When Meredith Whitney released her magnum opus on America’s municipalities in September, there was lots of grumbling about why an expert in financial stocks should be listened to on the subject of municipal bonds. But she’s serious about this: building on the work that she did for that 600-page report, she’s now formally setting herself up as a credit rating agency in direct competition with Moody’s and S&P.
I see two forces at work here. One is the way that the reputation of Moody’s (MCO) and S&P was shredded in the crisis, creating an opening for competitors; Jules Kroll sees that too. The second is the continued failure of the independent-research business model to actually make money. Many have tried and few have had any success: while financial institutions on both the buy-side and the sell-side do value high-quality research, they tend not to want to pay for it.
So Whitney is building a second revenue stream here: alongside selling research to investors, she’ll also sell ratings to issuers. I wish her luck: breaking the ratings duopoly is very hard, as anyone at Fitch will tell you.
But she’s chosen the right corner of the market to get involved in: municipal ratings are a racket. Municipalities are forced to pay big fees three times every time they issue debt: first to the bankers and lawyers for the debt issuance, then to the ratings agencies for a rating, and finally to the monolines for a wrap. The ratings agencies make sure that the ratings they give municipalities are lower than the ratings they give the monolines, so that the municipalities are forced to pay up to bridge the difference.
John Carney has published his theory that investors are wise to the idea that monolines are rated more leniently than municipalities, so none of this matters:
We’d only want to require the same criteria for corporate bonds and muni bonds if we discovered that measuring them by different criteria created some serious market failure. But markets aren’t as stupid as that. Markets are very much aware that muni bonds rarely default, regardless of the rating. This is why muni bond investors accept lower yields—they know they are getting less risk…
Rating munis according to the same criteria as corporate bonds would reduce the amount of information available to the market by obscuring differences in the risks of different municipalities. If two-thirds of munis were rated triple-A, investors would lack guidance about real differences between the issuers.
The truth is that different types of debt are rated on different scales, and the market is very well aware of this.
Muni spreads have gapped out since Carney wrote that, and so he’s changed his tune a little:
Without an exchange traded equity market, and free from many financial disclosure rules governing public companies, muni investors are dependent on analysts and ratings agencies to discover information about the financial health of issuers.
How bad can things get for munis? Very, very bad. During the 1873 Depression more than 24 percent of the outstanding municipal debt defaulted.
I’ve been saying something similar for a while, although I’ve been concentrating more on moral hazard than on financial considerations. (When a municipality’s bonds are insured, the cost of default falls quite a lot.)
What’s clear is that there’s real credit risk in the muni market, and that bond investors are very bad at doing the enormous amounts of legwork needed to measure it. Whitney sees profit there. And the more trouble munis get into, the more money she’s likely to be able to make in this market.