Rating bonds is fairly complex and takes into consideration numerous factors, such as financial competence, validity of securities, and good faith.
Financial competence is generally viewed as the most relevant factor;
however, other issues should not be ignored. Bonds have been repudiated in the past over issues of validity, a concept that includes: (1) the authority of the issue, (2) the purpose of the issue, (3) the process, and (4) debt and tax restrictions.
Proper authority must be followed in issuing bonds. Such authority resides in legislatures, statutes or state constitutions. Voter approval may be necessary in issuing a bond and irregularities that are discovered in balloting may be a reason to invalidate issues. Legitimacy of the purpose of debt must be verified. For example, the purpose of municipal obliga- tions must be public and in keeping with the demands of the jurisdiction.
Proper processes (such as advertisement of an issue) should be strictly followed. Finally, many jurisdictions place restrictions on obligations. As described above with reference to Hawaii and Texas, these restrictions usually refer to debt above a specific proportion of property tax value or general fund revenues.
Questions of validity are most often addressed in legal opinions. Since bondholders may have to go to court to enforce security rights, the integrity
and competence of the lawyers who review documents and write the legal opinions that are stated in the official documents are very important.
Lawyers should determine if issuers are legally able to issue bonds, if the issuer has enacted ordinances, resolutions and trusts without violating laws, and if security safeguards for bondholders are supported by federal, state, and local government laws (Fabozzi, Fabozzi, and Feldstein, 1995, 1996). Good faith refers to the willingness of a borrower to repay a lender.
Past behavior of jurisdictions can influence bond ratings and ability to borrow funds. The ability of San Francisco to sell bonds after its earthquake was attributed to both investor confidence in its future and its past history of never repudiating any of its obligations (Chamberlain and Edwards, 1927, 245–256). The exceptionally low interest rates paid on U.S.
Treasury bonds, in part, reflects the high level of good faith associated with those obligations.
While concepts such as validity and good faith are relevant, most con- temporary public finance texts cite the following factors in rating general obligation debt: economic base, financial factors, debt factors, governance factors and political mood (Lynch, 1995; Mikesell, 2003; Standard & Poor’s, 1996; Temel, 2001; Vogt, 2004).
11.4.1 Economic Base
The economic base refers to the local or regional economy. This is often seen as the most critical element in determining an issuer’s rating. It incor- porates both local and national economic factors. Economic base has been measured by factors such as employment, demographics, tax base, eco- nomic diversity, economic stability, local infrastructure, and local policies.
The economic base of a jurisdiction is linked to the importance of exports from the local economy. Sales to buyers outside of the local economy generate labor and business income. Good measures of total economic activity (export and import) include: (1) the dollar value of all goods and services produced, (2) quantities of goods and services produced, and (3) employment. Because employment data are more readily available than dollar or production statistics, the size of a local area’s economic base is often measured by employment in various sectors or standard industrial classification (SIC) categories (Galambos and Schreiber, 1996, 80).
In regard to demographics, a jurisdiction’s population base can be pro- filed in terms of age, education, labor skills, wealth, and income levels.
Demographic analysis should consider whether a population is becoming more dependent upon government services or is likely to contribute to future growth. Typically, indicators of wealth include changes in wealth over time, per capita personal income, and median family income.
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If data does not exist for the jurisdiction issuing the debt, statistics can be obtained from the county or standard metropolitan statistical area.
Tax base refers to all sources that are identified as being taxed. Local governments may choose to include salaries and wages in their income taxes but may exclude income from rents and stock investments. The federal government includes wages in income calculations but excludes employee benefits. A local tax base can be assessed by measures such as property tax valuation, the value of building permits issued, and retail sales.
Diversification considerations refer to the composition of employment (manufacturing, trade, construction, services, government, and agriculture), degree of concentration in major employers, employer commitment to the community, and employment trends. Concentration is viewed as a negative in rating bonds, particularly if the concentration is in a declining sector. For example, Standard & Poor’s uses multiple indicators to assess the financial health of farm-based jurisdictions. Credit ratings of farm-based economies have taken into consideration commodity prices for an area’s major cash crop, government subsidies, farm debt/equity ratios, foreclosure rates, land values, and local bank failures (Standard & Poor’s, 1996, p. 353).
