Remember how important your credit score was when you financed a car? That score not only determined if you got the loan; it also dictated your interest rates and monthly payments.
Like credit scores for an individual, bond ratings serve as a litmus test for the fiscal strength of a city, county or school district. Bonds are used to pay for such things as new schools and water treatment plants. A better bond rating can entice investors and lower borrowing costs — costs that are ultimately borne by the taxpayer.
But with California facing a budget crisis and the nation still battered from the Great Recession, those bond ratings are under pressure. That means local agencies may wind up paying more for the money they borrow.
Lodi Unified School District, for example, recently had a lower credit outlook of AA- affirmed by Fitch Ratings. Fitch grades bonds on an alphabetic scale ranging from highest — "AAA" — to lowest — "D."
While the rating still places the district well within the "investment-grade" category, it could lead to higher lending rates if the district were to refinance one of its bonds or look to issue another.
It is possible, through financial frugality and elbow grease, to raise a rating. The city of Lodi had a bond downgrade a few years ago, when the electric utility's rating dipped to BBB-. However, the city has strengthened it back up to A- by purchasing power in advance and getting its debt onto a fixed interest rate instead of adjustable.
Galt, meanwhile, is looking to issue bonds for redevelopment soon with a less-than-stellar rating of BBB. That reflects a generally volatile budget picture for the state of California, Galt officials say.
The bond market and related ratings are an esoteric fact of government finance. For taxpayers, it all comes down to one word: Money.
A brief history of bonds
Government bonds date back to World War I, when the United States financed combat through the sale of "Liberty Bonds." In 1935, President Franklin Roosevelt signed legislation creating "baby bonds" that helped citizens get involved in government financing and personal saving.
In 1909, John Moody became the first financial analyst to attach letter grades to rate the health of a private company's debt. The business that would become known as Standard & Poor's first started selling bond ratings to investors in 1916, and Fitch Ratings joined them in 1924.
As the years went by, the payment model for the ratings agencies changed. Instead of investors paying for bond rating information, the entity issuing the bond now forks over cash for its grade.
The issuer-paid model has been criticized for creating a conflict of interest between the ratings companies and bond-issuers. Think of it as a citizen paying for their credit score and being able to discuss why their score should be a certain number with the grading company.
It has been a hot topic in the wake of the world's financial crisis of the past few years, as some investments given solid ratings were later found to be defective.
The importance of bond ratings
Bond ratings matter because they are the fastest way to determine the fiscal status of an agency, said Kimberly Foss, president of Empyrion Wealth Management, an economic research and management firm in Roseville.
"This is all we have," she said. "How else do you measure a municipality's ability to pay back? You really have to trust it; it's really sad."
Although bond ratings carry enormous weight, ordinary citizens have the ability to make judgments for themselves if a bond rating is accurate — if they are willing to do a lot of research, Foss said.
Factors such as an agency's source of revenue, its expenses and ability to remain solvent are all items citizens should take into consideration if they are looking to grade a district on their own.
"Does a city have more income than expenses? Are they putting money away?" she said.
Lodi Unified's situation
To help make ends meet, Lodi Unified authorized eliminating more than 177 positions for the 2011-2012 school year and is expected to cut loose hundreds more in the coming months.
The Lodi district also has at least a $15 million deficit heading into the coming school year. If voters across the state strike down a tax revenue extension, the figure could grow.
More than $2 billion in federal funds padded California school budgets in 2010. That money will not return in 2011. In recent years, more than 70 percent of the Lodi Unified School District revenues have come from the state.
The bond rating will play a role in the short-term if the district needs to borrow money to cover itself if payments from the state are deferred, said Tim Hern, chief business officer for Lodi Unified School District.
"If the district has to borrow money because of cash issues and deferrals from state, we would have to borrow money at higher rate," he said.
When the state defers payments to local school districts because it is short on cash, the districts must fend for themselves for funding in the meantime. They typically do so by making cuts and dipping into reserve funds.
