The Los Angeles Times has a strange editorial in today’s paper, complaining about the effect that bond ratings and insurance have on municipal and state borrowing. Instead of pointing out that the problem lies with cities and states that spend more than they get in revenue, especially in California, the Times chooses to blame the lenders and the people who gauge the risk of the bonds. Of course, this means that those eeeeeevil Wall Street barons are exploiting borrowers … again, although the Times winds up arguing mildly against that interpretation:
State and local governments have borrowed, by selling bonds, for years. But in the 1980s, the federal government began scaling back its aid to cities and counties for housing, transportation and education, and local governments tried to make up the difference by increased borrowing. Meanwhile, local and regional banks that once had face-to-face relationships with civic and political leaders were being supplanted by international institutions; investors lost their intermediaries and began buying bonds directly on the debt market, but they needed information about the riskiness of particular bonds. They began relying more than ever on the reports of the big three bond rating agencies — Moody’s, Standard & Poor’s and Fisk.
Lockyer, Blumenthal and others claim that if state and local bonds were rated on the risk of default according to the same standard as taxable corporate bonds, almost all government bonds would be rated AAA (or, in the case of Moody’s, Aaa; each agency has its own designations). They say lower ratings, made on a different scale, force state and local governments to pay investors higher rates than they should. The agencies counter that investors want ratings that compare one municipal bond to another, and not to corporate bonds.
To get ratings higher than those the agencies were offering, governments began buying insurance. They were, in essence, paying more upfront to rent the superior rating of the insurance company, which in theory would pay bondholders in the unlikely event of default. Such purchases were unusual until 1994 — when Orange County declared bankruptcy. Then, suddenly, every muni bond buyer began to insist on insurance, although defaults remained rare.
Not all that rare, and it started before Reagan took office, which the Times neglects to mention. The two most significant municipal defaults took place in the 1970s, in New York City and in Cleveland. Dennis Kucinich presided over the latter example, and both resulted from an orgy of tax-and-spend policies driving businesses out of the urban centers, and progressive social policies driving capital out as well. Orange County was actually more of an anomaly, a collapse brought about by foolish investment choices and not poor overall financial structure — which is why the county recovered so quickly from bankruptcy.
With three signficant municipal defaults in 30 years, it’s small wonder that investors now want a realistic rating from independent analysts when choosing which bonds to purchase. Why should muni investors be expected to blindly choose California state or city bonds over those of other states without any sense of whether their investments are secure? This sounds very similar to the unbelievably idiotic meme in the energy-policy debate blaming a supply problem on speculation rather than a lack of supply.
Both sillinesses intend to cover the real solution to the problem. Oil prices will drop when more supply gets added to the market. Muni bonds will strengthen when governments stop borrowing and spending like … well, like their constituents do. California is about to pass a budget with a deficit in excess of the entire budgets of most states. Its cities and counties exercize similar fiscal discipline. And California is hardly alone in this behavior That’s why investors insist on bond insurance — because the borrower (the states and cities) engage in reckless fiscal behavior.
If they want better ratings and cheaper lending, then just like all consumers, they have to start living within their means.