Intense Scrutiny Taking Its Toll On the Municipal-Bond Industry
The municipal-bond industry operates at a rarefied level of finance that public school officials venture into when they need big money to build new schools.
For most educators, this remote realm of bond ratings, interest rates, and tax-exempt securities seems rock-solid, its pronouncements beyond reproach.
But in recent months, the image has cracked. Key players in the world of public finance have been the subject of intense and unwanted scrutiny in the form of lawsuits, news reports, and a federal antitrust investigation.
Much of the attention stems from a legal dispute between a Colorado school district and Moody's Investors Service, the oldest and most respected of the independent agencies that rate municipal-bond offerings. The Jefferson County district sued Moody's last fall, accusing the New York City-based company of anticompetitive conduct in its bond-rating practices.
Meanwhile, Moody's has acknowledged that it is the subject of a recently opened antitrust investigation by the U.S. Department of Justice. Federal investigators are reportedly examining the company's practice of offering so-called unsolicited ratings--opinions on bonds even when the issuer has not hired the firm to rate them.
And late last month, Moody's announced the merger of its public-finance department with its corporate-finance operation. Industry observers say the move is a cost-cutting measure related to declining business and increased competition.
"There is a great deal more scrutiny being focused on the municipal market," said Joe Mysak, the editor of Grant's Municipal Bond Observer, a New York City-based newsletter. "I bet everyone in municipal finance wishes it would go away."
'A Report Card'
The $1.2 trillion-a-year market for municipal bonds is attractive to large institutional investors, such as mutual funds and pension funds, because of its relative stability. Although municipal bonds usually offer lower rates of return than corporate stocks and bonds, their interest income is exempt from federal taxes.
Though the rating agencies are but one set of players in the municipal-bond market, they carry a lot of clout. A low rating can cost a school district, city, or other governmental unit millions of dollars on the interest rate it must pay to borrow money by issuing bonds.
"A rating is almost like a report card on your district's finances and management," said Gary Harmer, the business administrator of the Salt Lake City schools.
When a district is preparing a bond issue, it makes a presentation to one or more agencies. Moody's, Standard & Poor's Ratings Services, Fitch Investors Service, and other companies use intricate rating systems to tell investors about the financial risks involved with the bonds. (See chart, this page.)
School districts and other bond issuers pay the agencies to rate their bond issues; the fees increase with the size of the issue.
For example, the Salt Lake City district recently paid Moody's $7,000 to rate a $15 million bond issue for school construction, Mr. Harmer said. Moody's gave the bonds a coveted AAA rating, which means a lower interest rate--and therefore lower cost--for the district.
For years, Moody's and Standard & Poor's dominated the bond-rating business.
"Most issuers are required to get two ratings, so there was essentially a duopoly," said Byron Klapper, a managing director at New York City-based Fitch.
In fact, only six companies are authorized by the U.S. Securities and Exchange Commission to rate bonds, and a couple of those focus on small, specialized niches.
Only recently have the big two agencies begun to face real competition from two smaller competitors: Fitch and Chicago-based Duff & Phelps Credit Ratings Co.
As Fitch pushed into the market, several observers say, Moody's reacted aggressively.
In 1991, the Douglas County, Colo., school district was preparing a $30 million bond issue. Because of uncertainty created by the passage of a tax-limitation amendment to the state constitution, Moody's had downgraded the ratings of Douglas and other Colorado districts.
"We made a choice not to go to Moody's because they had downgraded our rating," said Bill Reimer, the assistant superintendent in Douglas County. "They said they were going to issue a rating anyway."
As a result, the district decided to insure its bond issue, at a cost of more than $100,000, which automatically resulted in the top AAA rating, he said. The insurance guarantees that investors will be repaid if the district defaults on its payments.
Gail Schoetler, Colorado's lieutenant governor, said that when she was the state treasurer in the early 1990s, a number of school districts bypassed Moody's because its fees were higher or because it issued tougher ratings.
The agency issued ratings on those districts anyway, she said.
Moody's defends its right to issue unsolicited ratings, especially when it has evaluated a district's debt in the past.
"It is in taking this stand of independence in publishing our research, sometimes in the face of challenges by issuers, that we have earned the trust and respect of investors," Moody's president, William O. Dwyer, said in a recent statement.
Many Colorado districts have replaced Moody's with Fitch, Ms. Schoetler said.
"When Fitch suddenly became an alternative to Moody's and Standard & Poor's, that created competition in a market that had never had competition," she said.
Investors take the unsolicited ratings as seriously as those paid for by the bond issuer, said Dale A. Oesterle, a professor of commercial law at the University of Colorado at Boulder.
That's what prompted the lawsuit against Moody's by the Jefferson County, Colo., district.
In 1993, officials in the 84,000-student district decided to use Standard & Poor's and Fitch to rate a $110 million bond issue. The district chose not to tell Moody's about the new issue until the day before it went to market, when it sent an overnight letter requesting that Moody's remove its existing rating on an older bond issue.
Instead, Moody's issued a statement the next morning on financial news wires saying it would rate the Jefferson County issue after the sale of the bonds.
Moody's statement also said: "The outlook on the district general-obligation-bond debt is negative, reflecting the district's ongoing financial pressures" from the tax-limitation amendment and other state fiscal concerns.
Jefferson County officials said the the Moody's statement dried up the market demand for its bonds. The district was forced to remove the bond issue and reissue it at a higher interest rate--a change that cost about $770,000.
The district sued Moody's in federal district court last fall, claiming the agency had recklessly interfered with the bond sale in retaliation for not being hired.
Last month, however, a federal judge rejected much of the district's lawsuit, saying Moody's has a First Amendment right to publish opinions about bond issues, whether solicited or not. (See Education Week, May 29, 1996.)
Moody's said it felt a responsibility to rate the new Jefferson County offering because the district had outstanding bonds that were rated by the agency. "The timing of events was determined by the school district's failure to notify us in advance of the sale," the company said in a statement.
The district's request that Moody's remove the past rating could not be honored because it would run counter to the agency's commitment to investors, the statement said:
"For Moody's to engage in, or tolerate, such a practice would violate our commitment to provide independent and objective information to the marketplace."
The lawsuit against Moody's was not dismissed entirely. U.S. District Judge William F. Downes is considering two antitrust claims added recently by the school district. Those claims allege that Moody's uses unsolicited ratings to maintain its powerful market position.
The Jefferson County suit may also have spurred the Justice Department review of Moody's.
George Fasel, a managing director of Moody's, confirmed that the Justice Department has begun an inquiry.
"They are talking to us at great length, but they have leveled no charges," he said in an interview last week.
"Every time the Justice Department sees smoke, it goes to see if there is fire," Mr. Fasel added. "But that doesn't mean there is fire very often."
Mr. Mysak of the Municipal Bond Observer said the intense scrutiny will probably blow over in time. "I don't think Moody's is going to fall apart or that the market is going to cease selling bonds."
Vol. 15, Issue 39