Wall Street Makes Main Street Pay More to Borrow

Wall Street's Bid-Rigging Scandal

By Matt Taibbi, Rolling Stone

23 June 12

http://readersupportednews.org/opinion2/279-82/12057-wall-streets-bid-rigging-scandal

For space reasons we had to leave a few interesting bits out of my latest magazine piece, "The Scam Wall Street Learned From the Mafia," about widespread corruption in the municipal bond markets. The odd thing is, we might actually have undersold the damage done by this sort of cartel-style corruption.

When we called around to towns and cities affected by the rigged auctions discussed in the trial, many of the local officials were quiet, mainly because there’s still pending civil litigation in many of those cases. But a few of them pointed out a little-discussed flip side to the damage caused by Carollo­-esque bid-rigging.

Bid-rigging skims from towns after they’ve already borrowed money through bond issues. But some communities insist they’re being skimmed before they borrow as well. The central complaint is that the credit ratings of municipalities are excessively low, compared with counterparts in the corporate market who have the same risk of default. If true, this would artificially hike borrowing costs for cities and towns.

"Municipals virtually never, never default," says Rebecca Kaplan, a city councilwoman in Oakland, one of the cities listed as a victim in the Carollo trial (the defendants rigged an auction for a Port of Oakland bond deal). "And yet munis receive ratings that, if you were comparing them to corporate ratings, you would think you were talking about a significant risk of default."

The statistics bear this out. If you look at this report prepared by the House of Representatives four years ago - look at page 5 in particular, in the table for "Cumulative Historical Default Rates" - you’ll see that munis consistently receive significantly lower ratings than comparable corporate bonds. [see below]

The ostensible reason for this is that ratings agencies like Moody’s use different methodologies for rating munis versus corporate bonds. Muni ratings are based upon the financial strength of the issuer, while corporate bond ratings are based upon risk of default. And who knows, maybe that makes sense. But the end result is that towns, when they borrow money, get clipped coming and going: they pay more to borrow the money in the first place, and then - thanks to rigged auctions for bond service - they earn less on the money they borrow. [SNIP]

Referenced Report:

[House Report 110-835]

[From the U.S. Government Printing Office]

110th Congress                                                   Report

HOUSE OF REPRESENTATIVES

2d Session                                                     110-835

============================================================

MUNICIPAL BOND FAIRNESS ACT

_______

September 9, 2008.--Committed to the Committee of the Whole House on

the State of the Union and ordered to be printed

_______

Mr. Frank of Massachusetts, from the Committee on Financial Services,

submitted the following

R E P O R T

[To accompany H.R. 6308]

[Including cost estimate of the Congressional Budget Office]

  The Committee on Financial Services, to whom was referred the

bill (H.R. 6308) to ensure uniform and accurate credit rating

of municipal bonds and provide for a review of the municipal

bond insurance industry, having considered the same, report

favorably thereon with an amendment and recommend that the bill

as amended do pass. [skip to page 5 reference]

Background and Need for Legislation

There are about 55,000 issuers of tax-exempt municipal bonds including state and local governments as well as various non-profit organizations such as hospitals and universities. These issuers range from the large and well known such as the state of California to the small and obscure school districts in rural areas. A 2004 study by the SEC found that about 74 percent of municipal bond issues are for $1 million or less.

Municipal bonds can generally be categorized as either general obligation (GO) or revenue bonds. GO bonds are backed by the taxing power of the issuing government and generally viewed as the safest of municipal bonds along with those revenue bonds backed by the ratepayers of public water and sewer utilities. A 2007 study by Moody's Investor Services found that only one Moody's-rated investment-grade bond in this category defaulted between 1970 and 2006.

The chart below describes the low default history of municipal bonds rated by Moody's and Standard & Poor's as compared to corporate bonds.

               

Cumulative Historic Bond Default Rates (in %)
	Moody's		S & P
Rating Category	Muni	Corp	Muni	Corp
Aaa/AAA	0	0.52	0	0.6
Aa/AA	0.06	0.52	0	1.5
A/A	0.03	1.29	0.23	2.91
Baa/BBB	0.13	4.64	0.32	10.29
Ba/BB	2.65	19.12	1.74	29.93
B/B	11.86	43.34	8.48	53.72
Caa-C/CCC-C	16.58	69.18	44.81	69.19
Investment Grade	0.07	2.09	0.2	4.14
Non-Invest Grade	4.29	31.37	7.37	42.35
All	0.1	9.7	0.29	12.98
All	0.1	9.7	0.29	12.98

Source. Moody's, S&P.

Despite the lack of defaults of municipal bonds, issuers of these securities have historically earned a lower rating than comparable corporate bonds when viewed in terms of likelihood of default. Moody's Investor Services, for example, has 

employed a distinctly separate method of evaluating municipal bonds for 70 years. In general, Moody's bases its municipal bond ratings on the fiscal strength of the municipality that issues the bonds. For corporate bonds and structured, or asset-backed bonds, on the other hand, Moody's bases its rating on risk of loss. The effect on ratings is illustrated by the table below which shows how the rating on a municipal bond would translate if the issuer was judged on a scale used to evaluate corporate bonds (what Moody's calls the global scale). Most single A-rated municipal bonds would merit AA or higher if they were rated as corporate bonds.

This ratings disparity can also have the effect of driving demand for bond insurance. Bond insurers, or monolines, guarantee repayment of securities for a fee. Many issuers will choose to insure A-rated bonds to the AAA level in order to pay lower interest rates over the life of the security.

Monolines can only insure to the AAA level if they, in turn, are rated as AAA insurance companies. In the fall of 2007, monoline exposure to structured mortgage securities began to cause some of the firms to lose their AAA ratings. The ratings on the bonds they insured consequently dropped at the same time. This created uncertainty in the municipal bond market for which investors demanded a higher risk premium--which raised borrowing costs for states, cities and other municipal bond issuers.