CDFA Spotlight: Engaging the Rating Agencies By Jerry Arkebauer, CDFA Bond Finance Course Advisor

In spite of a most difficult year and calls for significantly more oversight of rating agencies by the Security & Exchange Commission, representatives of three rating agencies said investors still can rely on ratings.

That was one consensus reached during a panel discussion on “Engaging Rating Agencies” May 13, 2010 at the Council of Development Finance Agencies Annual Summit in Portland, Ore.

Gail Sussman, managing director of Moody’s Investor Service in New York, explained during her presentation that the purpose of ratings is to provide investors with a simple system of gradation by which relative creditworthiness of securities may be noted. Moody’s uses nine symbols to designate the range between Triple A with the lowest risk to Single C with the highest risk.

She said ratings are independent objective assessments of the creditworthiness of debt obligations and the symbols denote the relative ability and willingness of debt issuers to make full and timely payments. They are not recommendations to purchase, sell, or hold particular securities, and the ratings are not fixed since ratings can be changed over time.

She noted that Moody’s methodology includes qualitative and quantitative analysis and “context is key to developing informed credit decisions.” Sussman said all of the parts must be looked at and the economy carries “heavy weight.”

As an example, Sussman said Moody’s has four key rating factors for a U.S. Local Government General Obligation issue: Economic Strength at 40%; Financial Strength at 30%; Management and Governance at 20%; and Debt Profile at 10%. No individual analyst at Moody’s determines a rating although the analyst does make a recommendation to the review group.

Sussman explained that Moody’s recently completed a “recalibration” of some 70,000 municipal ratings to align them more with corporate, sovereign and financial institutions ratings. She said there were no changes to credit profiles.

Pamela Berkowitz, director of client business management group of Standard & Poor’s Ratings Services in San Francisco, said S&P uses the same scale across all sectors. While ratings can be dynamic, S&P looks at who’s paying the bonds and what is the security for repayment.

Berkowitz noted that there is a code of conduct to act independently and there are four distinct roles at S&P:

· Analytical determines rating actions and develops and approves criteria;
· Commercial negotiates fees and handles collections and payments;
· General Management is responsible for managing the business; and
· Control Officer insures the quality, criteria and risk policy are applied appropriately.

Amy S. Doppelt, managing director of Fitch Ratings in San Francisco, said Fitch also examines four basic rating factors: the economy, debt, finances, and management although it gives no “weighting” to the factors although economic and market conditions can alter the importance of certain factors and sub-factors.

Although Fitch always has had only one rating scale for all issues it rates, it also recently adjusted ratings for about 2,100 of 3,600 U.S. public finance ratings. Most saw ratings “recalibrated upward by one-to-two notches.”

The percentage of AAA ratings increased to 15% from 6% and AA ratings increased to 67% from 46% while A ratings declined to 15% from 40%.

Doppelt noted that Tax Increment Financing (TIF) issues are generally highly leveraged and tax increment revenues are vulnerable to economic performance and tend to lag trends. In addition, Doppelt noted that tax increment revenues also are vulnerable to taxpayer assessment appeals.

In evaluating a TIF, Fitch looks at the development area, the specific development project, the tax base and its diversity, the legal structure, and historic and projected debt service coverage in determining a rating.

She said development to date is most important. However if the TIF relies on future plans, Fitch “views those with a healthy skepticism.” Diversity in land use and tax base can help to offset economic cycles and business downturns. Legal status including lien status, any additional bonds test, and the presence of a reserve fund also are examined. Doppelt said debt service coverage is very important, and the culmination of the other efforts.

Impediments or restrictions are evaluated by Fitch including environmental, political, and practical such as traffic and the area’s ability to attract certain types of development.

Noting that “lots of ratings are subjective,” Doppelt said Fitch also examines a volatility ratio, the incremental value to the base year, and efforts to mitigate credit weaknesses. “However, it is hard to overcome a small area or a new area,” she said.

Debt service coverage is the culmination of other rating factors, Doppelt noted, and is viewed both on a historical and projected basis. Fitch applies stress tests to forecasted Tax Increment revenue and coverage to examine slower base year and incremental value growth, appeals of values are double the historic average, a loss of three or more of the largest taxpayers, and “other tests as may be applicable.”

“The 12 Habits of Highly Effective Financial Officers,” updated in 2007 and the most requested Fitch Ratings Public Finance report, was cited as a way to evaluate management. Among the Habits are having a fund balance and working capital reserve policy, multi-year financial forecasting, contingency planning policies, debt affordability reviews and policies, and “pay-as-you-go capital funding policies.”

She offered two tips. First was “It’s all in the timing.” She asked issuers to give Fitch time to assemble the best possible team to review the project.

The second tip was “Honesty is the best policy” and remember that the information flow always should go both ways between the issuer and the analyst.

During the question/answer session, the rating agency representatives agreed that investors still can rely on ratings.

Sussman said investors should look at more than ratings. She noted that the three different ratings agencies could look at the same issue and apply different criteria. She said a rating is one element of what should be considered.

Berkowitz suggested that investors should look behind a rating at “what we look at.”

Doppelt said there is a credit report on each issue which should be reviewed. “In the end, ratings are just opinions.”

The panel discussion was led by Pepe Finn, chairman and chief executive officer of Stern Brothers & Co.