S&P Viewpoint

• General Obligation
• Lease/Appropriation/Moral Obligation
• Special Tax (sales, gas, etc.)
• Special District
• Water and Sewer Revenue
• Public Power
• Airports
• Ports
• Toll Roads and Bridges
• Parking
• Various Types of Bond Pools
• Transit
• Public and Private Higher Education
• Auxiliary Higher Education Debt
• Independent Schools
• Hospitals (stand alone and systems)
• Continuing Care
• Physicians' Practices

During the 18 years (1986-2003) covered by the study, the distribution of Standard & Poor's public finance ratings increased at the highest end of the rating scale. As of Jan. 1, 1986, 0.9% of unenhanced ratings were rated 'AAA'; in 2003, 1.4% of ratings were in this category. The 'AA' category showed a significant gain, with 17.2% of ratings in the 'AA' category in 1986, increasing to 29.5% in 2003. Improvement was evident at the other end of the scale as well; in 1986, 1.5% of ratings were below investment grade, while in 2000 this number was just 1.0% (see chart 1).

In broad terms, this overall rise in public finance ratings reflects the overall resilience of the sector in the face of the national economic stress experienced in the mid-1980s, early 1990s, and the early 2000s and the general economic prosperity and the strong track operating and financial performance of public finance credits. In addition, although pre-dating the period covered by the study, the New York City fiscal crisis in the mid-1970s caused fundamental changes in public finance practice that continue to affect the industry for the better. The strengthening and clarification of the powers and relationships of government, improved internal and external financial reporting, and better overall risk disclosure have over the long term improved the transparency and overall credit of public finance issuers.

Defaults, as defined at year-end, continue to be virtually non-existent.

• In 2003 there were defaults on two affordable housing projects: Woodland Heights, Texas and a Dallas-Fort Worth apartment pool project issued by the Austin Housing Finance Corp. and the Texas Department of Housing and Community Affairs, respectively.
• In 2002, there were defaults by the Oregon Aquarium and three housing issues: Willowbrook Apartment Project in Indianapolis, Ind.; Emerald Coast Housing Corp. in Okaloosa County, Fla.; and Patten Towers in Hamilton County, Tenn.

The study's transition analysis, which measures the stability of rating classes over time, shows that public finance ratings are highly stable, particularly at the uppermost end of the scale. At the 'AAA' level, for example, 96% of ratings are likely to remain at 'AAA' one year later. At 'BBB' or lower, however, ratings are about 90% likely to remain at the same level a year later. The diagonal in table 1 that begins at the top left in the 'AAA' category and descends to the lower right is a useful reference illustration of rating transition behavior. Numbers on the diagonal represent unchanged ratings, while those to its left and right represent, respectively, ratings upgrades and downgrades. The entries on this diagonal show that, without exception, the higher the rating the higher its stability. Generally, for ratings 'A' or lower, the numbers to the left of the diagonal are greater than those to the right (excluding ratings that have been withdrawn, which are designated as N.R.), showing a trend of more upgrades than downgrades. Across sectors there is an overall trend that ratings and credit volatility increases at the lower end of the scale, particularly in the most volatile sectors: housing and health care. The general governmental sectors of tax secured and utilities are the most stable of all sectors. The numbers of credits in those universes is also the largest, so the data is significantly driven by general governmental performance. All of Standard & Poor's default studies, the present update included, have found a clear correlation between credit quality and default remoteness: the higher the rating the lower the historical average of default, and vice versa. Over each time span, lower ratings correspond to higher default rates (see table 2).

Table 1 One-Year Transition Matrix (%) (1985-2003)
Rating	AAA	AA	A	BBB	BB	B	CCC/C	D	N.R.
AAA	96.17	1.11	0.09	0.00	0.00	0.00	0.00	0.00	2.64
AA	0.27	94.64	1.23	0.03	0.00	0.00	0.00	0.00	3.84
A	0.00	1.89	91.61	1.00	0.03	0.01	0.00	0.00	5.45
BBB	0.00	0.08	2.33	90.24	0.60	0.11	0.07	0.00	6.56
BB	0.00	0.19	0.10	7.29	78.79	3.26	0.67	0.29	9.40
B	0.00	0.00	0.36	3.56	6.41	70.11	6.05	2.14	11.39
CCC/C	0.00	0.00	0.00	0.00	2.24	6.72	66.42	11.94	12.69
N.R.--Not rated. Data: Standard & Poor's Public Finance Ratings; Calculations: CreditPro® Engine 6.60.

