Massive Bond Rating Scam

Even the most poorly-run state has less chance of defaulting on its debts than a typical well-run company. That’s because states, unfortunately, have the power to tax the living daylights out of their citizens — a prerogative businesses, which make money off of voluntary transactions, lack.

Yet the bond-rating agencies maintain the ridiculous pretense that states and local governments are risky creditors, by giving states low single “A” ratings while giving the municipal-bond-insurance companies that insure the states’ bonds a top “AAA” rating, even though some of these companies are in “awful” financial condition!

The bond-rating agencies only maintain this pretense domestically. In international markets, they give state governments what are effectively higher ratings, candidly explaining to investors that any American state government is unlikely to default.

This pretense enables them to create artificial distinctions between states, charge higher rates from states with lower ratings, and thus to generate income off of a needlessly complicated and expensive system of classifying states based on virtually non-existent differences in creditworthiness. (Such lousy bond ratings are reinforced by the fact that SEC and other government regulations effectively make it hard for any new competing entity to enter the bond-rating business).

This disparity has now reached absurd limits, judging from today’s Washington Post.

Municipal bond-insurance companies are in serious fiscal jeopardy, because they dabbled in the mortgage-securities business (which is now going south) as well as their traditional low-risk municipal-bond insurance business.

But the ratings agencies still expect states with less than perfect ratings, like single “A”, to seek insurance on their bonds from the financially shaky bond-insurance companies that have unjustified, top “AAA” ratings! That’s like asking Bill Gates to get a used-car dealer to guaranty repayment of a loan made to Microsoft. Since “some bond insurers are running out of money,” and are no longer financially strong enough to guarantee many such bonds, states with single “A” ratings are having difficulty getting their bonds properly rated and sold, forcing them to pay more to borrow.

I previously predicted that the municipal-bond insurance companies (one of which sicked then-New York attorney general Eliot Spitzer on a critic), such as MBIA and Ambac Financial, would be in financial jeopardy for messing around in the mortgage securities market they knew little about. (This was in the course of a post about how federal meddling in the mortgage business will only increase the inevitable losses in the industry and to society in general).

The Post notes that “the stock prices of most of the [bond-insurance] companies, including MBIA and Ambac Financial, have plummeted in recent weeks” as they lose more and more money.

Yet, astoundingly, ratings agencies such as Moody’s and Standard and Poor’s (S&P) have continued to give the financially shaky companies the highest possible credit rating — AAA or Aaa — compared to the low single “A” rating given to states that never default on anything and have growing economies. That is unbelievably silly and incompetent. It is a massive scam.

People have too blindly followed the prescriptions of the ratings agencies. They threatened to downgrade Virginia’s credit rating in 2004 if it didn’t raise taxes. The state then raised taxes, and then it turned out the tax increase was unnecessary — the state would have run a surplus even without the tax increase. (The legislature promptly increased spending after raising taxes, and today, Virginia, despite increased taxes, is facing a deficit as a result of runaway spending).