The State Credit Rating Process: How Healthy are State Public Finance Systems?

Standard & Poor’s Ratings Services has public ratings on all 50 states and certain U.S. territories based on an analysis of a range of factors as outlined in its U.S. State Ratings Methodology. In addition to the ratings provided on general obligation bonds or ratings linked to the general credit rating of a state, such as appropriation secured bonds, hundreds of other state tax and revenue-supported obligations are rated. Similar to the broader municipal bond market, the range of bond security types issued by states is very diverse and runs the gamut of sales tax, gas tax, hotel tax, income tax, lottery revenue, liquor profits, and insurance premium assessments. The diversity of issuance in the state sector reflects the broad service and infrastructure responsibilities each state is responsible for funding.
 

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About the Author

Robin Prunty is a Managing Director in the Public Finance Ratings Group at Standard & Poor’s Ratings Services and has been with the firm since 1987. She has a Bachelor of Science degree in Economics from Siena College and a Master of Public Administration from the University at Albany — Rockefeller College of Public Affairs & Policy.


The credit quality of state governments—including general obligation bonds and special tax and revenue bonds—is strong and has remained so during a range of economic cycles (see Table A). Standard & Poor’s Rating Service attributes this to the depth and diversity of state economies, the legal provisions supporting the bonds, and managerial and institutional characteristics of the state sector.
 
 
State governments have broad powers to establish their own tax structures and expenditure responsibilities under the U.S. Constitution and therefore possess unique administrative and financial flexibility. Some of the key credit factors that contribute to this relatively strong credit profile include:
  • States are not eligible to file for bankruptcy under the U.S. Bankruptcy Code.
  • They may adjust revenues, alter both the timing and amount of disbursements, and access reserves or other forms of liquidity when necessary to restore budgetary balance.
  • State public finance systems are, in Standard & Poor’s view, mature with well-developed accounting standards that contribute to a high level of transparency relative to regional governments in other countries.
  • States typically have balanced budget requirements and well-developed revenue and expenditure monitoring policies and procedures.
  • Although there is some variation in economic diversity and wealth among states, when evaluated on a global basis, state economies as a whole are generally diverse and income levels are above average.
  • The security features and priority of payment for debt service are generally well-defined and capital market access also is generally well-established. 
Standard & Poor’s also believes states typically have a strong commitment to their legal obligations to pay debt despite difficult economic cycles, as evidenced by the fact that there has been only one observed default for the sector in more than 100 years. When defaults have occurred, reforms have generally followed.
 
Eight states—Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi and Pennsylvania—plus what was then the Territory of Florida defaulted following the panic of 1837. Most debt issued for state and local purposes was issued at the state level, where large amounts of debt had been issued for economic development and public improvements. Following this episode, states’ borrowing abilities were curtailed and debt issuance for economic development shifted primarily to local governments. Only Arkansas defaulted on its debt during the Great Depression and, following this period, governments further diversified their revenue streams by increasing their reliance on personal income taxes and implementing sales taxes—largely the structure we see today. Additional improvements to states’ financial controls, reporting and disclosure also followed in the post Great Depression period.
 
What Are Credit Ratings?
Credit ratings are estimations about credit risk published by a rating agency. They express opinions about the ability and willingness of an issuer, such as a state or other government entity, to meet its financial obligations in accordance with the terms of those obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it could default. Other key things to know:
  • Credit ratings are not investment advice or buy, hold or sell recommendations. They are just one factor investors might consider in making investment decisions.
  • Credit ratings are not indications of the market liquidity of a debt security or its price in the secondary market.
  • Credit ratings are not guarantees of credit quality or of future credit risk.
Standard & Poor’s applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Typically, ratings are expressed as letter grades that range from a high of AAA to a low of D to communicate the agency’s opinion of relative level of credit risk (see Fig. A).
 