Table 2 Cumulative Default Rates (%) 1985-2003)
Rating	Y1	Y2	Y3	Y4	Y5	Y6	Y7	Y8	Y9	Y10	Y11	Y12	Y13	Y14	Y15	Y16	Y17	Y18
AAA	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00
AA	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00	0.00
A	0.00	0.00	0.01	0.02	0.02	0.02	0.03	0.03	0.04	0.04	0.05	0.05	0.06	0.06	0.07	0.07	0.07	0.07
BBB	0.00	0.04	0.08	0.13	0.18	0.24	0.29	0.31	0.33	0.34	0.35	0.36	0.38	0.40	0.40	0.40	0.40	0.40
BB	0.29	0.70	1.15	1.27	1.27	1.27	1.27	1.27	1.27	1.46	1.46	1.46	1.46	1.46	1.46	1.46	1.46	1.46
B	2.14	4.40	5.20	5.63	6.52	7.47	8.48	9.04	9.65	9.65	9.65	9.65	9.65	9.65	9.65	9.65	9.65	9.65
CCC/C	11.94	15.87	19.24	22.79	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78	23.78
Investment Grade	0.00	0.01	0.02	0.04	0.05	0.07	0.08	0.09	0.10	0.10	0.11	0.11	0.12	0.13	0.13	0.13	0.13	0.13
Speculative Grade	1.72	2.82	3.61	4.12	4.39	4.58	4.78	4.90	5.02	5.15	5.15	5.15	5.15	5.15	5.15	5.15	5.15	5.15
All Rated	0.02	0.04	0.07	0.09	0.11	0.12	0.14	0.15	0.16	0.17	0.17	0.18	0.18	0.19	0.19	0.19	0.19	0.19
Data: Standard & Poor's Public Finance Ratings; Calculations: CreditPro® Engine 6.60.

The study's cumulative default analysis measures the historical average of default of a rated obligation at any point during its life. The study indicates that the number of defaults and cumulative default rates are extremely low for public finance obligations rated by Standard & Poor's. Based on the study's data parameters, no defaults of 'AAA' or 'AA' rated debt occurred during the 1986-2003 period. It should be noted that while the Orange County, Calif. bankruptcy occurred in 1994, the assignment of the rating and the bankruptcy occurred within the same year and, therefore, although the Orange County default is reflected in the static pools, no rating change is apparent when viewed from a year-to-year perspective. Prior Orange County ratings were short term, which are excluded from the study.

The cumulative default analysis shows that there is less than a 1% chance of default over an 18-year horizon for both 'A' and 'BBB' rated debt. The analysis further suggests that it is only at the speculative-grade level that the cumulative default rate becomes significant. At the 'BB' level, 1% of the average pool has defaulted by year three; at the 'B' level, 2.1% of the typical pool defaulted within the first year. These low default rates reflect the fundamentals of the public finance market and the behavior of public finance borrowers. Default, bankruptcy, and reorganization are not generally perceived as available options for most municipal entities.

The fundamental stability of public finance ratings reflects the stability of government itself. Change at the state and local level is often difficult to achieve and is usually slowly implemented. Democratic institutions simply do not have the ability to move as quickly or dramatically as corporations; risk taking is not a "best practice" for a government. There are several factors that contribute to governmental stability and therefore rating stability, including:

• Statutory- and political-mandated requirements. Virtually every government has statutory duties (welfare, education, corrections, public safety, and transportation), as well as political necessities (parks, libraries, and recreation). Statutory duties are usually highly resistant to change. It is not uncommon to have statutory obligations account for three-quarters of a government's operating budget. Though in recent years governments have worked to create operating efficiencies, statutory duties often amount to a more or less permanent overhead that cannot be significantly reduced. Governments' operating flexibility is less than that of corporations, since for the former it is very difficult to adjust the "product line" and "sales" since so many government services are mandated.
• Economic development and the pace of growth. Changes in states and localities can vary widely, but nearly always include increased costs. Areas of rapid economic growth must provide increased levels of service to meet the development needs; it is extremely rare that a community has infrastructure in place and is capable of absorbing growth. Schools, water and sewer systems, and roads are typically constructed concurrently (though more often lag behind) with the municipality's economic development to avoid overbuilding and to allow use of developer fees to help with the costs of development.
• Bankruptcies are usually not an option. Distressed municipalities in most states do not have a bankruptcy option; it is frequently restricted by law. Some states allow "takeovers" of local governments by a state agency if credit deteriorates. Distressed municipalities will typically receive some type of additional state aid, oversight, or other outside intervention that prevents the dramatic credit deterioration that corporations may suffer. Fiscally, restructuring a municipality is not a viable option. Reallocations of responsibilities periodically occur, such as in the areas of courts or regionalization of water and sewer or transportation responsibilities, but the government itself remains. As a consequence, public finance ratings often reflect an expectation of relatively strong creditor protection and have higher recoveries than senior unsecured corporate debt.
• Governmental efficiencies and successes are difficult to measure. The electorate tends to be more tolerant than the equity market–decisions and actions do not necessarily need to be taken with the speed that characterizes the corporate world. In general, tax rates vary according to the levels of services provided. While services are important, change in the level of service generally occurs over a period of time.
• General governments' "perpetual" existence. No matter how dire a municipality's financial circumstances, governments simply do not go out of business.

