In May, Moody’s Investor Service made headlines when it downgraded Chicago’s debt rating to so-called junk status, dropping the city from level Baa2 to Ba1. In fact, the number of local governments that have been rated in what is referred to as speculative grade (here’s a primer on the rating system) has doubled over the past four years.

I spoke to Moody’s vice president and senior credit officer Al Medioli and asked him to give a context to this increase. He contends that this is an isolated trend: speculative grade cities, counties, school districts and special districts currently only account for fewer than 1.1 percent of the 8,600 local government issuers that they rate on a yearly basis.

He also explained how Moody’s makes its ratings, why public schools have had an increased presence in the speculative grade category and who has bounced back from downgrades in the past.

What does Moody’s take into account when making its grade ratings for local governments?
We rate debt. An investor says they’re willing to invest “x” amount of money in a city or a school district and asks what are the odds they’re getting they’re money back. Essentially what we’re doing is looking at the credit quality of the issuer. It is their ability and willingness to pay what they’ve promised.

Broadly speaking, we look at long-term trends. Specifically speaking, we look at their economic base to see what their economic future might be. We’re trying to do a forward-thinking assessment. We also look at the place’s financial structure and how the place operates. Is it paying its bills? Paying the police and fire department? Paving the streets?

Al Medioli

We also look at the level of debt. In the debt analysis, we’ve started to look at pensions. Pensions are a very substantial fixed cost. We know that when cities go into bankruptcy, oftentimes the pensioners get paid before the bondholders even though there might not be a legal claim [that puts them in front].

What can the public do to find out whether a rating change is due to financial stress or an unwillingness to pay debt service?
City residents may not like if a bond rating falls, because they’re going to have to pay more to entice borrowers to invest in their city.

On our website there’s a lot of publicly available information including all of our rating methodologies. The broadest one is the general obligation ratings for local governments. It explains in much more detail what I was just talking about. What goes into a bond rating, how we compare the various attributes and a complete explanation of what all of our rating categories mean. At the highest end, AAA, we think there’s very little risk of anything going wrong. As you go down the rating scale, we’re signaling more and more risk to investors.

What are the consequences of local government issuers slipping into a speculative grade rating? Are any misunderstood?
Essentially the key thing to understand is that most municipal ratings are quite high. We have thousands and thousands of ratings. The average rating is AA. In the corporate world, the average rating is a BA grade, which is a below investment level, speculative grade. Municipal governments tend to be around for a long time. They have lots of resources and ability to stave off problems because they can still keep collecting taxes even though they have to cut back services. A corporation has much tighter operations.

We have a very small percentage of our ratings that are below investment grade in the muni sector. If you go into the BA category that does not mean that we think you are going to default. It means that there are more speculative elements that investors should be aware of.

There have been a growing number of public school districts entering the speculative grade category. Why is this happening?
School districts have been very stable for most of the modern history of public finance. A couple of years ago we had our first school district default in Michigan. We’ve had a couple of close calls since. We’re now talking about 92 ratings in the speculative grade — less than half a percent of our ratings in an investment grade. So while yes, there is a notable relative increase, the speculative grade ratings are still tiny.

The school district phenomena tend to be very localized. They often vary by state, because they tend to rely a lot on state aid and funding formulas. There’s a lot of change in Michigan. Because they not only had areas of economic distress, especially in the southeastern part of the state, but Michigan put into effect a reform measure where a student could take their state aid and go to a competing private, charter or public school. That caused some places to lose a lot of enrollment.

There’s no magic formula, but [we watch and] look at a place and see if they’re not growing, if they’re not able to manage their financial obligations well and if they’re in a deficit.

Are there any notable examples of government entities that have risen from speculative grade?
Again, if you go into the BA category, we don’t think you are in risk of default, but that there are speculative elements. They do not manage their financial resources well and end up in a deficit position.

Typically they’ll do what they have to do. They’ll cut costs. They raise taxes. They do some combination of things to manage the problem and regain financial stability. We’ve seen that in Harrison, New Jersey, and Newburgh, New York. These are places that had problems and have basically managed to earn their way back into investment grade, because they worked really hard to rebalance.

Alexis Stephens was Next City’s 2014-2015 equitable cities fellow. She’s written about housing, pop culture, global music subcultures, and more for publications like Shelterforce, Rolling Stone, SPIN, and MTV Iggy. She has a B.A. in urban studies from Barnard College and an M.S. in historic preservation from the University of Pennsylvania.

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