 
While a key component of credit rating analysis is the evaluation of historical data, ratings opinions are designed to be forward looking. In other words, ratings take into account not only the present situation, but also the potential impact of future events on credit risk. For example, in assigning its ratings, Standard & Poor’s factors in anticipated ups and downs of business cycles in specific industries as well as trends and events that can be reasonably anticipated. At the same time, ratings are not static. Rating opinions could change if the credit quality of an issue or issuer alters in ways that were not expected at the time a rating was assigned. A change of policy by a government or erosion in the credit markets that was not foreseen might result in an adjusted rating that reflects this new information.
 
The Rating Process
Credit rating agencies assign ratings to issuers as well as to specific debt issues. To assess the credit-worthiness of an issuer, Standard & Poor’s evaluates the issuer’s ability and willingness to repay its obligations in accordance with the terms of those obligations. To form its ratings opinions, Standard & Poor’s reviews a broad range of financial and business attributes that could influence the issuer’s prompt repayment. The specific risk factors that are analyzed depend in part on the type of issuer. For example, the credit analysis of a state usually considers many financial, economic, managerial and institutional factors.
 
In rating a specific bond issue, Standard & Poor’s typically begins with an evaluation of the credit-worthiness of the issuer and then evaluates, among other things:
  • The terms and conditions of the debt security and, if relevant, its legal structure;
  • The relative seniority of the issue with regard to the issuer’s other debt and priority of payment in the event of default; and
  • The existence of external support or credit enhancements.
In rating a state, Standard & Poor’s uses an analyst-driven approach to assign a rating (see Fig. B). A primary analyst, often in conjunction with a team of specialists, is assigned to lead the evaluation of the state’s creditworthiness. Analysts typically obtain information from published reports, as well as from meetings and discussions with management. For U.S. states, this information generally includes audited financial statements, budget documents, other relevant financial documents, capital plans, economic data, an official statement if the review is tied to a specific bond issue, and other relevant information. The rating process is outlined in Fig. B.
 
 
State Rating Methodology
Standard & Poor’s in January 2011 updated its methodology for rating state governments. The update was designed to help market participants better understand the company’s approach to assigning state ratings. Standard & Poor’s assigns these ratings to a state’s general obligation debt; ratings also could refer to the issuer credit rating if a state has no general obligation debt outstanding. This methodology replaces portions of “U.S. Public Finance Criteria: GO Debt,” published Oct. 12, 2006, and relates to “Principles Of Corporate And Government Ratings,” published June 26, 2007.
 
Given the specific delegation of powers to states under the U.S. Constitution, Standard & Poor’s views states as having sovereign powers that warrant recognition in its criteria and has separated its analysis of states from its broader general obligation criteria.
 
  • Standard & Poor’s assigns credit ratings to U.S. states and territories based on its qualitative and quantitative analysis of a range of financial, economic, managerial and institutional factors. Its overall analytic framework centers on the five factors (see Fig. C).
  • Government framework;
  • Financial management;
  • Economy;
  • Budgetary performance; and
  • Debt and liability profile.
 
Standard & Poor’s assesses each of these five factors using various metrics that are scored on a scale from 1 (strongest) to 4 (weakest). Each metric might have several indicators that are evaluated to develop the score. Each indicator is scored individually and the indicators’ scores are averaged to develop the overall score for the metric. The metrics for each factor are averaged to develop a composite score for each.
 
 
The scores for the five factors are combined and averaged with equal weight to arrive at an overall score that is translated to an indicative credit level as illustrated in Table B. In most cases, the final state rating is expected to be within one notch of the indicative credit level, which is based on the state’s position relative to all other states. In certain circumstances, the following overriding factors could result in a rating that is different from the indicative credit level:
  • System support score. In the case of U.S. territories and commonwealths—where the policy and fiscal relationship with the federal government could result in a system support score that is different from the score assigned to all states—the rating could be multiple notches below the indicative credit level as a result of a lower system score.
  • Willingness to support debt. If Standard & Poor’s believes there is a change in a state’s willingness to support its debt, it will be assigned a rating below what is indicated, possibly by several categories.
  • Capital market access. If Standard & Poor’s deems access to the capital markets or other sources of external liquidity is questionable and that access is viewed as necessary for the state to maintain regular operations, the state will be assigned a rating no higher than the BBB category.
Standard & Poor’s also anticipates possible, but limited, circumstances where it will adjust a state rating by one notch compared to the indicative credit level. Those circumstances include a high level of expected future debt/liabilities, weak financial management or a high level of derivatives/variable rate debt where there might be requirements to fund accelerated payment provisions.
 
