Bill Lockyer: Government bonds deserve same ratings as business

State and local governments across the nation continue to struggle with the fallout from turmoil in capital markets and the severe economic downturn. Far from immune, California has suffered an especially hard fiscal hit, as the stubborn housing slump has crimped coffers statewide.

What much of the public probably doesn't know is this: Some of the Wall Street titans who helped create the current chaos have, through the years, heaped an unfair, multibillion-dollar burden on taxpayers. And now, as elected representatives in cities, counties and states try to keep their operations on firm financial footing, that burden serves as an undue budgetary constraint.

The Wall Street firms in question are the three major U.S. rating agencies – Standard & Poor's, Moody's Investors Service and Fitch Ratings. Unaccountable to the public, this powerful triumvirate dictates the creditworthiness not just of corporations, but also states and municipalities. When corporations and governmental entities sell bonds, the agencies bless or curse them with a rating that purports to assess the issuer's creditworthiness.

The agencies base their ratings of corporate bonds on the risk that the issuer will default. That's a perfectly sound measurement of creditworthiness. Unfortunately for taxpayers, the standard the agencies use to grade municipal bonds is largely unrelated to default risk. How else to explain Moody's failure to assign any rating other than triple-A – the highest rating – to general obligation municipal bonds when, of all such bonds they rated between 1970 and 2006, only one issuer defaulted?

The agencies' current system forces municipal bond issuers to meet a higher standard than corporate issuers. As a result, municipal issuers have a harder time obtaining the highest bond rating than their corporate counterparts.

Why should taxpayers care? Because the double standard increases their borrowing costs when they finance crucial infrastructure projects. Lower credit ratings mean higher interest payments. And municipal issuers frequently purchase bond insurance to "enhance" their credit, despite the extreme rarity of municipal bond defaults.

Here's the disturbing bottom line for taxpayers: Government budgets leak billions of dollars through the hole punched in public treasuries by the agencies' system for rating municipal bonds. That's money that could be used instead to fix budget problems.

If California's bonds received the proper rating, we could slash taxpayers' interest payments by billions of dollars on still-unissued bonds approved by voters to finance roads, schools and other infrastructure. Those savings would make a nice, long-term down payment on closing our state's structural budget shortfall.

S&P acknowledges that defaults on municipal bonds the firm rates are "virtually nonexistent." For a tax-backed bond rated BBB or better by S&P, the likelihood of default over a 20-year period is only 0.03 percent. This data suggests most tax-backed bonds should be rated triple-A. But S&P assigns such a rating to only 2.6 percent of the municipal bonds it rates that do not have credit enhancement.

In fact, the agencies' own studies consistently have demonstrated that municipal issuers default at much lower rates than corporations. Municipal bonds rated Baa by Moody's have experienced a default rate of only 0.13 percent, while corporate bonds rated Aaa by Moody's have defaulted at four times that rate, or 0.52 percent. Meanwhile, corporate bonds rated AAA by S&P have defaulted at almost twice the rate of municipal bonds rated BBB (0.60 percent and 0.32 percent, respectively).

When deciding whether to buy bonds, investors want to know the risk they will lose money because the issuer defaults. The current system misleads them by grossly inflating the risk of buying municipal bonds.

The current system is indefensible, and the voices advocating reform are growing in number. Nineteen state and local governments, including 14 state treasurers from California to Connecticut, have been joined by the nation's largest public pension fund and leading members of Congress to challenge this practice.

Moody's and Fitch have offered somewhat constructive responses to the call for reform. S&P, in contrast, has stonewalled, distorted facts and issued lectures defending the status quo. We don't need lectures from an agency that helped fuel the market meltdown by overrating the creditworthiness of complex investment instruments cooked up by corporate issuers. We need bond ratings based on facts.

The reformers' message to the agencies is simple: Treat taxpayers the same as corporations. Don't make them pay more to finance schools and roads than corporate entities pay when they bundle bonds into fancy, opaque investment vehicles. Rate municipal bonds based on the risk of default. End the double standard and create a unified, global rating approach that treats all issuers equally, and better serves taxpayers and investors.