THE IMPORTANCE OF BOND RATING

Bond ratings are of great public concern since they are assigned to a substantial number of the issues now outstanding. An increased rating increases the value of a bond and a decreased rating decreases it. Rating changes also have an enormous effect on the interest charges which issuers must pay when they borrow money from the public.

HISTORY OF RATINGS AND WHAT THEY MEAN

Municipal credit ratings are an outgrowth of corporate bond ratings. The birth of bond ratings occurred in 1909 when Moody's first rated railroads. In 1914, it expanded its service to cover public utilities and industrials. In 1922, Poor's began to rate industrials. In 1924, Standard's Statistics and Fitch entered the field. In 1941, Standard & Poor's merged. In 1919, Moody's began rating municipalities. In the late 1920's, Standard and Fitch followed suit. The early history of municipal rating is a dubious one. Prior to the depression, Moody's rated most issues AAA or AA. Defaults during the 1930's caused Moody's to re-evaluate its standards and adopt a more conservative approach. Forty-eight percent of the number of defaulting issues in the 1930's were rated AAA and 1929 and 78 percent of the defaulted issues were rated AA or AAA.

Explanations of the Moody's and Standard & Poor's bond ratings are given in Exhibit II, reproduced directly from the manuals of the two services. Moody's does not rate issues under $600,000. More than 16,000 public bodies are currently included in Moody's Municipal and Government Manual, although all are not rated. Standard & Poor's rates issues of governmental bodies having at least $1 million of debt outstanding. It rates about 7,000 issues. Dun & Bradstreet, Inc., does not rate municipal bonds per se. It does issue a series of credit surveys. It labels both tax and revenue-secured bonds either "above average," "favorable," "fair," "poor," etc., according to principal factors. Fitch Investor Service issues municipal bond ratings only on a specific request basis. Other agencies rate bonds but confine their activities to specific areas. Among these are the North Carolina, Oklahoma, California, Ohio, Michigan, Iowa, and Kansas Advisory Councils. The agencies with the broadest influence are Moody's and Standard & Poor's since they issue comparable letter ratings which are widely available to the public.

THE ENORMOUS INFLUENCE OF THE PRIVATE RATING SERVICES

Moody's and Standard & Poor's render a private service to their clients in return for a fee or subscription to their publications. Through a series of circumstances, they have assumed almost Biblical authority throughout the American investing economy and have an enormous influence on banks, trustees, institutional investors, and individuals. The issuer, underwriter, and taxpaying public are also directly affected by the decisions reached by the small handful of men in each organization.

Ratings normally are assigned to large, widely-known issues of municipal bonds prior to public sale by the issuer. Investors are so accustomed to the system that almost automatically, a rating will determine within certain limits the interest rate the issuer must pay on its bonds. Many states have legislatively enacted the "Prudent Man Rule" under which trustees and other fiduciaries are held liable for their negligence in the handling of investments. To avoid charges of negligence, they "play it safe" by investing in bonds rated A or better.

Similarly, many institutional investment committees, as a matter of policy, will only buy A or better or not even both to look at a BAA or unrated bond. Last May 4th, I conferred with high officials of the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. I learned from them that their bank examiners who supervise practices throughout the United States commercial banking system are heavily influenced in their regulation of bank portfolios by the letter ratings assigned by the two leading services. Most issues assigned less than BAA by both rating agencies are rejected out of hand for bank investment. Issues rated BAA are felt by some to have a faint odor which places a burden of proof upon the banks to justify the investment. Obviously bankers would prefer to avoid having to defend in detail their bank selections. Therefore, woe be to the city which

slips below an A rating, and woe be to its taxpayers who must pay a much higher borrowing cost occasioned by the distasterous slip from an A to a BAA. The rating agencies unwittingly have come to be looked upon by banks and the public at large as official bodies serving a public rather than private purpose. Of course, they are not official. Their only responsibility is to their clients and subscribers. Nevertheless, in today's market, the difference of a notch in a rating or between similar rated and unrated issues can range between 25 and 50 basis points or more (between one fourth and one half of 1 percent in annual interest rate). Thus, ratings also effect the economic development of municipalities which pay widely varying rates of interest per dollar borrowed.

