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Diners Stop Using Zagats After it Downgrades a Restaurant
August 17, 2011 Politics

You didn’t think I was actually going to write about food, did you? In today’s news, we learn that several municipal governments have decided to stop using the services of Standard & Poors (S&P). Why do municipalities rely on S&P services? Well, beyond the obvious need to have their “sovereign” debt issues rated, some municipalities have rather large “investment pools” that they have managed to accrue. Some of this is from accrued tax payments, for example. Municipalities want ready access to these funds, much like large corporations want ready access to liquid assets to pursue projects or make payroll when called for. But these municipalities would like to do better than store their excess funds under a mattress.

As a result, these municipalities end up creating what look like large institutional money market funds. And as a result of some famous municipal bankruptcies in the 1990s, some funds have taken up the habit of having their credit quality rated by the ratings agencies, much like they would for a bond issue. Most of these pools try to invest in safe and liquid assets and so typically these pools have that coveted AAA rating. But if you are looking to run a municipal investment pool what sorts of assets would you purchase? If you guessed US government debt, you are a winner. That debt is a popular investment choice because it is/was rated AAA – very safe (and also very liquid).

So what happens to the credit worthiness of your investment pool when the credit quality of the underlying assets is deemed to be worse? Of course it would be riskier too. When S&P downgraded the US government to AA+ status, that ended up triggering a downgrade in the municipal investment pools that were heavily invested in those assets.

And the reaction of the municipalities to such downgrades? They choose to fire S&P as their rating agency. Now, that is certainly within their rights, but the linked article above is simply nonsense. Here is one example:

“We are more than upset” about the downgrade, she said. “It’s just kind of mind-boggling at this point. You buy the most secure investment out there—U.S. debt—and I don’t think anyone can argue about that. … I guess double-A will be the new standard.”

Can anyone recognize the issue here? The investment pools seem to be complaining that the messenger delivered a message. S&P doesn’t advise investment pools about what to buy. That’s what they were accused of doing when it came to the rating of mortgage backed securities. And S&P doesn’t care whether the pools are buying Wintercow Corporate Paper or US Government Paper. Their ratings are computationally based and data driven (so I am told). If the paper is AAA and most of the underlying municipal investments are AAA, then the pool is AAA. If a part of their pool sours, then the rating of the pool would sour. I don’t see how that should make one drop S&P unless the effort is some sort of political retaliation for S&P delivering the widely understood bad news about US government debt.

Let me ask, did any municipal investment pools fire their rating agencies when the commercial paper market soured and some of those issues were downgraded? What would their reaction have been if some other non-federal government paper had been downgraded, causing their pools to be downgraded? And what is the purpose of having a credit rating simply toss it aside if it is unfavorable. Note to students: what does this behavior suggest about the credit quality of pools that do not have S&P ratings on them already? Is this outcome “good?”

The whole thing is a bunch of baloney.

(*) Full disclosure. If you read the linked article you will see a name that is very similar to mine. So yes, there is a potential “conflict of interests” here. The person in the article is the most honest person I know. But I am sure you’d all say the same about your family members too.

"3" Comments
  1. This is a big subject, WC.

    The ratings agencies have been useful, but we all took the ratings as guideposts. With the birth of MBIA, et cetera many municipalities paid for insurance to get AAA ratings, but many of us said no Philadelphia, no IDA’s, no any story bonds.

    Actually, I think that S&P would not have to have lowered the rating on treasurys. They should have pointed out that US debt is denominated in dollars, which they will print, and therefore that all bondholders will be paid. Same old story.

    It is not S&P’s job to tell the world that a dollar is worth five empty clamshells. Other investment advisors can make such assertions.

    With the creation of the euro, many, including Mundell, thought it would be great, breaking down the barriers of the breaks in the track, as our friend Bastiat would say.

    My first thought was about how the Italians and all of the southern Europeans would handle it, with their mindset being twenty five millione lire for a pair of loafers. It has turned out that they cannot manage it. Too many siestas, and too much Mussolini. Too many pairs of loafers.

    For now, my local municipality is flush with cash, and can afford to borrow at the cheapest rate from any bank, assuming it needs a bank.

  2. Wait For It … And here’s your political payback and intimidation.

    US Inquiry Eyes S&P Ratings of Mortgages – CNBC
    “The Justice Department is investigating whether the nation’s largest credit ratings agency, Standard & Poor’s, improperly rated dozens of mortgage securities in the years leading up to the financial crisis …”
    http://www.cnbc.com/id/44184348

  3. Great thought Speedmaster. Everyone wants to kill the messinger.

    What I find appalling is how enormously powerful agencies of our government swiftly wield the sword against their enemies. I hope that I, along with you, my family, and friends do not suffer from their wrath.

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