Is there another shoe to drop in the credit rating of municipal bonds?

Author:Estes, Jim
 
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  1. INTRODUCTION

    In June 2004 the Government Accounting Standards Board (GASB), which provides accounting guidelines to public agencies, passed rule GASB 45. This rule, at the time of its release received little publicity or notice. This changed in 2006 as the dates for disclosure by the states and municipalities and the amount of debt involved became clearer. Prior to this, most states and municipalities had seldom considered the long-term effect in terms of ultimate costs of their tradeoff of current salary expense in the form of lower increases for free or low cost health care to their employees after retirement. While no agency must abide by the new rule, or any of the GASB rules for that matter, failure to do so can mean increased scrutiny by Moody's & Standard and Poor's analysts' resulting in reduced credit ratings at a time of decreasing municipal and state revenues. This reduction would certainly increase funding costs for new municipal bonds and possibly lowered pricing with higher yield to reflect any drop in credit rating on their current bonds. GASB 45 requires that States and Municipalities, for fiscal periods beginning after December 15, 2006, must report the projected cost of retiree health care benefits as debt. This is unlike the previous system where governments were not required to report the cost of benefits until after employees retire and then only on an as paid basis. Even further, they will also be required to create a system for paying down other pension and post employment benefits (OPEB) debt over the next 30 years and regularly track and report that progress. (Johnson, 2006) While the new rules don't require funding of the new debt, just disclosure and a plan for funding, the bond market very well may require that the public entities complete this projected funding in order to maintain their credit rating. To date, this issue has not seen much publicity in the general press.

    We are starting to see increasing focus on municipal and state financing as they both seek to reduce their deficits. As of 2007, only Michigan, the District of Columbia and Alaska have adapted a defined contribution retirement plans as their primary plans for general public employees while Indiana and Oregon combine both a defined contribution and a defined benefit plan and Nebraska has adapted a cash balance defined benefit plan. The others continue to have the traditional defined benefit plans as their primary retirement plans for public employees. It is difficult to compare the funded status of different pension plans under GASB reporting standards because governments use different actuarial cost methods, assumptions and amortizations and "smoothing" methods; although only three make up the vast majority of choices. (GAO, 2008)

    In order to receive a "clean" opinion from auditors, local and state government entities must comply with GASB 45. As stated above, the required date of implementation will be based on size of revenue: for public entities with revenue in excess of $100 million the above date of December 15, 2006 applies. For public entities with annual revenue of between $10 and $100 million per year the start date is December 15, 2007 and year later for those public entities with revenue under $10 million.

    Under federal securities laws, if these local public governments and agencies have information that potential sizeable liabilities could affect their finances and that may be material to investors; this information must be disclosed whenever new bonds are issued. (Hume, 2006) Bond issuers are required to issue information on any OPEB in disclosure documents as soon as it is known. According to Martha Mahan Hayes, chief of the SEC's Office of Municipal Securities "the GASB effective dates for inclusion of OPEB in financial statements do not justify withholding material information from investors". Thus, even with phase in effective dates for the shift from a recognition model system to a disclosure model. It certainly appears that any material information on the amount of the debt must be disclosed when known. To date this has been done through newspaper articles, there is little in the financial press about the issue, it is not clear if this will be sufficient to meet the SEC requirement..

  2. RATING AGENCIES REACTION

    While major rating agencies readily acknowledge that they look at numerous factors in addition to debt load in establishing ratings and estimating default risk, it is clear that this issue can have a negative effect. In a November 9, 2006 report on California's Contra Costa County, analysts at Standard and Poor's explained their negative outlook rating on that county as partially due to pressures from it's $2.57 billion retiree health-care obligation. Contrarily, Moody's credit rating agency however after simultaneously assigning a negative outlook rating, removed their "negative outlook" rating during the week of November 19th 2006, raising the rating from Aa3 back to Aa2. This was due to budget adjustments in other areas but Moody's stated that they remain "concerned" about how the county intends to fund future health care benefits for retirees. (Huff, 2006) In another case, involving municipal bonds from Duluth Minnesota where liabilities from health care costs have grown from $180 million to $280 million in the last three years, the concern has led to a...

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