INADEQUATE FACT GATHERING

Are rating agencies able to obtain the data they must have in order to fulfill their important responsibility of issuing accurate ratings? A little simple arithmetic suggests no. Moody's, for example, has 12 analysts on its staff and rates 12,000 out of the 16,000 municipalities in its manual. Hence, each analyst on average rates 1,000 municipalities. There are 250 working days per year. This means four municipalities must be rated each day. Presumably, to be at all thorough, the agency would have to review ratings quarterly which would mean at least 16 credit reviews per day per analyst. Assuming complete efficiency and an 8-hour day, this would mean that each analyst would have to review one credit every half hour. Obviously an impossibility.

Unless an agency representative visits each community personally, there can be no assurance that information supplied is complete and unbiased. The lack of any uniform procedure for financial reporting between the several states makes the task of the agencies extremely difficult. The rating agencies must rely in large measure upon questionnaire information supplied by fiscal officers. There is no way to be certain of the completeness or accuracy of the information supplied.

Peoria, Illinois provides a case in point. For many years, the general obligations of Peoria had been rated A. Just before the city came to the market in July 1965 to borrow $4.2 million in serial bonds. Moody's withdrew the AA rating. Claiming insufficient credit information, no rating at all was given. After the sale, Moody's obtained additional information and assigned an "A". But in September, 1965, the rating was restored to AA. New information revealed that for almost a year, Peoria had neglected to report a 20 percent increase in taxable valuations resulting from the annexation of a high school district. Also not reported was a favorable restatement of the city's tax collection experience. Moody's had neither the staff nor the funds to find the correct information itself. An official at Dun & Bradstreet has estimated that a proper investigation of a municipality would cost between $1,500 and $2,000. Rating agencies cannot afford such a price. Well-informed professionals have advised me that rating is an unprofitable business. The agencies have inadequate staffs and suffer a high employee turnover because they cannot afford to pay competitive salaries with Wall Street. Municipalities are rarely visited more than once every five years. Also, despite its obvious adaptability to the statistical problems involved, computerization has not yet been utilized for bond rating.

NOT ENOUGH BONDS RECEIVE RATINGS

Serious problems stem from the inability of the rating agencies to rate many projects worthy of rating. For the most part, only bonds rated BAA or better are acceptable to banks and insurance companies. If a bank wishes to buy an unrated bond, it must show the bank examiner the merits of that bond in great detail. Only about 2,000 out of the Nation's 12,000 banks are big enough to take on such a burden and only a few of them bother. It is always easier to "play it safe." When a community is forced to offer higher interest rates, the investor benefits but the added cost to the community means less public improvements for its people.

DISAGREEMENTS IN RATINGS BETWEEN THE AGENCIES

The two major rating agencies often look at data through different lenses and arrive at different conclusions. Approximately 70 percent of all issues rated by both Moody's and Standard & Poor's have similar ratings. But 20 percent receive higher ratings from Standard & Poor's and 10 percent are given higher ratings by Moody's.

CONFLICT OF INTEREST

The common practice of employing rating services as fiscal consultant creates conflicts of interest. On November 10, 1964, the Florida Securities Dealers Association passed a resolution condemning this practice. The FSDA stated that the issuance of ratings by rating services having a confidential and fiduciary relationship with municipalities would creat a serious conflict with those entitled to rely on the integrity of such ratings.

VARIATIONS IN REPORTING PRACTICES

Certain municipalities have suffered due to variations in reporting practices. In Minnesota, for example, generally lower credit ratings are assigned than similar towns receive in neighboring states. The disparity occurs not because Minnesota's economic condition is worse than her neighbor's, but because of her statewide practice of setting the assessed value of property at 8 to 10 percent of market value. In contrast, assessed valuations in Wisconsin average above 90 percent of market value. Of 266 Minnesota municipalities rated by Moody's, 19 are classified as AA and 109 as A, 108 as BAA, and 30 as BA. Wisconsin, on the other hand, has 58 municipalities rated AA, 155 as A, and only 7 rated BAA. There are no BA ratings in the State. Minnesota is thus being penalized by Moody's for the State's property assessment procedures. With so many municipalities to rate, the extra effort involved in the research needed to put municipalities on a comparable rating basis is apparently not feasible. Yet unless rating agencies dig for the facts, others must be found who will, since the public is too greatly penalized under the present system.

