State Government Credit Quality: Down, but Not Out!

Abstract

Municipal (state and local) governments issue debt to finance capital projects and meet their cash flow needs. Most state governments issue large amounts of long-term debt on a regular basis. The state government share of outstanding municipal debt grew significantly from 1961 to 1992, from 26 percent to 38 percent (U.S. Department of Commerce, 1975-1996), with the rate of growth accelerating in the 1980's (Regens and Lauth, 1992). Accordingly, state government debt is taking up an increasingly larger share of municipal financial resources and will continue to do so in the future. Yet, the ability of state governments to repay their debt may have been adversely affected by the fiscal stress they underwent in the 1980's and early 1990's (Poterba, 1994; Gold, 1995). Since the state government sector surplus peaked at historical highs in the mid-1980's, the fiscal position of the states has deteriorated to the point where in 1992 the state sector suffered its largest deficit in U.S. history (Fleenor, 1995). Inevitably, such fiscal problems adversely affect the ability of state governments to finance their citizens' capital needs at lowest cost. In this article state government credit ratings are used to analyze aggregate state government credit quality from 1970 to 1995. Our analysis focuses on changes in the overall credit quality of state governments, and changes in the comparative credit ratings of Moody's Investors Service and Standard and Poor's. This article adds to the public administration and financial certification literatures by providing a new means of understanding and analyzing the aggregate structure of state government credit quality over time. In addition, it appears that the only prior time series study of state government credit quality in the academic literature was published in 1978 and examined the period 1950-1972 (Osteryoung and Blevins). The study used Moody's ratings, but did not compare credit quality judgements across rating agencies. The other state government credit quality study in the literature measures the impact of ratings on yields at a single point in time (Liu and Thakor, 1984). An analysis of credit rating changes over time provides a useful framework for analyzing the relationship between government financial management decisions and the actions of rating agencies. Specifically, a finding of deteriorating credit quality over time would suggest that public officials have been ineffective at managing the factors--economic, financial, debt, and administrative--that credit rating agencies consider important. Such a finding would demand a major reassessment of state government financial management. On the other hand, an improving credit condition would imply just the opposite, that state government officials have been increasingly successful at managing their fiscal affairs. This article also adds to the financial certification literature by examining dual certification on a market structure basis by comparing Moody's and Standard and Poor's credit ratings for the same issuer over time. Prior certification studies (Hsueh and Kidwell, 1988; Thompson and Vaz, 1990) have analyzed dual certification for individual debt issuers at one point in time by estimating the value of a second rating on the cost of a new bond issue. Historically, state governments obtained a single credit rating from Moody's or Standard and Poor's when bringing a new bond issue to market. Now, state governments routinely purchase two ratings from Moody's and Standard and Poor's. This study addresses the question of whether more than one rating on a state government bond issue is necessary. Also, virtually all of the credit certification literature looks at local governments and corporations. This article extends the literature by analyzing state governments exclusively. Our analysis shows that the distribution of state credit ratings have changed markedly since 1970. In the aggregate, state governments in the United Stares are less creditworthy (rated lower) in 1995 than they were in 1970. …