Credit Ratings A Rating Agency Perspective Capital Area

Credit Ratings: A Rating Agency Perspective Capital Area Suburban Exchange, 2012 Andy Hobbs & Keaton Hoppe June 2012

Role of Rating Agencies Purpose of Credit Ratings » Ratings provide investors with a simple system of gradation by which relative creditworthiness of securities may be noted » Gradations of creditworthiness are indicated by rating symbols » Each symbol represents a group in which the credit characteristics are broadly the same » There are nine symbols used to designate the range between: – Lowest credit risk (Triple-A) – Highest credit risk (Single-C) » Modifiers are appended to further differentiate between broad rating category Credit Ratings: A Rating Agency Perspective 2

Moody’s Long-Term Debt Rating Scale Lowest Risk Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk. A Obligations rated A are considered upper-medium grade and are subject to low credit risk. Baa Obligations rated Baa are subject to moderate credit risk. They are considered medium grade and as such may possess certain speculative characteristics. Ba Obligations rated Ba are judged to have speculative and are subject to high credit risk. B Obligations rated B are considered speculative and are subject to high credit risk. Caa Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk. Ca Highest Risk Aaa Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest. C Obligations rated C are the lowest rated class and are typically in default, with little prospect for recovery of principal or interest. Investment Grade Speculative Grade Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating category from Aa through Caa. The modifier 1 indicates that the issuer or obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Credit Ratings: A Rating Agency Perspective 3

Meaning of Credit Ratings What They Are: » Independent, objective assessments of the relative creditworthiness of debt obligations » Shorthand symbols denoting the relative ability and willingness of debt issuers to make full and timely payment » Opinions about the future What They’re Not: » Ratings are not recommendations to purchase, sell, or hold particular securities » Ratings are not predictors of non-credit-related market price movements » Ratings are not audits, and do not guarantee the authenticity of information from issuers » Ratings are not public policy report cards, although politicians may use them as such » Ratings are not fixed; they may change over time » Rating analysts are neither financial advisors nor investment bankers Credit Ratings: A Rating Agency Perspective 4

The Rating Process How Ratings are Derived » In the course of the rating process, a Moody’s analyst: – Gathers information sufficient to evaluate risk to investors who might own or buy a given security – Develops a conclusion in committee on the appropriate rating – Monitors the security on an ongoing basis to determine whether the rating should be changed – Informs the marketplace of any rating actions via press release, including detailed rating rationale » Process involves an active, ongoing dialogue between the issuer and analyst – Conduct introductory discussions to explain Moody’s rating methodology and process – Hold meetings with management to gain insight into: » The entity and its operations, strategic goals, governance structure, & financial condition » Relevant sector trends and operating environment – Issuers encouraged to raise any concerns and present all materials pertinent to the analysis » Ratings determined by Committee – Based on evaluation of key rating factors outlined in published methodologies – Various viewpoints bring objectivity into the process Credit Ratings: A Rating Agency Perspective 5

Rating Methodologies » Published methodologies describe analytical framework for determining ratings » Specific risk factors that apply will vary considerably by sector » Rating approach includes an analysis of key factors and sub-factors – Each factor is evaluated individually – Some factors are easily quantifiable, while others involve qualitative assessment – Factors are assigned different weightings according to their predictive value » Example: U. S. Local Government G. O. Methodology involves four key rating factors: – Economic Strength (40%) – Financial Strength (30%) – Management and Governance (20%) – Debt Profile (10%) » Benefits: (1) Uphold rating consistency; (2) Enhance transparency, recognizing that rating outcomes ultimately involve judgment Credit Ratings: A Rating Agency Perspective 6

1) Economic Strength Tax Base Growth and Trend » Relative size » Has it been growing? » Tax rate pledge » Industry concentration Type of Economy » Tax base make-up: residential, industrial, or agricultural » Presence of high growth or poorly performing industries » Amount of land available for (re)development Wealth, Demographics, and Workforce » Full value per capita » Per Capita income » Unemployment (critical for cities that have income tax) Credit Ratings: A Rating Agency Perspective 7

2) Financial Strength Balance Sheet and Liquidity » General Fund Balance = Assets – liabilities » General fund balance relative to operating revenues » Size of general fund balance depends on revenue sources » Cash is king » Quality of receivables Operating Flexibility / Budgetary Operations » Statutory ability of local government to raise revenues » Accuracy of forecasts » Surplus good, deficit bad. » Two ways to end a deficit – raise revenues or cut expenses Credit Ratings: A Rating Agency Perspective 8

3) Debt Profile Leveraging » Most defaults involve over-leveraging » High debt burdens make it difficult for municipalities to deal with economic downturns » Direct Debt As a % of Full Value » Direct Debt Per Capita » Remaining Debt Capacity (How Close to Debt Limit? ) » Amount of Operating Budget Dedicated to Debt Service Amortization » Repayment vs. Useful Life of the Asset? » Amount of Total Principal Outstanding Repaid in 10 Years » Balloon Payments Credit Ratings: A Rating Agency Perspective 9

4) Management & Governance Fund Balance Policies » Adoption of fiscal plan which includes fund balance target, and instances in which reserves may be used Debt Planning » Debt Plan which includes target and maximum debt levels targeting pay as you go funding of capital work as part of a multi year CIP » Don’t assume high rates of growth in tax base Succession and Contingency Planning » Formalized succession/contingency plan identifying organizational structures, succession plans should key personnel change Timely Disclosure » Timely audited financial documents which are attested to by an outside firm, and the direct disclosure of any material events as soon as possible Credit Ratings: A Rating Agency Perspective 10

Most MUDs Rated A 1 or A 2 Percent of MUDs in Each Rating 45% 40% 35% Category 30% 25% 20% 15% 10% 5% 0% Aaa Aa 1 Aa 2 Aa 3 A 1 A 2 A 3 Baa 1 Baa 2 Baa 3 Credit Ratings: A Rating Agency Perspective 11

MUDs with Larger Assessed Values Tend to Have Higher Ratings Median $3. 5 Assessed Value $3. 0 ($ Billions) $2. 5 $2. 0 $1. 5 $1. 0 $0. 5 $0. 0 Aaa Aa 1 Aa 2 Aa 3 A 1 A 2 A 3 Baa 1 Baa 2 Baa 3 Credit Ratings: A Rating Agency Perspective 12

MUDs with Lower Direct Debt Burdens Tend to Have Higher Ratings Median 14% Direct Debt as a % of 12% Assessed Value 10% 8% 6% 4% 2% 0% Aaa Aa 1 Aa 2 Aa 3 A 1 A 2 A 3 Baa 1 Baa 2 Baa 3 Credit Ratings: A Rating Agency Perspective 13

James Hobbs 214. 220. 4382 James. Hobbs@moodys. com Keaton Hoppe 214. 880. 8662 Keaton. Hoppe@moodys. com Credit Ratings: A Rating Agency Perspective

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