Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / Why Your City's Budget Is Probably Bond-Rated Wrong
Transcript
- Lucas: So when a city borrows money — to build a bridge, fix a sewer, maybe refinance a pension shortfall — it goes to the bond market. And before it can sell those bonds, it needs a credit rating. That rating is supposed to tell investors: is this city going to pay you back, or not? Luna: Right. And most people assume that rating is rigorous — like a mortgage underwriting, but for an entire municipality. Lucas: Exactly. But the reality is a lot messier. There's a 2025 paper from the New York Fed that looked at over half a million municipal bond ratings from the two biggest agencies — Moody's and S&P Global — and found that about 40 percent of them carry what's called a 'split rating.' Same bond, two different grades. Luna: Split — meaning Moody's calls it investment grade and S&P calls it junk, something like that? Lucas: Sometimes that extreme, yes. More often it's a notch or two apart — say Moody's says Aa3, S&P says A-plus. But here's the thing: that one-notch difference can cost a city real money. The study estimates that a medium-sized issuer — think a city of 100,000 people — pays roughly 15 to 20 basis points more in interest on the lower-rated tranche of its debt. Over a 20-year bond, that's hundreds of thousands of extra taxpayer dollars. Luna: I want to understand why the ratings diverge in the first place. Is it just a methodology difference? Lucas: Partly. Moody's puts more weight on the local economy — tax base diversity, unemployment trends. S&P focuses more on fiscal management — debt burden, pension funding ratios. So you can have a city with a strong economy but terrible pension obligations, and Moody's will grade it up, S&P down. But there's a darker angle: ratings shopping. Luna: You mean the city chooses which agency to hire based on who'll give it a better grade? Lucas: Exactly. Municipalities are actually allowed to pick their own rating agency. And because the bond market is structured so that many institutional investors require two ratings, a city can hire Moody's for one bond and S&P for another, essentially cherry-picking the higher rating for each deal. The SEC started looking into this more closely after a 2024 case out of Illinois — a school district that hired a third agency, got a rating two notches above the incumbent, and refinanced $300 million in bonds overnight. Luna: $300 million — that's not a rounding error. So the incentive is to game the system, and the taxpayer eats the cost of the rating agency's competitive pressure. Lucas: That's one way to put it. And there's an even more famous cautionary tale here: Jefferson County, Alabama. Not exactly the same mechanism, but eerily related. In the early 2000s, Jefferson County took on massive sewer debt — roughly $3.2 billion — much of it financed through complex variable-rate bonds and interest-rate swaps. And the ratings agencies gave those bonds solid investment-grade ratings right up until the county filed the largest municipal bankruptcy in U.S. history in 2011. Luna: I remember that case. The ratings didn't catch the corruption — the county commissioners taking bribes from the swap dealers — but they also didn't catch the structural risk of variable-rate debt in a rising-rate environment. Lucas: Right. Moody's and S&P had Jefferson County's sewer bonds at A3 and A, respectively, in 2007. By 2008, they downgraded to junk. But the damage was done — the county had already borrowed based on those initial ratings. And here's the kicker: the county's pension fund, which was separate from the sewer debt, was also underfunded — about 60 percent funded at the time. Neither agency incorporated the pension liability into the sewer bond rating, because it was technically a different legal entity. Luna: So the ratings were siloed. The sewer authority's rating didn't reflect the county's overall fiscal health. That seems like a fundamental flaw in how municipal credit analysis works. Lucas: It is. And the New York Fed paper confirms that this siloing is still widespread. They found that when a city has a large unfunded pension liability — say, more than 50 percent of its annual revenue — the split between Moody's and S&P ratings gets wider. Moody's tends to downgrade more aggressively on pension risk; S&P is slower to act. So the split rating itself becomes a signal of how seriously each agency treats long-term obligations. Luna: And that split costs the city in higher interest. So we're talking about a hidden tax on municipalities that have pension problems, because the bond market can't get a consistent signal. Lucas: Precisely. And it's not a small tax. The paper calculates that for every 10 percent of a city's own-source revenue that is diverted to pension contributions, the city's borrowing cost rises by roughly 5 basis points. Over a 30-year bond, that compounds into real money — money that could have gone to a new fire station or road repairs. Luna: Makes you wonder: if the ratings aren't reliable, what's the alternative? Some cities are starting to issue what are called 'social bonds' or 'sustainability bonds,' where the rating is tied to specific performance metrics — like reducing carbon emissions or improving public health outcomes. Does that help? Lucas: It's a growing trend. The World Bank issued its first sustainability bond in 2008, but the U.S. municipal market really picked it up post-2020. By 2025, roughly $40 billion in green or social muni bonds had been issued. The idea is that the bond's coupon steps up or down based on whether the city hits agreed targets. So the rating becomes dynamic, not static. Luna: But those are still rated by the same agencies, using the same