Bond ratings don’t get much attention, but they should. Why? Because they play a crucial role in the health and well-being of our communities.
Three bond-rating agencies this week issued reports on the quality of debt issued by the city of Minneapolis. Two of them—Fitch and Standard & Poors—reassigned their highest rating. Moody’s Investors Services, however, downgraded the city from its highest level to its second-highest.
The agencies determine the bond issuers’ ability to make interest payments to the investors who buy the bonds. The better the rating for a city, for example, the lower the interest rate, thus, the lower the cost to taxpayers.
While the Moody’s change is mildly bad news for Minneapolis residents, the bond-rating process is a reassuring sign for society as a whole. It’s a small example of how the U.S. capital markets function efficiently, making their contribution to our high standard of living and general level of good government. Such markets are one of the great social innovations in human history.
The average citizen could care less about municipal bonds and their ratings, as long as potholes are filled, water flows from the tap, schools are good and crime is checked. Moreover, that citizen may not understand how these municipal services are related to bond ratings.
Many people on the political left tend to be particularly skeptical about anything connected to financial markets. James Carville, the Clinton advisor and political savant, reportedly once remarked that if he died, he wanted to be reincarnated as the bond markets so that he could scare everyone. This was his response to being told that a policy measure he supported would get a cold reception in bond markets.
Such idiocy may be motivated by the belief that only a few rich plutocrats own bonds and that the interest they earn is exploitively extracted from the rest of the population.
In reality, most bonds are purchased by institutional investors such as pension plans and insurance companies. Most households own some bonds through a public or private defined benefit pension plan, 401(k), or simple life insurance policy.
Furthermore, all households indirectly are bond sellers because their local governments use these financial instruments to fund infrastructure — parks, water mains, sewers and streets. And anyone who has gone to, or has children in a public school, benefits from bond markets.
Building such facilities takes a lot of money, more than can easily be raised by taxes in any year or two. The process is much easier when governments can borrow money long-term, build the needed infrastructure and pay for these facilities over 10 to 30 years.
Anyone who has ever had a home mortgage knows, on long-term loans, interest rates play a crucial role in the total cost of buying on credit. Over a 20- or 30-year period, a few percentage points difference in interest can amount to as much the original principal. Differences in long-term interest rates are largely related to the risks involved in different deals and the administrative costs of completing each transaction.
Bond-rating services provide information that lowers both risk and transaction costs. As a result, cities, counties and school districts in the U.S. can obtain funds to construct needed projects at a lower cost than in any other country of the world.
Part of the reason that potentially wealthy countries such as Nigeria, Indonesia or Brazil face such difficulty in providing school houses and clean water to their populations is that these nations lack capital markets to channel private saving into public infrastructure.
Institutions such as bond-rating agencies also provide an incentive for good government. Few citizens have the time or expertise to follow the financial management of their city or county. In the 1800s, financial malfeasance in local government was much more common than now.
Part of the reason for improvement is that any city of size today has analysts from the rating agencies poring over all the fine print in the city’s accounts and waving red flags when things appear out of line.
Critics may be right that minor incompetence and even fraud are still common, but the potential for gross abuse of the citizenry is much less than it would be without the deterrence provided by corps of accountants and financial analysts.
So if you’re inclined to dismiss news about your city’s debt rating — don’t. It matters.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.