I consider myself fairly well versed in the intricacies of finance, but every once in a while I realize how naive even I am.
Via Bloomber.com: House’s Frank Says Municipal Ratings Add Unfair Costs
To paraphrase, ratings agencies have been judging Municipal Debt and Corporate Debt according to different criteria. A single A rated municipality has less of a risk of defaulting on a loan than some AAA rated corporate entities. The result of this double standard being increased cost for cities and states and increased profits for high-net worth investors and debt insurance agencies.
Municipal bonds are only appropriate investments for high net worth individuals because of their tax exempt status. The rating of Debt determines how much the interest rate will be; think of it as a city’s credit score. A municipality with the same ability to pay, or rating as a AAA rated Corporation may only receive a single-A rating and be forced to pay a higher interest then is justified by their ability to pay. In order to get high net worth investors interested these municipalities will pay large fees for bond insurance to achieve the necessary AAA rating or pay higher interest rates.
Hundreds of municipalities have been paying for this bond insurance to achieve the necessary AAA rating. This insurance is now approaching worthlessness as the companies who sold this insurance have also insured vast sums of mortgage securities. As the increasing default rate of mortgage’s saps the funds of the incorrectly named Monoline insurers (AMBAC, MBIA et all), not only is Municipal Bond insurance possibly worthless, but also unnecessary.
Imagine purchasing Auto insurance only to find out that, not only is the insurance company bankrupt, but your car is really a bicycle.