic bases are likely to grow much slower than in years past.”
Now, more than six years later, the numbers indicate that most cities have rebounded from the credit crisis, particularly in relation to current operations and are in little danger of a near-term fiscal crisis.
The Achilles Heel
Still, the long-term outlook is less clear as the Achilles heel for many cities remains the escalating burden of the dollars that they owe to pay existing and future retirees. In addition, many cities have deferred infrastructure financing to the extent that it creates a less conspicuous balance sheet “liability” despite the potential to eventually pose a new burden to taxpayers and ratepayers. From that perspective, today’s high concentration of city ratings in the upper two brackets appears to paint too rosy a picture for a number of cities whose categorical legal protections, including those associated with a general obligation bond, earn them better ratings than their fundamental characteristics deserve. Accordingly, these cities may be less motivated to significantly correct their deficiencies or resize their governments than if they were more accurately distinguished by the rating agencies or the market.
Richard A. Ciccarone is a Co-Publisher of MuniNet Guide. He is also President and Chief Executive Officer of Merritt Research Services, a municipal bond credit database and research company that primarily serves institutional investors, investment dealers and bankers.
Coming soon: The State of the Cities: Part Two, which will focus largely on the funding status of city pensions both relating to single employer and multi-employer plans.