Impact of Management Practices on Municipal Credit.

• Author: Larkin, Richard P.

Management has always been viewed as a crucial component of credit analysis at all levels of government. This article discusses the management practices that are conducive to strong creditworthiness and those that are detrimental to financial stability.

Editor's note: This report has been condensed and edited for Government Finance Review. To view the full report, visit the Fitch IBCA Web site at www.fitchibca.com.

Rating agencies have always given consideration to financial management practices in assigning bond ratings. Policies that call for contingency operating reserve funds, pay-as you-go capital spending, and multiyear budgeting have been encouraged, although their rating value has been left vague in rating agencies' guidelines. In the same spirit, the achievement of budgeting and financial reporting awards by organizations like the Government Finance Officers Association (GFOA) generally have been lauded by rating agencies but given the same lukewarm response as to their value for ratings. Most rating adjustments for management reasons have occurred on a case-by-case basis, rather than by consistent benchmarks that describe their worth in an issuer's ultimate rating assignment.

In analyzing actual financial crises over the past 25 years, it is clear that management has had a significant impact in salvaging, as well as exacerbating situations. In the 1970s, New York City had more than its share of economic problems with declining population, employment, and property values. The financial crisis, however, was precipitated by cash basis accounting, excessive short-term debt, poor management decisions, lack of internal controls, overspending, and poor record keeping. The default by the Washington Public Power Supply System was as much a result of unrealistic projections as it was of a national shift away from nuclear power generation to conservation as a means of addressing energy shortages. Finally, the inappropriately speculative investment strategy and lack of internal controls in Orange County caused the huge investment losses that led the county to seek bankruptcy protection. On the positive side, fiscal discipline and strong management practices have significantly benefited credit s. Baltimore, Maryland, has been faced with long-term economic erosion and urban flight as much as any center city in the United States. However, the city's budgets are consistently balanced, and its bond ratings have remained in the upper end of the 'A' category by all three major rating agencies. The cities of Detroit and New York also have employed management practices that have resulted in enhanced credit quality.

So, what does this all mean? It means that management practices and policies can add stability to weak credits, maximizing their credit rating potential. Conversely, it also shows that weak financial management can negatively impact even the strongest economies and local government structures. In the extreme, poor management can cause rating downgrades to below investment grade, and, on rare occasions, bankruptcy or missed debt service payments.

Best Practices. Best practices promoting efficiency in government and solvency in public finance have been identified or disseminated by the GFOA; the national associations for state auditors, controllers and treasurers, and budget officers; the National Association of Counties; and the International City/County Management Association. In 1997, the National Advisory Council on State and Local Budgeting (NACSLB) was created by these and numerous other government organizations and business leaders. NACSLB published a report of approximately 60 best practices in budgeting and financial management for state and local government in 1998. Its recommendations form the basis of many of the financial management practices that Fitch IBCA recognizes as superior and considers in the credit rating process.

Not all of NACSLB's best practices deal with financial management, many deal with taxpayer communications or assessing programs and services. If taxpayers understand the services governments provide, they may be less likely to propose restrictive initiatives or to force dramatic political or management changes through the electoral process. Exhibit 1 represents those financial management practices in the government sector that Fitch IBCA believes to have the most value in credit analysis.

Fund Balance Reserve Policy/Working Capital Reserves. Maintaining an operating reserve or "rainy day fund" is perhaps the most effective practice that can enhance an issuer's credit rating. Financial reserves may be used to address unanticipated revenue shortfalls or unanticipated expenditures. This provides a first defense against deficit spending and helps maintain liquidity when budgeted drawdowns are inevitable. The appropriate size of such a reserve depends on the potential variability of...