By Christine Richard
May 18 (Bloomberg) -- When California sells taxable bonds to foreigners, Moody's Investors Service says the state's credit is Aaa, the highest possible. When the state sells tax-free debt to U.S. citizens, its creditworthiness is four levels lower.
The discrepancy may cost taxpayers as much as $3.6 billion in extra interest on bonds sold during 2006, said Matt Fabian, an analyst at Municipal Market Advisors, a research firm in Concord, Massachusetts. New York-based Moody's doesn't allow towns and cities to apply the higher rankings to tax-exempt financings that make up 90 percent of the $2.4 trillion in outstanding municipal bonds.
``There has been a double standard for a long time,'' said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer, who oversees finances for the biggest government borrower in the U.S. after the Treasury. ``To the extent that the ratings increase debt service cost and are not truly a reflection of the risk, taxpayers come out on the short end of the stick.''
Moody's has been the arbiter of financing costs for companies and governments since it slapped a letter grade on the creditworthiness of railroad bonds in 1909. Its distinction between municipal bonds and other debt penalizes local governments and taxpayers, even though Moody's data show a corporation is about 97 times more likely than a municipality to default over a 10-year period.
Moody's Report
Standard & Poor's and Fitch Ratings, Moody's New York-based competitors, also assign ratings to tax-exempt debt that may exaggerate the risk of default. Moody's is the one under fire because its new dual-rating system for municipal bonds makes it clearer to investors how much the risk is overstated.
A Moody's report released in March said every state except Louisiana would be rated Aaa, based on the scale for taxable bonds that evaluates the likelihood of a borrower defaulting.
Just nine states -- Delaware, Georgia, Maryland, Missouri, North Carolina, South Carolina, Utah, Vermont and Virginia -- received that evaluation for their tax-exempt bonds. Those ratings are based on tax revenue and spending plans.
Institutional investors already know that bonds of cities and states are safer than their ratings imply, said Gail Sussman, group managing director for public finance at Moody's in New York. That's because tax-exempt municipal ratings don't take into account the possibility of a taxpayer bailout if the borrower can't make payments.
Moody's new ratings were developed to help buyers compare risks in different markets, such as between government and corporate borrowings, as investors including European banks and hedge funds moved into municipal bonds in recent years, Sussman said.
`Pandora's Box'
``They're for users who need to decide if they want to buy an Indiana pension bond that's taxable or an IBM bond,'' she said.
Moody's opened ``a Pandora's box'' and may cause public finance officials to question whether credit-rating companies' practices cost local governments money, said Richard Larkin, an analyst with JB Hanauer & Co., a fixed-income broker in Parsippany, New Jersey. Larkin previously worked at S&P for more than 20 years and was head of municipal ratings there.
``Ratings don't reflect the low default rates of municipalities,'' said Richard Green, a public finance professor at Carnegie Mellon University's Tepper School of Business in Pittsburgh. ``Pennsylvania is not going to stand by while garbage piles up in the streets of Pittsburgh or Philadelphia.''
Potential Cost
States and cities may have paid 0.05 percentage point, or 5 basis points, more to sell bonds because of the lower municipal ratings, Fabian said. That adds up to $3.6 billion in extra interest over the life of the $358 billion of tax-exempt debt sold last year by borrowers whose ratings are lower than Aaa, according to data compiled by Bloomberg and Thomson Financial. The estimate assumes the bonds mature on average in 20 years.
``I give Moody's credit for exposing something that's wrong with the municipal bond market,'' said Fabian. ``I think they're the only rating agency to actually read and think about their own default study.''
Moody's is limiting the use of the rankings because tax- exempt investors are accustomed to using the traditional ratings to compare different types of state and local government debt and may be misled if borrowers use more than one rating, Sussman said.
The majority of bankers, financial advisers, bond insurers, issuers and investors who gave feedback on the new scale recommended keeping the ratings separate, she said. It's impossible to know whether or how much traditional municipal rankings are costing taxpayers, she said.
May Escalate
Jonathan Fiebach, co-founder of Duration Capital Management Advisors, a municipal bond hedge fund in Bala Cynwyd, Pennsylvania, said extra costs will escalate as yields on municipal bonds rise from near historical lows.
Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets and participate substantially in profits from money invested.
Cutting even a few basis points off the borrowing rates for municipalities ``builds a lot of schools and buys a lot of textbooks,'' Fiebach said.
Officials at the University of Miami in Florida saw the cost of the dual ratings last month when the college sold $500 million of tax-exempt and taxable bonds. The tax-exempt bonds are ranked A2 and the taxable debt is two levels higher at Aa3.
The uninsured tax-free bonds due in 2010 were priced to yield 3.83 percent, the equivalent of 5.32 percent on a taxable basis, assuming a 28 percent tax rate. That compares with 5.23 percent on taxable debt sold with the same maturity.
No Benefit
``As an issuer, it's hard to explain'' the double ratings, said Alan Matthews, the university's associate vice president for finance. ``It's the same issuer, the same terms.''
The University of Pittsburgh Medical Center wanted to use the higher rating when it sold $220 million of tax-exempt bonds this week to refinance outstanding debt and upgrade hospitals. Moody's refused the request.
``We don't see any benefit to being viewed just on the municipal scale,'' said Talbot Heppenstall, treasurer of the hospital system, which borrows through the Allegheny County Hospital Development Authority. ``Institutional investors, maybe, are aware that our rating would be higher. Retail investors definitely are not.''
The Pittsburgh medical center's bonds are Aa1 under Moody's taxable-bond scale, two levels higher than its municipal rating. The hospital, which employs 43,000 in Pittsburgh, had revenue of almost $6 billion in 2006.
`The 1950s'
The medical center disclosed that it has a higher rating in offering documents even though it couldn't put the rating on its bonds.
Heppenstall said it wouldn't be necessary to insure any of its bonds if investors knew that when compared with corporations, the hospital's rating was one level below Aaa. The medical center paid almost $1.5 million to insure $85 million of bonds last year, he said.
``There needs to be an end to this big game by having one rating scale,'' Fiebach said. ``The financial markets have become global but the municipal bond market is living in the 1950s.''
Municipalities buy insurance for about half their bonds from companies such as Armonk, New York-based MBIA Inc. and Ambac Financial Group Inc. in New York to obtain Aaa ratings and reduce interest payments. The two bond insurers collected $181 million to insure public finance bonds during the first quarter of 2007.
`Open Secret'
Individual investors, who buy about two-thirds of all municipal bonds, prefer the safety of an Aaa rating, said Larkin at JB Hanauer. Buying insurance would be less necessary if borrowers were able to publicize their own Aaa ratings on the taxable scale, he said.
``It's the biggest open secret in the bond market, that insurers are insuring municipal bonds that don't need it,'' Larkin said.
Corporate bonds with Aaa ratings are more than eight times as likely to default over a 10-year period than investment- grade-rated municipal debt, according to 36 years of data compiled by Moody's. The default rate for those municipal bonds was 0.06 percent, compared with a default rate of 0.52 percent for companies rated Aaa, Moody's said.
Just 0.1 percent of all municipal bonds would be expected to default over a 10-year period, compared with 9.7 percent of corporate bonds, based on the Moody's data.
Better Understanding
California taxpayers might benefit from a better understanding of municipal default risk as the state sells $43 billion of new bonds in coming years. Governor Arnold Schwarzenegger wants voters to approve another $43 billion to repair crumbling infrastructure.
They could save $21.5 million a year if borrowing costs on the approved $43 billion in bonds were shaved by 5 basis points.
``If bond buyers are buying based on the risks of default, there's no reason why California should be paying a higher yield than any other state,'' said Paul Rosenstiel, California's debt manager and deputy state treasurer. ``There should be no distinction.''
California's $4 billion of tax-exempt bonds sold March 26 were rated A1 on the municipal scale and the state paid as much as 52 basis points to insure some of the bonds. The state's taxable bonds are ranked Aaa.
``We would like to see Moody's and other agencies rate us the same way they do corporate and other issuers around the globe,'' said Dresslar, the treasury spokesman. ``We cannot, however, tell them how to conduct their affairs.''
To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net
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