The municipal bond ratings debate made the front page of the New York Times this morning, no doubt giving succor to fans of the Eisinger Thesis and its correlative, the Radically Inefficient Markets Hypothesis. By way of background, in the last issue of Portfolio senior writer Jesse Eisinger argued that ratings agencies were being burdened with ratings that are too low and therefore forced to pay higher interest rates or buy bond insurance to raise their ratings.
The evidence for the Eisinger Thesis is that municipal bonds default at much lower rates than similarly rated corporate bonds. But to suppose that this means that their interest rates get set too high requires a belief that investors have ignored the evidence of lower default rates in favor of blind adherence to ratings. The evidence of low muni default rates has been available for close to a decade, so this conclusion amounts to a belief that the muni market is radically inefficient. Hence the term Radically Inefficient Markets Hypothesis.
At the heart of the matter is the claim by the ratings agencies that muni investors demand a ratings scale that rates the ability of muni issuers to repay loans on a relative scale that compares them against other muni issuers, rather than other types of debt issuers. Some, like Felix Salmon, have doubted that such market demand for finely-tuned ratings exists. He even issued a challenge to DealBreaker to name at least one bond investor who wants this type of ratings system.
This morning the NYT does the job so we don’t have to.

Some sophisticated bond investors say that if municipalities were rated on the same scale as corporations, it would be harder to distinguish the relative riskiness of various cities, states and school districts, and mutual fund companies would have to evaluate bonds issue by issue.
“If you rate 95 percent of the issues the same, the ratings cease to be useful, and investors need and utilize these ratings to differentiate credits,” said John Miller, chief investment officer at Nuveen Asset Management in Chicago, which manages about $65 billion in mostly tax-exempt bonds.

Salmon, faced with such evidence, just rejects it out of hand. “I still don’t see why tiny differences which would be comfortably absorbed within the AAA range were they in the corporate arena suddenly become hugely important when they’re in the municipal arena,” he writes.
Well, we’ve explained all this before, so after the jump, we’ll simply quote ourselves.

States and Cities Start Rebelling on Bond Ratings

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Felix Salmon is skeptical that there is a market demand for bond ratings the differentiate between various issuers. His skepticism, however, is built on a simplistic image of who invests in bonds. To Salmon, it seems that muni bond investors are mostly old ladies in tennis shoes who buy bonds when they aren’t protesting water fluoridation. With this image in mind, he simple can’t believe that there would be a market demand for muni bonds to be rated relative other muni bonds rather than corporate bonds.
Our response begins with the observation that the alternative is simply implausible. If there is no market demand for the relative rating of muni bonds, why on earth is it happening? Jesse Eisinger hints at some kind of grand conspiracy between the ratings agencies and bond insurers but doesn’t really have any evidence for this conspiracy other than the fact that because he rejects the idea—on some principal that’s never been articulated—that there’s a market demand for relative ratings, he think there must be a conspiracy. This is question begging and violates Occam’s razor.
What’s more, Salmon’s image of bond investors is inaccurate. They are a heterogeneous lot made up of households, mutual funds, pension funds and banks. Even if a good deal of the investors are uninformed, the demand by sophisticated investors at the margin is enough to create the demand for relative bond ratings. Many of these investors have been so sophisticated that they created a demand for services which provide them with the underlying ratings of muni bonds regardless of bond insurance. In short, muni bonds are not the simplistic retail customers Salmon thinks they are.
It may help to take a look at why muni investors require such granular credit analysis. The reason is relatively easy to understand: municipalities have far less and less consistent financial transparency than corporations, especially public corporations. We can see this in the different ways bond prices respond to ratings downgrades. In the publicly held corporate sector, bond prices often don’t move much after a ratings change because the ratings are late to the game. The information driving the ratings change is typically already reflected in the bond prices (as well as the stock price). But for municipalities the situation is very different. Without an equity market and free from many financial disclosure rules governing public companies, muni investors are dependent on the ratings agencies to discover information about the financial health of muni issuers. This makes muni investors far more focused on ratings showing small gradations in issuers health than corporate bond investors.