Relevant measures of economic stability include the local unemployment rate. The quality of local infrastructure in terms of transportation systems, utilities, schools, housing, health care facilities, and cultural and recreational amenities has become increasingly important to bond ratings. Finally, a jurisdiction’s creditworthiness is also influenced by policies to support development and growth (Vogt, 2004).
11.4.2 Financial Factors
Financial factors refer to a jurisdiction’s current, past, and prospective situation with regard to revenues, expenditures, and fund balances.
Accounting methods, analysis of revenues and expenditures, balance sheet analysis, and the management of long-term financial obligations are impor- tant considerations for rating bonds.
11.4.3 Accounting
Standard & Poor’s (1996, p. 354) notes that the first important variable in judging financial performance of jurisdictions is the method of accounting and financial reporting. The use of Generally Accepted Accounting Princi- ples (GAAP) is considered a strength for the jurisdiction, as is the ability to meet the Government Finance Officers Association’s (GFOA) Certificate of Conformance requirements. Standard & Poor’s state:
Issuers are expected to supply adequate and timely financial reports. Financial reports prepared by an independent certified
public accountant are preferred. Lack of an audited financial report prepared according to GAAP could have a negative impact on an issuer’s rating since the quality of financial reporting may be considered suspect (Standard & Poor’s, 1996, p. 354).
11.4.4 Revenues, Expenditures and Balance Sheet Analysis
Standard & Poor’s examines revenue sources such as property taxes, sales taxes, income taxes, user charges, intergovernmental aid, and investment income over a three to five year period. They review unusual patterns that could lead to problems in financial performance in the future. Large expenditure patterns are identified to determine if continued growth could endanger existing services or require additional taxation. Typical indicators of spending that can be examined include numbers of full-time workers and spending per capita for salaries. Comparisons for these indicators can be made with spending in similar jurisdictions.
Analysis of balance sheets focus on liquidity, fund balance positions, and the composition of assets and liabilities. Deficits in any of the funds used by municipalities are causes of concern. Whether the deficits are temporary and easily remedied or chronic and longer term should be identified. Deficits or surpluses should be analyzed in light of a munici- pality’s past operations. Healthy levels of working capital as well as liquid current assets are considered beneficial. Reserves for items such as uncol- lected taxes should be considered (Temel, 2001, p. 180).
A comprehensive analysis of municipal financial performance also considers revenue transfers between funds, short-term finances, and the management of pension funds. Transfers of revenue from other funds to the general fund may be a sign of fiscal stress. Short-term borrowing may indicate a weakening financial position as was the case of New York City in the 1970s and California in the early 1990s. Standard & Poor’s asserts that the growth of unfunded pension liabilities must be avoided since it endangers the government’s ability to meet its long-term debt obligations.
11.4.5 Debt Factors
A local government’s outstanding and authorized debt affects its ability to borrow. Lee, Johnson, and Joyce (2004, p. 464) contend that determining the reasonableness of a state’s or municipality’s debt level is a subjective judgment. The main factors in making such a judgment are the financial burden on individual taxpayers, the size of the economy, and the perceived value of the goods and services purchased by the debt. Some states such as New York rank high in both per capita income and per capita debt.
Others such as Connecticut have high income but low debt levels.
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Standard & Poor’s measures a jurisdiction’s debt burden against the community’s ability to repay. Three key indicators of ability to pay are the tax base, the wealth and income of the community, and total budget resources. Standard & Poor’s contends that, in general, a debt burden is viewed as high when debt service payments comprise 15 to 20 percent of the total expenditures, including both operating expenses and debt service.
Other good indicators of debt burdens exist such as net debt per capita, net debt as a percent of market valuation, net debt as a percent of personal family income, pay down pace on long term debt, and net debt of over- lapping jurisdictions.
Standard & Poor’s note that debt can be used to cover up underlying fiscal weaknesses, stating the following:
In difficult fiscal situations where jurisdictions face operating deficits, some entities choose long-term financing of accumulated deficits as a solution. S&P believes the ‘‘bonding out’’ of finan- cial problems is not a permanent cure and may complicate the ultimate resolution of the crisis (1996, p. 356).