THE NEW YORK CITY RATING FIASCO

A classic example of inadequate rating analysis is provided by New York City. On July 19, 1965, Moody's lowered the rating of New York City's tax-secured bonds from A to BAA. The action was triggered by a $250 million borrow-now, pay-later financing undertaken by a prior administration to balance its current expense budget through the flotation of serial bonds. A number of municipal finance experts in the investment banking and institutional investing fraternities took issue with Moody's action arguing that the Nation's largest city and economic capital could not possibly be reduced below an A rating by the transitory policy of the administration. A most vigorous defense of the city's strength was made by James Reilly, senior partner of the respected municipal bond firm of Goodbody & Co., who cited seven reasons reflecting New York's ability to pay its indebtedness. These were:

1. The assessed value of real property owned by the city of New York is almost double the total municipal debt. Only a modest development of some of these properties could result in the creation of enormous values;

2. Only $3.0 billion of New York's $4,875 billion debt is held by the public-the rest is held by the city itself in pension and trust funds. New York has almost $2 billion invested in itself;

3. More than 60 percent of New York's bonds have been issued to construct and acquire revenue-producing improvements such as parking facilities, water and sewer properties. Increases in only a few of the currently subsidized rate structures on these utility enterprises could produce immense earnings to meet future needs;

4. New York's present debt structure is heavily weighted in short maturities and more than 50 percent of the debt is scheduled for payment by 1975. A slight lengthening of the debt to a mere 15 years average life could have resulted in a 1965-66 budget surplus compared to the $250 million deficit experienced.

5. More than 8 percent of New York's debt outstanding as of July 1, 1964 was pair off by July 1, 1965. This suggests an unusual ability to adequately meet debt requirements even if economic conditions in the future warrant expenditure cutbacks;

6. The ratio of debt to assessed valuation is less now than it was in 1944, or, for that matter, in 1939;

7. As of June 30, 1965, only 1.6 percent of all real estate taxes levied during the past 5 years had not been collected. New York City bonds remain as full faith and credit general obligations payable from unlimited real estate taxes levied on all taxable property within the city's boundaries.

A year after Moody's lowered New York City's credit rating, Standard & Poor's followed suit. They chose July 25, 1966, the day before New York City borrowed $112,929,000 to lower the city's credit rating from A to BBB. In so doing. Standard & Poor's, according to a fair sampling of Wall Street experts, added some 10 basis point to the interest cost New York City had to bear. The rating agency, in effect, told investors that New York City's bonds were risker than in the past.

But, Standard & Poor's also said:

"*** the city's continuing ability to meet debt service requirements is of course not questioned. Its bonds are payable from unlimited property taxes, and debt service is unhampered by rigid constitutional limitations. Net debt has increased less rapidly than estimated full property valuation, currently standing at about 8.9 percent, compared with 10.4 percent in fiscal 1962. This is still a heavy load, but the rapid schedule of principal payments permit flexibility in planning future requirements as additional borrowing power is generated, within the debt limit."

While Standard & Poor's was lowering New York City's rating, Wade S. Smith, Vice President and Director of the Municipal Research Service of Dun & Bradstreet, one of the two agencies which had downgraded New York City last year, was saying how much better the city's credit looked. The New York Times reported that even Moody's, though not yet prepared to change its rating upward, was encouraged by the city's current fiscal position.

According to all the agencies, New York's credit is better today than it was a year ago for four principal reasons:

1. A policy, instituted during the Wagner Administration, to borrow to meet operating expenditures has been ended. The new administration is determined that it shall not be reinstituted.

2. The city's floating debt has been reduced by $40 million.

3. The city has, for the first time in three years, lived within the estimates of the general fund without having to borrow from reserves.

4. The city finished its 1965-1966 fiscal year without the issuance of budget notes for the first time in more than 20 years.

In Standard & Poor's Outlook, the following appears relative to New York City's ability to increase revenues:

"With the advent of the income levy the tax pattern is set for some time to come. Offtrack betting and the legalized lottery are possible escape hatches, but the likelihood that these will be adopted is tenuous in the existing socio-political climate. Except for these areas, virtually every known form of taxation has now been tapped."

