Preparing for the next recession is extremely difficult. Especially in the state and local government sector. Which leads us to this — is there any real way to do so? For an Issuer, perhaps, building up reserves and watching the pace of new hires and new spending priorities would be prudent. Traders and sales forces become even more sensitive to the flows and any minute changes in investor preferences or behavior. Investors will consider dialing back on risk in order to avoid the worst effects of a downdraft. Fed watchers continue to parse the language of the Open Market Committee meetings and releases and recalibrate their estimates of the probabilities of easing at future meetings.
What do rating agencies and the credit community do? They review the criteria to see if it is completely up to date and whether any elements should be reconsidered. They also need to be mindful that these updates need to be filtered down to the organization so that said changes will be fully implemented in the process of ratings. They also have to deal with history to not repeat those shortcomings of the past. The memories of 2008 are indelibly imprinted on participants who were around during that time. The best policy is to remain objective and as analytical as practical. The ratings still need to go out the door. There is no time for endless debate.
The topic has been raised once again: Are the rating agencies being too generous in their interpretation of current financial results and policy outcomes? Let’s be fair here. Times have been quite favorable for nearly all issuers of every stripe and this status has translated into relative stability for ratings despite some of the negative outlooks that have been assigned to particular sectors.
One aspect that I learned during my tenure at a rating agency that I have grown to appreciate even more over the years is that the analyst or credit person should focus on the category for the credit first. After that process has been duly contemplated, only then should any modifier to the rating in the form of a plus or minus should be considered. Either of those modifiers by definition should reveal a bit as to where the future course of the credit is being contemplated.
The challenge for a rater headed into a recession is that careful considerations of the audits, budgets and general disclosure still must be relied on in the first instance. There cannot be too much forward-looking speculation as to the course of any of these inputs and yet the emerging trends clearly should not be ignored. There is much judgment involved in the process and a historic perspective is very helpful to have in the committee.
This consideration of the process returns me to one of the hot topics of the day that appears to be persisting — namely the timeliness of audits.
In other markets the information flow is much more timely and the discipline of filing quarterly reports means the timeframe for review of critical information is much more current.While quarterly reporting may not be as practical for a state or locality, it is the standard in the healthcare sector, for example. Some would say that because of the sovereign and sub-sovereign nature of the credits, we should not be as concerned. It is not so much as a matter of the probability of default as it is about financial decline. When the finances erode, there will clearly be an impact on price in the market. Rating agencies in general do not opine on prices in the market. But of course, everyone else does.
The importance of timeliness of audits and financials became clear when Build America Bonds were in their heyday back in 2009 and 2010. For many of the taxable buyers who first considered the purchase of a municipal, there was a sharp learning curve as to the many aspects of the municipal market. First, there was the consideration of municipal bond structure including serials and terms. The greater amount of time spent was on credit. Some of that focus had to do with the assigning of the proper risk weightings in the process for reporting purposes. However, the greatest risk perceived by the crossover buyers was the timeliness of audits and other financial information. Many were aghast at the thought that the last available annual audit was six months to a year beyond the end of the fiscal year. “How do you even know where they stand right now?” was often asked. There were no easy retorts to this lament at the time.
Myself and other market participants are openly wondering about how much of this concern is around at present. The main rationale for this question is that many issuers are now turning to taxable paper. Given the lack of advance refunding and the extremely low rate environment that we are currently experiencing, the taxable trend may be with us for some time. Crossover buyers are more attracted to our market, especially, those buyers who only have negative yields to choose from in their home bases.
I recently participated in a conference that was centered around the implementation of XBRL in municipal financial documents. There is a fair amount of resistance to the efforts but the potential adoption of the principles may lead to more ease of use and some faster and better analysis.
There is no real way to speculate on recession with pinpoint accuracy. However, taking steps to improve timeliness of information so the market is not taken by surprise has great value. Many buyers of individual issuers paper are repeat buyers. One would think that many participants would like to sustain such an environment when the time gets tough and volatility widens along with spreads.