As we see from the case of California, jurisdictions use their ability to borrow in order to address their fiscal problems. This is politically expedient; however, according to Standard & Poor’s it should be avoided.
As demonstrated in New York City’s fiscal crisis and numerous other examples, overuse of long-term debt that is used to paper over structural imbalances between expenditures and collections will destroy a jurisdic- tion’s ability to borrow. Operating budget imbalances must be corrected by raising taxes (see Virginia case below) or cutting expenditures. The general rule of debt financing, as stated above, still holds; long-term debt should be used to pay for capital improvements that have a long life span. Payments for such projects should be spaced out so that those who receive the benefits also make the payments.
11.4.6 Governance and Administrative Factors
As described above, criteria for assessing a local government’s economic base, financial conditions and debt burden are well established. Numerous quantitative indicators have been developed to assess these factors. Eval- uation of governance and administrative factors, however, is more sub- jective. Vogt (2004, p. 231) states that the following governance factors are important for rating GO bonds.
Coherence of Government Structure
Cooperative Nature of the Governing Board
Degree of Professionalism Multiyear Planning Process
Ratings organizations have increasingly recognized the importance of governance issues. Local governance structures are established under state statutes or local charters. A coherent government structure should produce clear assignment of responsibility, good policy making processes, and effective implementation of policies. Local government is also enhanced by members of a governing board that work well together. In general, ratings agencies feel that a strong mayor or council-manager form of government will be able to control finances better than a weak mayor system. Better governance is also associated with multiyear approaches found in capital improvements plans, multiyear forecasting, and strategic planning.
11.4.7 Political Mood
Analysts recognize that changes in the political mood of taxpayers can be as important for the value of bonds as the issuer’s financial ability to pay (Temel, 2001, p. 172). This is directly observed in the actions of the first Secretary of Treasury, Alexander Hamilton. Hamilton’s declaration to repay Revolutionary War debt signaled a clear change in mood from that of repudiation to that of fiscal responsibility. Such action was not lost on future investors and helped the United States establish the type of credit status it enjoys today.
The Orange County, California, bankruptcy of 1994 presents an alter- native example, where a wealthy jurisdiction chose to walk away from its financial losses. Citizen repulsion with what many considered to be inap- propriate speculation on the part of civil servants, no doubt, contributed to the county’s default. At its height, Orange County was investing its own funds and the funds for almost 200 other local government units in risky securities such as derivatives or financial instruments that based its value on the interest rates of other investments. The aftermath of Orange County caused prices of other California bonds to drop dramatically (Lee, Johnson and Joyce, 2004, p. 466).
Throughout history, willingness to pay has been a critical element is assessing the likelihood of repayment on debt. Perhaps the most infamous example of unwillingness to pay debt is traced to the Treaty of Versailles that ended World War I. The people of Germany were outraged by the amount of reparations they were obligated to pay under the conditions of the treaty. Nationalist politicians such as Adolf Hitler claimed that if they
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gained power they would stop paying reparations. The 1932 Lausanne Conference attempted to reduce German reparation debt; however, by this time Germany was not making payment, and the Nazi government repudiated what it termed ‘‘interest slavery.’’ In 1932 European nations such as Britain and France also ended debt payments on the approxi- mately $7.25 billion in loans made to them by the United States (Blatt, 2001).
Table 11.3 summarizes economic base, financial, debt, and govern- ance factors as well as political mood. As previously stated, these criteria must be considered in assessing the credit worthiness of general obligation debt.
Table 11.3 Criteria for Rating General Obligation Debt
Economic base
Population Economic stability
Wealth Local infrastructure
Local tax base Local policies
Economic diversity
Financial factors
Major revenue sources Budgeting practices Number of full-time equivalent
positions
Accounting practices Spending per capita Revenue administration General fund balances Investment practices
Debt factors
Net debt per capita Debt service as a percent of general fund spending
Net debt as percent of market valuation
Debt pay down pace Net debt as percent of personal family
income
Debt of overlapping jurisdictions Governance
Coherent structure of governance Professional management Cooperative governing board Multiyear planning processes
Political mood Willingness to Pay
Source: Vogt, John A. Capital Budgeting and Finance: A Guide for Local Governments, pp. 228–232; Temel, The Fundamentals of Municipal Bonds, p. 172.