Yet, the very next page of the bond Outlook offers this contradiction: "Economically, New York enjoys a unique status *** By every measure, New York's resources remain unmatched."

Standard & Poor's is unhappy that "since 1962, the share of revenues afforded by Federal grants and State aid has risen from 20.8 percent to 28.8 percent." For years, ever since Federal and State income taxes were instituted, New York City has rightly complained that its share of benefits was in no way commensurate with its payments. Now, finally, something is being done to end this inequality. An office was opened in Washington to help assure New York City its fair share of Federal disbursements.

Mr. Reilly included his commentary on New York City as follows:

"The biggest city of all must have the biggest problems. But New York City has more than demonstrated its ability to meet its obligations. Much of the New York City experience is directly applicable to other great cities such as Boston, Los Angeles, and Detroit, which have, of late, been so rudely jostled by ratings. What needs emphasizing is the public welfare and the significance of a notch on the rating scale. How many schools would 25 less basis points have built over 20 years? This is the question of prime importance, for it once again points up the heavy responsibility carried by rating agencies."

WHAT THE LOWER RATING COSTS NEW YORK CITY

At today's interest rates, bond experts have advised me that a BAA bond carries a 5.20 percent net interest cost versus an A-rated bond's 4.70 percent. This is a difference of 50 basis points or one-half of one percent annual interest. Since New York City floats $500 million per year of new debt, the extra interest cost occasioned by the lowering of New York City's rating will be $2.5 million per year on each issue. Since the average life of recent issues has been about 8

years, this will mean about $20 million per year total extra cost. This is enough to provide hospital space for 500 patients or build seven elementary schools or put 2,000 policemen on the beat.

ATTEMPTS AT CORRECTIVE MEASURES

Certain steps have been taken to dispel misimpressions about New York City's creditworthiness. Exhibits III, IV, and V reflect efforts to take our story direct to the investing public. The exhibits include a public rebuttal to the Moody's commentary of May, 1967; the first two issues of a new Fiscal Newsletter.

ELEMENTS OF NEW YORK CITY'S FISCAL STRENGTH

The committee has specifically requested certain data about New York City and it is provided herewith. Under the New York State constitution, taxes on real estate to pay interest and principal installments on the city's debt may be levied without limit. Debt service has, therefore, remained consistently outside recurrent expense budget problems because the city has the power to levy, and has levied, adequate taxes for its payment.

The provision of the State constitution in Article VIII, Section 2, providing that the chief fiscal officer of any city or other political subdivision in the State shall apply the first revenues received to debt service is a strong protective bulwark for New York City bondholders. This enduring provision requires that New York City's funded debt shall be backed by the full faith and credit of the municipality. Thus, payment of the city's debt service is the first lien on its revenues. These revenues include $1.66 billion real estate tax and the $1.69 billion General Fund (including sales, business, personal income, utility, water, commercial rent, and a wide range of taxes and other charges). The city must pay its debt service before it meets its payroll or any other expense. The taxpayer's obligation to pay real estate taxes to the city takes precedence over the obligation to pay debt service on the many billions of dollars of private mortgages held by banks, insurance companies, and other institutional investors. Paradoxically, however, the rating of much of that indebtedness is substantially higher than is the rating of New York City which has a prior lien on revenues required for debt service.

In view of the unusual protection afforded to New York City bondholders under the State constitution, we have felt it appropriate to present a chart indicating the history of New York City's debt service coverage from 1929 to the present. At the depths of the Depression in 1932, when debt service totalled $201 million, city revenues aggregated $611 million. The coverage ratio was then 3.04. This was the low point for the entire 39-year period. The long-term in this ratio has been generally upward. In 1966-67, the coverage ratio was 4.70, and we envisage a ratio of approximately 4.89 in fiscal 1967-68.

THE REVENUE SYSTEM

Overall, the city's revenue system is growing and is becoming broader-based. The table below shows the changes that have occurred in 1965-66, 1966-67 (estimated) and 1967-68 (estimated). Each component of the city's revenue system has grown except "other funds," which in 1965-66 were made up chiefiy of borrowed funds.