Feds should butt out of bond ratings

By DAVID MOON, Moon Capital Management, LLC
June 22, 2008

They're at it again in Washington.

Chairman Barney Frank (D-Mass.) of the House Financial Services Committee said last week that he might propose legislation mandating the type of evaluation processes to be used by bond-rating agencies. He argued that it was unfair that companies like Moody's, Standard & Poor's and Fitch don't necessarily use the same metrics for municipal bonds when applying credit ratings as they do for corporate or even federal government debt.

Frank says that if the same methods were used on municipal bonds, cities and states would receive higher credit ratings, implying a lower risk of default. This would, presumably, lower the borrowing costs for these states and cities.

Have they run out of things to do in Washington? Can't they have some baseball hearings or sex scandals? Either would make more sense and be more productive.

Bond ratings are produced by private companies. If the federal government wants to get into that business, it shouldn't tell private businesses what to do. Instead, Representative Frank and his buddies could build a huge new marble building in Washington, hire a few thousand bureaucrats and produce whatever type of ratings they want. Heck, they could even produce ratings on stocks and mutual funds. On slow days, they might start an NFL betting line.

But they have no business telling Moody's how to do its job.

The crux of Frank's position is that an investor can't easily compare the creditworthiness of a corporate bond and a municipal bond each possessing the same credit rating. Municipal bonds have been much less likely to default than corporate bonds, yet the ratings don't suggest that.

But the ratings are not meant to measure risk across asset classes. What they do purport to assess is the relative risk of two bonds within the same asset class. An A-rated municipal bond is considered less risky, all else being equal, than a B-rated municipal bond.

Congressman Frank's position is that if the ratings reflected the relative safeness of the municipal bonds vis-'-vis corporate and federal government bonds, munis would generally have higher ratings than they now do.

There is, of course, another possibility. The bond-rating agencies could simply downgrade all the other bonds, including those of the federal government.

That's right.

If Washington politicians are so concerned about properly evaluating the balance sheets of debt issuers, they could start by evaluating the balance sheet they run.

From a strict asset-liability standpoint, most states are more solvent than the federal government. Forty-four governors ' who, unlike the feds, can't just print more money ' are required to submit balanced budgets to their legislatures. Managing a fiscally sound state is apparently easier than an entire country.

If Barney Frank wants the bond-rating agencies to more accurately reflect the relative creditworthiness of different types of bonds, he'd better be careful what he wishes for.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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