Academic journal article The Journal of Law in Society

Public Disservice: The Negative Impact of Credit Ratings on U.S. Municipal Bond Issuers

Academic journal article The Journal of Law in Society

Public Disservice: The Negative Impact of Credit Ratings on U.S. Municipal Bond Issuers

Article excerpt

Table of Contents     I. Introduction   II. Role of Credit Rating Agencies  III. Ratings Across Asset Classes: Where the Agencies Often Fail   IV. More Granular Asset Class Comparison: US States v. Bond Insurers    V. Why Bond Insurers Failed   VI. Harm to Municipal Bond Issuers  VII. Emergence of the "Dual Rating System" VIII. Legal Solutions to the Dual Rating Issue  IX. The Problem Returns   X. Toward A Solution  XI. Conclusion 

I. Introduction

Many commentators blame credit rating agencies for helping to precipitate the 2007-2008 financial crisis by incorrectly rating subprime Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs). (1) But the rating agency role in the crisis is much broader than generally understood--extending to incorrect ratings for bond insurers and for US state and local governments. The interplay of incorrect RMBS, CDO, bond insurance and public finance ratings and their role in destabilizing the financial markets is thoroughly described by plaintiffs counsel and their experts in the Ambac Bond Insurance Cases, Superior Court of California Case Number CJC-08-004555. (2)

The case alleges that bond insurers and credit rating agencies conspired against municipal bond issuers to extract excess rating and insurance fees. (3) In exchange for a fee, rating agencies assign letter grades to bond issuers ranging from AAA to D in the case of Standard & Poor's (S&P) and Fitch, or Aaa to C in the case of Moody's. (4) Before the financial crisis seven bond insurers received the highest rating: AAA/Aaa from S&P and Moody's respectively.

State and local governments with lower ratings could purchase an insurance policy from one of these insurers providing a guarantee of interest and principal payments to investors. (5) With this "insurance wrapper" or "credit enhancement," the government could then use the insurer's AAA/Aaa rating when marketing its bonds, thereby lowering the coupon (or interest rate) it would have to pay. (6)

The Ambac Bond Insurance Case plaintiffs--a group of California cities, counties and other municipal bond market issuers--argue that rating agencies graded them using harsher criteria than those applied to bond insurers and other classes of bond issuers. (7) As a result, the rating agencies created an artificial market for bond insurance--a financial product that may not have ever existed had ratings been more consistent. (8)

For an antitrust case like this to succeed, plaintiffs also have to prove that the rating agencies and bond insurers actually conspired against government bond issuers. (9) Since such conspiracies are often discussed in private they are hard to document. The complaint cites movement of personnel between rating agencies and bond insurers, and frequent industry conferences at which these employees could meet to discuss the conspiracy. (10)

While such circumstantial evidence may be insufficient to prove the antitrust claim, the case record provides a public service by presenting a comprehensive survey of rating agency errors and malfeasance as they related to a wide variety of asset classes and demonstrating how these problems adversely affected government bond issuers before, during and after the financial crisis. (11) In this author's view, problems identified in the complaint persist, resulting in unnecessary costs to taxpayers and reduced investment in infrastructure.

In this paper, I will use the Ambac Bond Insurance Case filings as a reference point to survey rating agency problems as they relate to government bond issuers. I will begin with an explanation of rating agencies' role in the economy. Next, I will review the evidence documenting inconsistencies of ratings across asset classes, explain why these misalignments developed and show how they adversely impact cities, counties and states. Finally, I will suggest a systemic solution to the credit ratings problem. …

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