Our default and transition studies indicate that defaults by rated U.S. public finance (USPF) entities have been relatively rare in recent years. We believe a number of factors may explain these results. In the first instance, we believe the basic stability of public finance ratings reflects the constancy and "perpetual" existence of governments. No matter how dire a municipality's financial circumstances, governments simply do not go out of business. These fundamental government characteristics generally lead to both operating and financial stability, which, in turn, lead to governments' credit and ratings stability.
To conclude from this, however, that all securities issued by municipalities are free from default risk would be a mistake. The municipal market tends to be self-selecting -- municipal issuers of lower credit quality tend not to request ratings. Correspondingly, the universe of rated municipalities is, as a general proposition, more creditworthy and, of course, less likely to default. Standard & Poor's Ratings Services' municipal transition and default study of 9,700 borrowing entities shows 34 defaults by issuers rated by Standard & Poor's between 1986 and 2006 (see "U.S. Municipal Rating Transitions And Defaults, 1986-2007," published May 3, 2007). In addition, 56 of 8,700 housing issues rated by Standard & Poor's defaulted. When the entirety of the public finance issuers and issues is evaluated, as opposed to simply the rated universe, however, more defaults are seen. Data received from Standard & Poor's Securities Evaluations shows more than 1,100 issue defaults during the same period, with only 167 of those issues having been rated. This comparison suggests a level of credit risk attendant to municipal finance that is greater than one might discern from a default study of Standard & Poor's-rated municipals alone.
In fact, a number of municipalities are facing credit challenges today. Officials of the Jefferson County, Ala., sewer system recently stated that it "can provide no assurance that net revenues from the sewer system will be sufficient to permit the county to continue to meet its debt service obligations" due to increased interest rates and the inability to remarket debt. The county also announced that it "does not presently intend to post collateral or provide insurance" to swap counterparties. Separately, the failure of growth-related revenues to materialize leaves Vallejo, Calif., unable to meet current expenses, and the city had been giving consideration to filing for bankruptcy. These examples demonstrate that credit risk is ever present in the public finance universe.
In our view, the same features that can promote the credit stability found in recent default studies can also make it difficult for municipalities to react effectively in times of stress. As a general rule, American democratic institutions do not have the ability to move as quickly or dramatically as corporations, nor has fiscally restructuring a municipality historically been a practical 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 remains.
In addition, credit quality is not always a top priority for municipalities. A corporate entity can more or less be expected to behave in a manner that maximizes the present value of future cash flows, but public governance and objectives are less simple. Credit quality must compete more directly with social and political objectives such as uninterrupted service provision, universal or unlimited access, affordability, and other goals specific to the unique nature of the services being provided. As a result, credit quality is frequently required to be traded for social and political considerations. We factor our view of these characteristics into our ratings.
Standard & Poor's continually reviews our U.S. public finance criteria to help confirm that our criteria produce ratings that best reflect the credit quality and default performance of public finance ratings. These reviews were undertaken after giving consideration to the historical default experiences observed in the USPF default studies. In part because of these efforts, the distribution of USPF ratings has in recent years moved up the rating scale in areas including lease and appropriation, state-supported bonding programs, and special revenue bonds such as sales and gas taxes. With a small exception in 2003, municipal upgrades have outnumbered downgrades since 1993, and upgrades have accounted for at least 70% of tax-backed rating changes in every year since 1991. Since 2000 alone, approximately 4,770 upgrades have occurred in the public finance sector, reflecting a combination of criteria changes and strong credit performance. In 1986, about 20% of USPF ratings were in the 'AA' category or higher; by 2007, the percentage had increased to about 33%. At the same time, the 'BBB' category declined from about 20% to 16% of all ratings. USPF entity ratings are now weighted toward the higher end of the rating scale.
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We will revise and refresh criteria as appropriate to best reflect rating performance. We anticipate further migration up the rating scale in the USPF sector, assuming that creditworthiness, particularly of governmental credits, remains strong. We believe it is distinctly possible that, over time, much of the public finance-rated universe will be weighted to the 'A' category or better. We would not expect the same trend in housing, health care, toll roads, or other sectors that exhibit more risk characteristics. We believe a more incremental understanding of the factors driving credit stability adds value to the market.
