From the perspective of an independent financial adviser in the public finance market who has over 20 years experience at a major rating agency, the last 11 of which spent as the head of the public finance department, I believe there have been enormous changes in the rating business, and I think we are on the threshold of many more in the near future.
There is only one reason ratings exist: to provide efficiency to the marketplace.
They expedite the capital formation process because they are easy to understand and represent a shorthand symbol which communicates quickly a wealth of information and analysis which went into their formulation.
Moreover, ratings have become a commonly accepted opinion used by the market to judge the quality of the thousands of issues in the municipal market.
Unlike a basis point or return on equity, the value of ratings is more difficult to quantify; nevertheless, we know that the market clearly ascribes important value to ratings.
The credibility of the business of ratings comes from the integrity and responsiveness of the respective agencies which issue them.
If the processes which the various agencies use are not perceived to be credible, thorough and comprehensive, if the personnel at the agencies are not presumed to be unbiased and subject to exogenous pressures, and if ratings are not issued in a timely and the ultimate users, then ratings would lose their value and their use would decline.
In the municipal market, the two dominant agencies have historically been Standard & Poor's Corp. and Moody's Investors Service. Each of these agencies has been in the municipal rating business for over seventy years and has accumulated favorable reputations respected in the marketplace.
Although each has its particular emphases and methods of communicating its judgments, and although each would claim a dominance in the municipal market, together they constitute the key source of rating information for all players in the municipal market.
Nevertheless, with the advent of a revitalized Fitch Investors Service, both S&P and Moody's have had to refine their strategies.
Now competition among rating agencies, which has existed for many years in the corporate rating business, has finally arrived in the municipal market in full force.
Although the competitive environment is more perceived than real, since Fitch is still in a "reborn infancy", the two "old-timers" have recently engaged in far more market orientation than they have in the past.
The rejuvenated Fitch has made all the agencies more healthy as they now have had to develop a clearer focus on their customers (i.e. issuer, financial intermediary, bond insurer, financial adviser, ultimate investor, among others).
The choice of which agency to use is not as straightforward as it was previously. Although Moody's and S&P remain the dominant agencies, and although it is highly unlikely that a truly national market name issuer would not now go to both for a rating, the existence of Fitch has raised a lot of questions about the previously assumed necessity for only a Moody's and/or S&P rating.
The focus of streamlining activities to target products and services to each customer segment is now underway at all the agencies.
This task must be undertaken in an environment of large, inquisitive corporate parents in the case of S&P and Moody's or concerned investors in the case of Fitch.
The environment today also includes a market greatly affected by the Tax Reform Act of 1986, one of the effects of which was to reduce spreads in many deals, thereby leaving less room in certain transactions for associated fees, including rating agency fees.
The environment also includes the challenge each agency faces to keep up with new developments in the market while also directing internal resources toward maintaining timely and current evaluations of the thousands of outstanding ratings Moody's and S&P have, in a deteriorating economic climate, with rating downgrades outpacing upgrades.
Gross numbers of outstanding ratings can be misleading in terms of the efforts required for currency.
Moody's and S&P have publicly stated that they each, respectively, have well over 20,000 outstanding ratings.
It should be kept in mind, however, that these ratings include, among other classes of ratings or issuers:
* Bonds which have been refunded and are now secured by an escrow which require no additional review, lease rental, or certificate of participation issues payable from the general funds of borrowers which have general obligation ratings outstanding, such that a direct rating correlation exists;
* Revenue bond ratings for subordinate lien bonds rated in tandem with superior lien bond ratings;
* Bond issues which have a programmatic support from a state and are therefore rated in relation to that state's rating;
* And, last but not least, ratings which reflect third party guaranties (which are rated using the providers' rating), including letters of credit and insured bond ratings.
Nonetheless, the agencies face a formidable task in remaining current on all their ratings.
With respect to this aspect of the rating business, a lot of criticism has been leveled at the agencies.
One reason for the recent criticism of the job they are doing is the strong emergence of non-rating agency research and credit evaluations.
Historically, the primary "competition" in this regard was from "Street research", performed by analysts at investment banking firms and brokerage firms.
With the dominance of bond insurers in the municipal market (with nearly 30% of all new issues obtaining insurance), these companies also have large staffs of analysts who perform independent research.
With such formidable technical competition in this area of credit monitoring, it will remain a major challenge for the agencies to maintain a high standing among their customer groups as the primary sources of current information about the credit quality of outstanding issues. And it is to this issue I would now like to turn.
Outside Technical Capability
The recent creation of the National Federation of Municipal Analysts speaks to the existence of highly qualified analysts outside the agencies who perform their own research, aided by a keen understanding of the mechanics of the market.
The presence of these analysts is giving the agencies another level of competition.
Their existence does not so much lessen the need for ratings, although one could make that argument, as create the need for the agencies to provide more timely, succinct and tailored ratings and products, both for new issue and for surveillance purposes.
