Confidence Game - Christine Richard [145]
Blumenthal said he discovered a 10-year record of the rating companies failing to reveal flaws in the municipal rating scale. The first evidence of those flaws had appeared almost a decade earlier when Fitch Ratings published a study showing that public bonds defaulted far less frequently than corporate bonds with the same ratings. In 2001, Standard & Poor’s (S&P) published a similar report. Moody’s Investors Service followed in 2002 with a report showing that between 1970 and 2000 municipal bonds were 130 times less likely to default than corporate bonds.
Another report published later that year by Moody’s stated, “If municipalities were rated on the corporate scale, Moody’s would likely assign Aaa ratings to the vast majority of general-obligation debt issued by fiscally sound, large municipal issuers.” The report also said top ratings would likely be given to most senior obligations of entities that provided essential services such as water and sewer authorities.
Blumenthal continued to lay out the history of municipal ratings. In 2005, Moody’s produced a draft copy of a second public bond-default study, this one focusing on public “enterprise” bonds used to fund projects such as airports, hospitals, and housing projects. The study found that these bonds were as much as four times less likely to default than Moody’s highest-rated Aaa corporate bonds. The study was never made public.
Some employees within Moody’s raised objections, Blumenthal told the committee. In September 2005, a top Moody’s public-bond analyst said in an internal memo that Moody’s should clearly identify that municipal ratings weren’t comparable to corporate ratings. “Without a ‘flag,’ users of our ratings may not know what scale a rating is on, and this could understate credit risk if the user thought the rating was on the municipal scale when it was based on the corporate scale.” No flags were ever used.
In early 2006, Moody’s decided to seek advice from those in the market about what to do. The credit-rating company drafted a request for comment about creating a “corporate-equivalent rating for U.S. municipal obligations.” Among those who submitted comments was a bond-insurance executive who wrote, “At first blush this looks pretty serious to me. . . . This is cutting at the heart of our industry, given that investors buy on rating. While we in the industry might agree with the default/loss conclusion (this is in part the basis of our success and ability to leverage as high as we are), to lay it out there like this could be very detrimental.”
The conclusion Blumenthal drew was troubling. “We have found no legitimate business reason for this dual standard,” he told the committee.
Next to testify was Laura Levenstein, a senior managing director from Moody’s, who had the unenviable job of defending the dual-rating scale to the committee. “We’ve been rating based on this scale since 1920,” she told them.
“But the fact that you’ve been doing it doesn’t mean that there is an investor demand that you keep doing it,” said Frank.
“We have queried the market many, many times. And the feedback—”
“How did you query?” Frank interrupted. “In what sense? You’ve done a survey?”
“We’ve reached out and had one-on-one meetings. We’ve had briefings. We’ve done publications. We’ve—”
“And they’ve told you that they insist on a separate rating system even though they know that there’s no default risk?” said Frank.
“Yes.”
“All right,” Frank told her. “I’m skeptical sometimes,” he said. “You’re saying that when people buy municipal bonds, they’re not interested in the likelihood of default. They’re interested in financial stress on the entity, even though your own evidence shows that financial stress on the entity appears to be unrelated in any statistically significant way to default. Is that a rational basis for the market to do this?”
Levenstein explained that a municipal bond rating provides a measure of default risk relative to other municipalities. The head of Warren Buffett’s insurance operations weighed