Barney Frank Rousts Credit Rating Firm For…Being Too Negative?

Credit rating agencies are coming under fire from Congress again — but this time it’s for being too pessimistic. After Moody’s issued an unprecedented across-the-board negative credit outlook on all American cities and towns yesterday, House Financial Services Committee Chairman Barney Frank issued his own negative assessment of Moody’s, and scheduled a hearing to investigate:

I am troubled by the action of Moody’s Investors Service to issue a negative outlook across the board on America’s municipalities, which could raise the interest rates on cities and towns making it more expensive to borrow funds for infrastructure improvements.

On the face of it, this seems like a perverse round of messenger shooting. But last March, as cities and towns across the country started getting flooded with demands for huge payouts rooted in arcane details of “swap” contracts they’d inked with banks that managed their bond offerings, Frank discovered something truly perverse: the public sector was being scammed on multiple fronts by the investment banks underwriting their bond offerings — and the profits directly fed the disastrous trade of risky mortgage-linked credit default swaps that hastened the financial meltdown.

The scheme started at the credit ratings agencies, which keep two sets of standards for grading corporate and municipal bonds — and municipalities are held to a much higher standard, as Frank explained in a hearing using Moody’s own data:

I will be giving out this chart, sectoral breakdown of Moody’s rated issuers and defaulters, 1970 to 2000, general obligation bonds, there it is. Number of issuers 14,775. Number of defaults, 0.

So why, given this sterling record, did states and cities across the country suddenly start getting hit with huge collateral calls early last year? Because despite this sterling record, most had been pressured into buying a form of bond insurance to protect investors from the (minute) risk they might default.

When the rating agencies downgraded the ratings of the insurance companies that protected those bonds, it triggered provisions in the insurance contract that required them to post collateral. Those insurance companies, you see, had essentially turned into mini AIGs, as the CEO of AMBAC, the insurer that triggered all the collateral calls in Tennessee we read about yesterday, explained in a Wall Street Journal interview just before the hearing:

We then decided, because we wanted some growth we didn’t perceive available in the muni market, that golden triple-A kind of proposition, we then decided we would get into this thing called [collateralized debt obligation]. And we went beyond that and got into CDO-squareds…

In other words, they got sick of what Frank termed “selling life insurance to vampires” and decided to try out the Joseph Cassano business model, flooding the market with “insurance” swaps on riskier and riskier bonds.

The “perverse” part, of course, is that if the credit rating agencies had been grading municipalities on the same curve they used to assess the companies insuring their bonds, they wouldn’t need “insurance” in the first place.

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