Thursday, January 31, 2013

The California Ontario Ratings Paradox

Today, the Fraser Institute published a compendium entitled “The State of Ontario’s Indebtedness” which includes my research comparing Canada’s largest province to California, America’s largest state. While media reports often suggests that California is on the verge of bankruptcy, the Golden State appears to be a model of fiscal probity when compared to Ontario. Consider these 2011 statistics from the report:

Indicator
Ontario
California
Total Bonded Debt
$236.6 billion
$143.9 billion
Bonded Debt-to-GDP
38.6%
7.7%
Bonded Debt Per Capita
$17,922
$3,833
Interest Expense
$9.5 billion
$ 5.5 billion
Interest Expense to Revenues
8.9%
2.8%
Deficit (Fiscal 2011)
$14.0 billion
$2.6 billion
Source: Fraser Institute based on California Comprehensive Annual Financial Report and Ontario Public Accounts. For comparability. California debt includes that of separately reporting component units.

Now, guess which of these sub-sovereigns has a lower rating. While reason suggests Ontario, the fact is California is rated below Ontario by the three major rating agencies. Here are the ratings:

Agency
Ontario
California
Moody’s
Aa2
A1
Standard & Poor’s
AA-
A-
Fitch
AA
A-

Rating agencies have admitted to applying a different, harsher, scale to US municipal bond issuers – including states –compared to other types of debt. In testimony to a US Congressional Committee, Moody’s Managing Director Laura Levenstein reported that this dual scale (i.e., one more severe rating system for US municipal bonds and another, less punitive scale for all other long term instruments) originated when John Moody first issued municipal bond ratings over 90 years ago.

In an attachment to written testimony to the same Congressional committee, California State Treasurer Bill Lockyer reported that when the state issued a taxable bond in 2007, Moody’s assigned a rating of A1 on its municipal scale and Aaa on its global scale. The implication is that Moody’s would have assigned California its highest rating – above that of Ontario – if it employed a single rating scale.

After being sued by Connecticut Attorney General Richard Blumenthal (now a US Senator), Moody’s and Fitch rescaled their municipal bond ratings, while S&P claimed that no such adjustment was necessary.

Not only was such a rescaling sorely needed, but it appears that the rescaling that was performed was insufficient. As I’ve discussed on ExpectedLoss previously, the inconsistency between municipal and other ratings is harmful to taxpayers. Monoline insurers arbitraged this discrepancy by selling unneeded insurance to general obligation issuers that have a long-term historic default rate on the order of 0.1%. If corporate and municipal ratings reflected similar default risk, it would have been impossible for an undercapitalized insurance provider to sell a wrapper to the nation’s largest state. As long as municipal and corporate ratings remain inconsistent, the risk of the monoline insurance business returning persists.

Also, besides ensuring that ratings for different asset classes have consistent definitions in default probability (or expected loss) terms, rating agencies should improve their monitoring efforts by using models that can be automatically updated as new fiscal data becomes available.

For example, we recently learned that California’s budget deficits have been closed through a mixture of tax increases and spending cuts. Yet the state’s ratings remain fixed in single A territory. If rating agencies ran new revenue and expenditure figures through a fiscal simulation model - like our Public Sector Credit Framework - they would be able to adjust their ratings more promptly. 

In Part II of this blog post, I will provide some comparative information on California and Ontario education, health and pension costs.

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