The following is a more detailed account of each of the five major factors that make up Standard & Poor’s analytical framework:
  • Government framework. A state’s government structure and political environment can affect its powers as defined by federal and state law and influence its fiscal position. Fiscal policy framework, system support and intergovernmental funding are the metrics used to assess government framework.
  • Financial management. Standard & Poor’s view of the rigor of a government’s financial management practices is an important factor in its analysis of creditworthiness. Managerial decisions, policies and practices have a direct effect on a government’s financial position and operations, debt burden and other key credit factors. A government’s ability to implement timely and sound financial and operational decisions in response to economic and fiscal demands is, in Standard & Poor’s view, a key factor in assessing credit quality.The financial policies as outlined in our Financial Management Assessment (FMA) methodology and the budget management framework are the key metrics used to assess financial management. These are scored individually and averaged to develop an overall score for financial management. Standard & Poor’s analyzes the impact of financial management policies and practices through the use of its FMA which the company believes provides a transparent assessment of a government’s financial practices and highlights aspects of management that are common to most governments in a consistent manner. Standard & Poor’s evaluates the following established and ongoing management practices and policies in the seven areas most likely to affect credit quality:
  • Revenue and expenditure assumptions;
  • Budget amendments and updates;
  • Long-term financial planning;
  • Long-term capital planning;
  • Investment management policies;
  • Debt management policies; and
  • Reserve and liquidity policies.
    States are assigned a score of strong (1), good (2), standard (3), or vulnerable (4).
 
  • Economy. Standard & Poor’s economic review focuses on four metrics: demographic profile; economic structure, including employment composition and performance; wealth and income indicators; and economic development. While the first four metrics analyze historical data and patterns, each state’s economic development initiatives and future growth prospects are considered because they are likely to affect future revenue generating capacity.
  • Budgetary performance. While states prepare financial statements each year using generally accepted accounting principles (GAAP)—which include accruals— budget development, appropriations, budget monitoring and reserves are expressed on a budgetary basis, which is more closely aligned with a cash basis presentation. Budget-based financial information is a primary focus of Standard & Poor’s financial review because it shows how state finances are managed day-to-day. The company also analyzes the GAAP-audited financial statements and variations between GAAP and budget-based financial disclosure to gain a more complete understanding of a state’s financial condition. To evaluate budgetary performance, Standard and Poor’s assesses six key metrics—budget reserves, liquidity, tax/revenue structure, revenue forecasting, service levels and structural budget performance.
  • Debt and liability profile. In particular, Standard & Poor’s reviews debt service expenditures and how they are prioritized versus funding of other long-term liabilities and operating costs for future tax streams and other revenue sources. Three key metrics—debt burden, pension liabilities and other postemployment benefits—are evaluated, scored individually and weighted equally.
Ratings Relative to the Sovereign
Finally, although many economic credit factors are similar and some expenditure responsibilities are linked, Standard & Poor’s does not directly constrain state ratings to the rating on the U.S. The rating on a state or local government can be higher than a sovereign rating if, in the company’s view, the individual credit characteristics remain stronger than those of the sovereign in a scenario of economic or political stress. Other factors Standard and Poor’s reviews include the predictability of the institutional framework that limits the risk of negative sovereign intervention and the state’s ability to mitigate negative intervention from the sovereign due to the state’s high financial flexibility and limited dependence on the federal government.

 

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