methodologies. So the split-rating problem doesn't go away — it just gets applied to a more complex product. Lucas: Exactly. And there's a risk of 'greenwashing' — a city gets a higher rating because it promises to plant trees, but its underlying fiscal fundamentals are shaky. The SEC has flagged this as a concern in its 2026 exam priorities. They're looking at whether the agencies are applying consistent standards to sustainability-linked bonds. Luna: So the core issue remains: the rating system is opaque, inconsistent, and the people who pay for it — the cities and, ultimately, the taxpayers — have limited recourse when the rating is wrong. Lucas: Right. And that's the part that doesn't get enough attention in public debates about infrastructure. We talk about 'shovel-ready projects' and 'federal matching funds,' but the actual cost of borrowing is shaped by a ratings game that most city council members don't fully understand. If you're a finance director in a mid-sized city, you're spending a non-trivial amount of time just managing your rating agency relationships. Luna: Which brings us back to the listener who might be thinking: this sounds like a dry, technical topic, but it's literally costing my town money. And I think that's the kind of thing we try to unpack on this show — the hidden mechanisms that shape everyday fiscal reality. Lucas: Absolutely. And if walking through the economy with us has made something click — whether it's bond ratings or pension math or just the way your local park got funded — that's exactly why we do this ad-free. Listener support is what keeps the podcast independent and focused on the substance, not the sponsors. Luna: Yeah, it's a small gesture that makes a big difference. If you've gotten value from episodes like this one, you can support the show at buy me a coffee dot com slash fexingo. It helps us keep digging into the systems that most people never see. Lucas: And a quick note — that support goes directly to research time, fact-checking, and keeping the conversation going without commercials. So thank you to everyone who's already chipped in. Luna: Now, back to those split ratings. Lucas, you mentioned that the New York Fed paper has some policy recommendations. What do they propose? Lucas: A few things. First, mandatory disclosure of any ratings shopping — if a city gets a rating from one agency and then hires another, that history should be public. Second, a standardized pension liability disclosure that every rating agency would be required to use, not just the one they prefer. And third, a kind of 'rating audit' by the SEC — a random sample of municipal ratings every year to check for consistency. Luna: Those seem like common-sense reforms. But hasn't the municipal bond market resisted regulation historically? I mean, munis are famously under-disclosed compared to corporate bonds. Lucas: That's true. The Municipal Securities Rulemaking Board, the MSRB, exists, but it's much less aggressive than the SEC on corporates. There's a strong 'states' rights' lobbying push against federal oversight of local borrowing. But I think the calculus is shifting. You had the Detroit bankruptcy in 2013, the Puerto Rico debt crisis, and now the lingering risk from covid era fiscal stress. Combined, those events have made investors — and voters — more aware that ratings can be wrong. Luna: And wrong ratings have real consequences: higher taxes, delayed projects, sometimes even default. So maybe the next big infrastructure bill should include a provision on rating transparency, not just funding. Lucas: That's an interesting thought. The current White House seems open to that — the Treasury Department issued a paper in early 2026 calling for 'enhanced disclosure in the municipal market,' though it didn't go into specifics. But the political will is building. There's a bipartisan bill in the House right now, the Municipal Bond Market Transparency Act, that would require all municipal issuers to file annual financial reports in a standardized electronic format — similar to what corporations do with the SEC. Luna: That would be a huge shift. Right now, many small cities still file paper documents or PDFs that are hard to compare. A standardized format would let investors — and researchers — analyze risk much more efficiently. Lucas: Exactly. And it could help reduce the split-rating problem, because agencies would all start from the same data. But it's not a silver bullet. Ratings are ultimately judgments, not formulas. Two smart analysts can look at the same numbers and reach different conclusions. The goal isn't to eliminate disagreement — it's to make sure the disagreement is honest, not manufactured by the issuer's choice of agency. Luna: So the real fix might be a combination of transparency, standardised data, and a regulatory nudge against ratings shopping. That would at least level the playing field. Lucas: I think so. And for the individual listener — say you're on your city's finance committee or just a concerned voter — the takeaway is: ask your city's finance director which agency rates your bonds and whether they've ever gotten a second opinion. That's a question that can open up a whole conversation about how your tax dollars are being spent on interest. Luna: And that's the kind of civic engagement that doesn't require running for office. Just showing up to a council meeting and asking the right question. Lucas: Exactly. So we'll keep an eye on that Municipal Bond Market Transparency Act as it moves through committee, and we'll come back to the rating agencies' next set of reforms — if they happen. But for now, I think the key takeaway is: that A-rating on your city's bond might look solid, but it's worth a second look. Luna: Good advice. Thanks, Lucas.