Will Meredith Whitney Be Proven Right In The End?
We noted, in September, that corporate bond downgrades were outpacing upgrades very notably and today we get the other side of that with Moody's noting that in Q3, Muni downgrades outweighed upgrades by the most since the financial crisis began. At 5.3 to 1, the third quarter of 2011 had the highest downgrade-to-upgrade ratio of any quarter for the U.S. public finance sector since the onset of the financial crisis in 2008. "A rapid deterioration in credit metrics led to a higher-than-average 14 multi-notch downgrades."
While the number of defaults (and size) has hardly been what Ms. Whitney expected, and the overall performance of Muni bonds has been strong - especially relative to corporates - the volumes of downgrades from S&P and Moody's is definitely 'unusual' from a cyclical perspective and we note the rather systemic decompression between General Purpose Revenue bonds vs high-quality G.O.s.
Moody's 'government' upgrade/downgrades over past few years from Bloomberg's RATT screen.
S&P's upgrade/downgrades over the past few years.
And from Moody's:
At 5.3 to 1, the third quarter of 2011 had the highest downgrade-to-upgrade ratio of any quarter for the U.S. public finance sector since the onset of the financial crisis in 2008, says Moody's Investors Service in its quarterly report on rating activity in the sector. The previous high of 4.6 to 1 was registered in the fourth quarter of 2010.
"Downgrades dominated rating revisions across all public finance sectors except for healthcare," said Assistant Vice President-Analyst Dan Steed, author of the report. "A rapid deterioration in credit metrics led to a higher-than-average 14 multi-notch downgrades."
The impact of deficit-cutting measures by the federal and state governments will be a key driver of rating changes across public finance sectors as the strains on core operating expenses and revenue sources of the last three years will likely persist over the next year, according to Moody's.
"This will be mostly due to economic stagnation, high unemployment, declining home values, and low consumer confidence," said Steed. "We expect downgrades to continue exceeding upgrades in upcoming quarters."
--State ratings: Downgrades outpaced upgrades by 10 to 1, as transit and highway revenue bonds accounted for 60% of the downgrades. We expect the trend to continue against a backdrop of federal budget cuts, and lackluster revenue growth exacerbated by increased reliance on personal income taxes.
--Local governments: At 9 to 1, the ratio of downgrades to upgrades significantly exceeded totals (3 to 1)of the prior quarter. Similar to the first half of 2011, school districts were challenged by declining property tax revenues, as well as reduced state funding. A total of 26 local government issuers were downgraded by multiple notches given the sharp deterioration in their financial metrics.
--Not-for-profit hospitals: Upgrades outpaced downgrades for only the second quarter in the last two years. We do not expect this positive trend to continue, especially for smaller-sized hospitals, given continued pressures on major revenue sources such as Medicare.
-- Higher education and other not-for-profits: Ongoing operating pressures and strained liquidity drove the elevated level of downgrades. Unlike the previous two quarters, there were no multi-notch downgrades of higher education or not-for-profit credits. Over the near term, the number of downgrades will likely continue to exceed upgrades due to operating challenges and strained liquidity.
--Infrastructure: The third quarter's single upgrade was significantly overshadowed by 18 downgrades. Downgrade activity might stabilize as operating conditions for infrastructure credits are likely to stabilize over the next year unless economic growth declines precipitously.
--Housing: Continued challenges in the housing and mortgage market led to another quarter in which downgrades exceeded upgrades by a material 3-to-1 margin. The outlook remains negative due to high delinquency and foreclosure rates, low reinvestment rates, and the deterioration of counterparty credit quality.
It is worth bearing in mind that if downgrades continue and Munis underperform then the MtM changes may well be enough to drive significant negative pro-cyclical behavior as the typical investor (in a similar way to Italy bond holders perhaps) is not used to seeing capital depreciation while they earn their modest yield. Perhaps that is the catalyst - further downgrades, fund outflows on price depreciation, and exaggerated liquidity dry ups - as opposed to simple fiscal concerns?
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