These fundamental government characteristics lead to both operating and financial stability, which in turn lead to governments' credit and ratings stability.

The rating transition and default experience in the public finance sector is not surprising. The general improvement in sector ratings in the 1986-2003 period reflects a general strengthening of the sector's credit fundamentals, despite recent economic pressures. The performance of the sector suggests that public finance issuers have largely outperformed other areas in terms of credit strength. Moreover, Standard & Poor's expects these differences to persist and will continue to be evidenced by relative ratings stability and infrequent defaults.

Limited insight can be derived from the study with respect to the credit performance of speculative-grade public finance debt due to the sparse ratings coverage of the below-investment-grade sector. Standard & Poor's believes default experience in the unrated market is meaningfully higher than reflected in the investment-grade-rated market.

When evaluating and comparing the results of this study to other Standard & Poor's rating transition and default studies, it is important to reference our rating definitions. Standard & Poor's definitions speak to the overall creditworthiness of an issue or issues. Standard & Poor's issue credit ratings are based in varying degrees on the following considerations:

• Likelihood of payment--capacity and willingness of the obligor to meet its financial commitment on an obligation in accordance with the terms of the obligation;
• Nature and provisions of the obligation; and
• Protection afforded by and relative position of the obligation in the event of bankruptcy, reorganization, or other arrangements under the laws of bankruptcy and other laws affecting creditors' rights.

The first element--the capacity of the obligor to meet its financial commitments--addresses the fundamental credit strength of the issuer and is a significantly weighted factor in public finance ratings.

Although default patterns at the 'AA' and 'AAA' level are identical (the default rates equal zero in both cases), transition performance is even more stable at the 'AAA' level. 'AAA' ratings are characterized by the highest levels of credit quality and bear no discernable weaknesses in financial, economic, debt, or management areas. Long trends of sustainable strength through both cycles and events mark 'AAA' ratings. Equally important, Standard & Poor's believes that meaningful differences in bondholder protection among public finance obligations, such as limitations on access to general revenues, dependence on an appropriation process for ongoing funding, narrower or constricted tax revenue bases, etc., should continue to be reflected in rating differentials even in the context of the relative absence of default experience that has characterized the sector over the recent period covered by the study. Although there are defaults in investment-grade credits, default patterns are much more prevalent in the speculative categories. The rated public finance market includes few speculatively rated credits. There is evidence in the unrated municipal market sectors that defaults occur in transactions that fall into the speculative grade. Should the rated municipal market begin to include more non-investment grade credits, however, Standard & Poor's believes that the rating behavior of those credits would more closely resemble the behavior of similarly rated corporate entities.

The study is based on a performance analysis of the unenhanced debt obligations (i.e., obligations not relying on external support provided by guaranties, outside support, or alternative revenue streams) of public finance issuers and includes bonds issued by a range of entities. Long-term parity debt ratings were used throughout the study. These ratings reflect Standard & Poor's opinion of an issuer's overall capacity to pay its obligations, that is, its fundamental creditworthiness. As such, the analysis focuses on the issuer's payment capacity and willingness to meet its financial commitment on an obligation according to its terms.

The data tracked the rating histories of 5,063 parity debt obligations outstanding in 1986, increasing to 11,330 parity debt obligations outstanding in 2003. The data includes general obligation, appropriation-backed, special tax, revenue, and higher education and health care bonds. Although the rating of an appropriation-backed bond is usually linked to that of the obligor, since, in certain cases, the ratings of appropriation-backed bonds can move independently of those of the obligor, those ratings have been included. One of the study's goals was to show the rating transitions and default history of the traditional public finance market: cities, towns, school districts, and hospitals, as well as the bonds issued by those entities. Bonds wrapped by a monoline insurer have been excluded from the study, unless the bonds bear an underlying, unenhanced rating by Standard & Poor's (a SPUR), in which case the SPUR was included. The study is based on individual issuances, rather than on dollar amounts, to avoid the risks of magnitude skewing results.