Statement of Mark D. Blake at the SEC Field Hearing
San Francisco, September 21, 2010
[The following comments do not reflect the policies or positions of any office, agency or department of the City and County of San Francisco, including the Office of the City Attorney, and reflect only my views.]
I want to thank the Securities and Exchange Commission, including the Office of Municipal Securities, Division of Trading and Markets, for inviting me to participate on this panel. It is an honor and privilege to be here today.
My comments will be brief, and tailored to the bread of butter municipal finance issuers.
My name is Mark Blake, and I have worked in the municipal securities industry as an attorney for the past 22 years. I have worked for private law firms (as bond, disclosure or underwriter's counsel), and most recently as in-house counsel to public issuers, including the Metropolitan Water District of Southern California (during the last part of its $4 billion capital program), and the cities of San Francisco and San Diego. Interestingly, my career in California spans work touching on two significant Securities and Exchange Commission actions, one involving my work on certain notes issued by Orange County (where I was a very junior associate) and another involving the City of San Diego (where I was Chief Deputy City Attorney for Finance and Disclosure during its challenging period, and where I had the opportunity to work on the establishment of one of most rigorous set of controls and procedures of any municipal issuer). For the past 2 1/2 years, I have worked as a Deputy City Attorney for the City and County of San Francisco providing in-house advice for the City's bond offerings.
Our task today is to provide comments to the SEC on rating agency practices and the impact of rating agencies on the municipal securities practice. As we all know, the credit rating agencies play an indispensible and central role in US financial markets. The three primary rating agencies, Fitch Ratings, Moody's Investors Service and Standard and Poor's, all carry the SEC's designation as Nationally Recognized Statistical Rating Organizations (NRSROs), which has facilitated the market dominance by such firms. These agencies provide opinions on the credit quality of a debt issue or issuer. The ratings are not in-and-of-themselves recommendations to buy, hold or sell any particular bond but an assessment, indeed simply one firm's opinion, of the likelihood that the issuer of the bond has the capacity and willingness to repay the debt when due.
Credit ratings serve in large measure, like the securities laws, to reduce the informational asymmetry between the issuer and a prospective investor. Let me be clear, in my experience the rating process is a serious process undertaken in a professional manner, and, quite frankly, provides a value added service within the debt issuance process. But . . . of course there has to be a ‘but.’
With the financial meltdown beginning in the summer of 2007, the practices of the rating agencies, and particularly those affecting municipal securities, have come under intense scrutiny and criticism. The Treasurer of the State of California, among others, has been a consistent and outspoken critic asserting, correctly I think, that the rating agencies have adopted rating methodologies that unfairly discriminate against municipal issuers and in so doing have raised the cost to taxpayers of financing critical infrastructure projects. In the midst of today’s economic challenges and constrained budgets this discrimination is real pain, costing local government precious resources.
Important for taxpayers and ratepayers, bond ratings set by the rating agencies raise or lower the cost of the financing of capital project. Higher ratings lead to lower borrowing costs; lower ratings lead to higher borrowing costs. From the financing of police stations, to firehouses to critical water and sewer infrastructure — in a word everything that government does---is directly affected by the ratings assigned to the bond issued to finance the project.
It has been well established that historically credit rating agencies have held municipal issuers to a higher standard than their corporate bonding counterparts. The heart of the matter is that municipal issuers rarely default on their obligations, and yet carry lower ratings. Studies prepared by the rating agencies capture this point. For example, Moody's in a 2007 study of default rates [of municipal issuers] over the period 1970 to 2007 found that only one general obligation bond defaulted (and that default was cured in 15 days). More startling, that same study showed that all investment grade municipal debt, excluding general obligation bonds and water and sewer bonds, had default rates half that of triple "A" rated corporate debt.
Similarly, Standard and Poor's in its 2008 study showed default rates of .02% for an "A" rated municipal bond and .08% for a triple "B" rated bond. This means that municipal bonds rated in the lowest investment grade category had a negligible default risk.
Finally, Fitch the smallest (in terms of market share) of the big three rating agencies, shows in a 2008 study an even more startling statistic. This study shows that the five-year cumulative default rate for municipal securities over the period 1990 through 2007 was 0%. And, while Fitch indicates that over such period the default rate was negligible, municipal securities were nonetheless rated more stringently than their corporate brethren.
However, perhaps the best evidence of this discrimination by the rating agencies against municipal issuers is that a niche industry flourished for a short time "insuring" municipal bonds. MBIA and Ambac corporations, to name two of the most prominent, carried coveted "AAA" ratings on their principal business of ensuring municipal bonds. The bond insurance business was a beautiful thing. The bond insurers collected millions of dollars in premiums to insure against events that both the bond insurers and ratings agencies (from their own studies) knew would rarely occur — a default by one of their municipal insureds.
So, what is to be done? More competition, more transparency, improved rating methodologies — yes, yes, and yes.
It is my belief that reforms directed at the municipal bond market, either direct or indirect (e.g., efforts to improve disclosure practices) have to include as a necessary component rating agency reform. While the Securities and Exchange Commission is prohibited under the Credit Rating Agency Reform Act of 2006 from regulating the processes or methodology of ratings, surely the SEC has not lost its central role of ensuring that investors receive accurate information on which to base investment decisions. The SEC should utilize its traditional tools of rulemaking, interpretive releases and, as a last resort, enforcement actions to bring about the change it seeks. The ratings provided to municipal issuers over the past 30 years or so have overstated the risk of default and loss as compared to a similarly rated corporate security. While moves to a single scale are intellectually appealing (and perhaps desirable from the investment community) I think, ironically, they head in the wrong direction. Municipal bonds and corporate bonds are simply not comparable.
Government is by its very nature different from for-profit private corporations. Governments have broad taxing and revenue generating powers, police powers and captive populations. Most important, these powers are exercised in public, in plain view, with notice provided to any and all who want it. The compensation of all public employees in California is public, in plain view. The public has the right to demand any public document (contracts, agreements, resolutions, email, etc.) maintained by the government. In short, governments do not in most instances have the luxury of saying ‘none of your business.’ Paradoxically, an investor, were she so inclined, could obtain more timely and accurate information about the operations of government than they could for any publically traded corporation. Are governments divorced from economic uncertainty, financial market turbulence and long term fiscal challenges — of course not. And, yes, governments do, rarely, file for bankruptcy protection. But all of this argues that governments be rated on a completely different scale, a rating scale based upon the unique characteristics of government.
Perhaps this scale would be a simpler pass/fail scale (investment grade or not), or perhaps a three-part scale red, white or blue. In an event the core of any such governmental rating methology would contain verifiable metrics correlated to default risk — leaving the remainder of the subjective analysis or the making of finer credit distinctions to investors. That may not be a sophisticated rating system, but perhaps government is just not that complicated.