The agencies need to provide germane, supplementary, and complimentary services to these analysts, rather than providing what can be construed as competing products.
The other new development in the market affecting the manner in which agencies will have to manage is, of course, the new disclosure requirements and environment.
With increasingly larger numbers of issuers providing greater and more frequent disclosure, with more likely in the near term, and with the existence of repositories into which issuers and their intermediaries must deposit information, the role of the rating agencies will again have to be redefined.
The rating itself may continue to be a vital part of a transaction, but questions arise as to all the supporting (and internally expensive to generate) information that the agencies produce.
Disclosure, particularly if the Municipal Securities Rulemaking Board's Municipal Securities Information Library comes into being, may in fact become the largest "competitor" the agencies have ever faced.
If improved and more quantified information is more accessible, the marketplace can more readily and easily draw its own conclusions and thereby lessen the need for a formal rating.
Severe Credit Deterioration
Municipal issuers are facing a difficult period ahead. Approximately 80% of all states are reporting deficits, ones which cannot be easily or quickly cured.
Those of us in the market know that if the states are having problems, then local governments cannot be far behind, especially in a climate of continued federal budget pressure and devolution of responsibilities.
Rating downgrades will again outpace upgrades this year and likely will do so next year as well.
The dilemma faced by the rating agencies is to be predictive, without disenfranchising themselves by either lowering large numbers of ratings and thereby aggravating their issuer customers or by raising ratings and thereby impairing their justification and business strategy through the loss of the appropriate distribution among rating classifications.
As ratings are relative rankings of creditworthiness, they are most useful to the marketplace when there is a meaningful distribution among rating categories.
Lack of a full rating schema (whatever the causal factors) would produce a loss of relativity and would ultimately diminish the value of ratings.
Rating agencies are privately-owned businesses and, as such, must provide services which their customers value while at the same time providing adequate levels of return to their parents or owners.
Although the issuer pays for the rating, it is the ultimate users of the rating who drive the process for the issuer to obtain a rating. As long as the marketplace finds ratings a useful tool, then issuers will apply for them.
However, the environment in which the agencies operate can become less certain (from a business perspective) and more complicated, if:
* Issuers become dissatisfied with the process or the end result, particularly as they will now have to supply detailed information on a regular basis to repositories, not just rating agencies (this concern is particularly relevant to the-smaller borrower);
* Non-agency analysts draw maximum benefit from the new disclosure regulations;
* Bond insurers continue to grow in terms of market share and credibility.
Both established agencies, and particularly Moody's, have extensive databases which enhance and broaden their analyses and provide time-savings.
But if repositories become computerized as well, giving investors access to comprehensive information almost instantaneously, and if the bond insurers maximize the value of their extensive databases, how will be agencies be able to continue to provide a value-added product to the marketplace?
With information more broadly available, with an increasingly higher percentage of bonds insured, and with a strong analytical force in the marketplace, the agencies will be challenged to maintain their dominant role.
They have successfully achieved this in the corporate market, where disclosure regulations have virtually always existed, because the end-user desires the rating product.
But in a much more highly price-sensitive and limited market, both in terms of individual transactions and issuers of debt, the municipal rating agencies' ability to mirror their corporate counterparts' success is a formidable assignment.
Notwithstanding the business aspects of the rating agencies, the manner in which credit evaluation is performed and the use of ratings will clearly be modified in the future.
First, ratings and their associated research will be issued in a more timely manner, due primarily to computerization and easier access to information.
Second, it will be necessary for all rating products, including the ratings themselves, to become more tailored to individual, changing customer needs (witness the rapid growth of interest rate swaps), particularly as the type of debt instruments continues to evolve as a result of the long-term effects of federal tax law changes and likely future restrictions.
Third, enhanced disclosure and sophisticated market analyses by non-rating agency analysis (especially in a climate of credit deterioration where issuers will respond negatively to the market implications of lower ratings) will probably generate more sales and placements of unrated securities.
And, fourth, bond insurance and other third party guaranties may create a less meaningful distribution of ratings (with increasingly larger numbers of ratings supplanted by the high quality guarantors' ratings) and, in fact, may hold the potential, at least partially, to displace ratings as we now know them, as these guarantors become more accepted on their own merits in the marketplace.
The Balancing Act
In summary, the rating business faces many formidable challenges in the future. The balancing act for the agencies will be complicated and somewhat uncertain:
* Investing to maintain and expand market share while providing realistic returns for corporate parents and investors.
* Retaining market importance in an environment of constant change that gives no indication of abatement.
* Providing traditional services that even the federal agencies are now invading.
At the same time, the size, complexity and durability of the municipal market suggest that the fundamental purposes served by the agencies, by providing value added benefits and efficiency to the market, will keep the agencies integral, albeit different, in the municipal market for the future.
Ms. Johnson is a special consultant to Government Finance Associates Inc. Between 1979 and 1990, she was head of the public finance department of Moody's Investors Service.