Since the state is expected to defer payments again this year, Hern said the district will likely have to ask for more money in May or June.
"The state is transferring their financial problems onto us," Hern said.
While workers' salaries account for the largest percentage of the district's budget, Hern said the rising cost of fuel has also provided recent challenges for the district.
"We've been good about staying solvent," said Art Hand, assistant superintendent of facilities for Lodi Unified. "But any school district being rated will run into identical problems."
When it comes to improving bond ratings, Hand said the district's options are limited.
"We have to pay our bills on time and do what we need to do to stay successful," he said.
Galt looks to head to bond market
As Galt looks for funds to back a redevelopment effort, the city's finance director, Inez Kiriu, said she expects the bonds to be rated BBB when they go on the market in the near future. Since Gov. Jerry Brown has put a target on California's 425 redevelopment agencies, Kiriu said ratings companies are being more cautious when they rate redevelopment bonds.
"We're seeing the market be more sensitive to financial conditions, especially on something reliant on money from state," she said.
Galt's redevelopment agency is looking to sell $17 million in bonds that would help construct new medians and sidewalks on C Street, acquire new property and possibly build a movie theater.
Brown has said axing the state's redevelopment agencies could allow California to spend up to $3 billion on other state and local services.
How does the grading happen?
When a group wants to obtain a bond rating, it reaches out to one of the three main grading agencies — Fitch, Moody's or Standard & Poor's. Groups will sometimes get a grade from more than one agency.
The city of Lodi chooses ratings agencies by working with ones that are familiar with what they are grading, said city spokesman Jeff Hood.
It costs between $15,000 and $20,000 to have an agency grade a bond. The process of looking through the books and determining the quality of the bond's revenue source the agency about a month, said Hood.
There are committee meetings and then a presentation where the ratings agency pores through the information and asks questions. Then the ratings agency makes its decision in private and drafts a press release. The discussion is typically over at that point, he said.
"Once they come up with a rating, that's usually it," said Hood. "You do all the lobbying ahead of time."
Should the issuer-pay model be changed?
Since a school district or municipality can choose which agency will attach a grade to one of its bonds, it's likely they will look for the one they are the most familiar with or know they have the chance at getting the best grade from.
Although the company is paid to offer an impartial evaluation of a bond's strength, the ratings agency is also in competition with other similar businesses. While it is argued conflicts of interest can exist from the issuer-pay model, one professor believes it is in a ratings agency's best interest to remain unbiased.
Rob Wassmer, public policy professor at California State University, Sacramento, said it does a ratings agency no good to kowtow to bond issuers, because the agency's trustworthiness would be severely damaged by such a reputation.
"If a buyer found out there was conflict, the agency's credibility would go down," he said.
Ratings agencies have been widely criticized for their work in the private sector in the wake of the Great Recession. Columnists, comedians and lawmakers have complained the companies gave overly favorable marks to banks that ultimately failed and mortgage-backed-securities that went into default.
However, municipal bonds, unlike corporate bonds, have seen a far lower rate of default.
Others argue the ratings agencies tilt towards harsher grades to avoid a conflict of interest.
Paul Rosenstiel is a partner at De la Rosa & Co., a full-service investment bank. He also served as California's Deputy State Treasurer from 2007 to 2009.
"I never saw (a conflict of interest) because the state was paying a substantial amount to ratings agencies, and we never saw that the agencies were making any kind of attempt to please us," he said. "Instead, we were always of the belief that the ratings drew attention to much more risk than there really was."
But there are those who believe conflicts of interest will always exist and it is up to investors to look through it, said Geoffrey Mitchell, a partner at McKenna Long & Aldridge law firm in Los Angeles.
"We still have conflicts of interest, but what the impact of those are right now is hard to say," he said. "We will see the most sophisticated investors become much more skeptical of bond ratings than they used to."
Contact reporter Jordan Guinn at firstname.lastname@example.org.