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This is a public policy/ Accounting paper. Identify and explain the key concepts in the preparation of credit ratings, including the alternative model. Identify and explain theories of how public policy is developed in the United States. Explain how governments (i.e., federal; state, and local) finance projects and programs, including how economic variables influence public policy. The concept of “pay as you go” how does that affect the financing of public projects. Utilize this source to answer question. https://www.governing.com/columns/public-money/gov-how-to-make-paygo-work.html Source #1 can be accessed through this link https://regulatorystudies.columbian.gwu.edu/sites/g/files/zaxdzs3306/f/downloads/Reports/GW%20Reg%20Studies%20-%20US-Stakeholder-Reg-Process%20-%20SDudley%20and%20SBalla.pdf Source number #2: Alternative Model on Page 19 Use whole document as necessary. The document has been uploaded in files. Source #3: Answers question as to how public policy is formed. Use also Source #1 along with this source to explain how public policy is formed. https://journalistsresource.org/studies/politics/finance-lobbying/the-influence-of-elites-interest-groups-and-average-voters-on-american-politics/ Please reach out to me with any questions

Introduction
WHEN LOCAL GOVERNMENTS OVERPAY for financial services, the extra costs must be borne elsewhere.
Since cities cannot print money, they must either raise taxes or reduce services to o”set extra
money paid to bond investors and financial industry providers. One type of financial service is the
assignment of credit ratings, which tell bond investors how much risk they incur by purchasing
the local government’s obligations. Since US local government debt issues rarely default, the rating
process should be straightforward and inexpensive. Instead, the credit rating process imposes substantial
direct and indirect costs on issuers, resulting in higher taxes and degraded public services.
In this study, I measure the financial burden of the credit rating system on US municipal bond
issuers and propose a less costly alternative rating approach. In addition to the fees rating agencies
collect from municipal bond issuers, I also estimate costs municipal bond issuers incur because
they are rated more harshly than corporate and structured finance issuers. !ese costs take the
form of higher interest expenses and premiums on municipal bond insurance policies—which municipalities
would not need if they were rated on par with corporate bond issuers. I also discuss the
connection between low ratings and accelerated swap termination payments that some municipalities
have or will incur—although I don’t include this a”ect in the total.
After measuring the cost of the current rating system, I outline and assess a model-based municipal
rating system that generally assigns higher ratings. I find that, despite being more lenient,
this system would still have been able to alert investors to the risks of bonds o”ered by defaulting
cities such as Detroit, Michigan; Harrisburg, Pennsylvania; and Stockton, California.
A model-based rating system like the one proposed here would reduce municipal financing
costs. It would also lead to lower rating fees by allowing greater automation of the credit ratings
process.
!is study begins by surveying evidence that municipal bond ratings are indeed more severe
than those for other asset classes. With that basis, I then estimate the overall cost of the municipal
rating system. Finally, I describe the model based alternative and provide some preliminary results
from the proposed rating model.
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Harsh Municipal
Bond Ratings
CORNAGGIA, CORNAGGIA, AND HUND1 evaluated default rates by major asset class by Moody’s rating.
!eir results are reproduced in Table 1.
High default percentages for Aaa and Aa bonds suggest more lenient rating standards. Overall,
the authors find that government bond issuers (sovereign and municipal) are rated more harshly
than corporate issuers—including financial corporations—which are rated more harshly than structured
finance securities. !ey further observe that rating severity is inversely proportional to rating
fee levels. Rating agencies charge structured finance issuers the most and government bond issuers
the least, with corporates in between.
!ese findings are corroborated by Micah Hauptman and Barbara Roper in a March 2014
Securities and Exchange Commission (SEC) comment letter.2 !e authors reviewed forms Nationally
Recognized Statistical Ratings Organization (NRSRO) filed by Moody’s, Standard & Poor’s
and Fitch, observing large di”erences in default and downgrade behavior across asset classes. !e
authors conclude:
Ratings agencies are likely to grant more favorable ratings to issuers who are likely
to seek significant current and future business. !is phenomenon is likely reinforced
when there are few issuers in a certain asset class, which is common in the
structured finance arena, because those issuers will choose whichever NRSRO rates
their securities most favorably, and because NRSROs won’t risk losing any business
from an issuer with such market power. (Page 25)
Since the municipal bond market is fragmented among tens of thousands of relatively small issuers,
a local government has far less ability to a”ect rating agency behavior than Goldman Sachs,
JP Morgan and other major financial industry players that create structured finance instruments.
Within the broad category of government bond issuers, US states have performed exceptionally
well. In fact, the last time any state entered default status was 1933, when both Arkansas and
Louisiana missed interest payments. Louisiana’s problem—the result of a local bank failure—was
quickly rectified. Arkansas did not fully emerge from default until 1941, when the Reconstruction
Finance Corporation—a federal agency—purchased previously non-performing Arkansas bonds at
par (meaning that private bondholders experienced no loss of principal).3
!us, US states have reliably serviced their bonds for as long as most anyone can remember. Yet
TABLE 1
Default Rates by Asset Class and Rating
Source: Cornaggia, Cornaggia and Hund, 2014.
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most of their obligations do not receive the highest ratings from the major rating agencies. For example,
rating histories published by the California State Treasurer4 show that all three major rating
agencies have rated California below AAA/Aaa5 since the early 1990s.
Moody’s6 downgraded California from Aaa to Aa1 in February 1992. Since then, the state’s
rating has fallen as low as Baa1, which is seven notches below Moody’s highest rating. Currently,
Moody’s assigns California a rating of Aa3, three notches below Aaa. Two states—Illinois and New
Jersey—currently have lower ratings than California: A3 and A1 respectively.
In 2008 Congressional testimony7, Moody’s Senior Managing Director Laura Levenstein stated:
Investors in corporate or structured securities typically have looked to Moody’s
ratings for an opinion on whether a security or an issuer will meet its payment
obligations. Historically, this type of analysis has not been as helpful to municipal
investors. If municipal bonds were rated using my global ratings system, the great
majority of my ratings likely would fall between just two rating categories: Aaa
and Aa. !is would eliminate the primary value that municipal investors have
historically sought from ratings—namely, the ability to di”erentiate among various
municipal securities. I have been told by investors that eliminating that di”erentiation
would make the market less transparent, more opaque, and presumably,
less e#cient both for investors and issuers (Page 122).
Levenstein asserts that Moody’s provided the harsher rating scale for municipal bonds because
of investor demand. But I wonder whether Moody’s surveyed a good cross-section of municipal
bond investors, which include large numbers of individuals—who rarely have any reason to contact
a rating agency and who were probably unaware that rating agencies have separate standards for
municipal bonds. Most likely, the universe of investors Levenstein and her colleagues consulted
included a disproportionate number of bond insurers, who had a vested interest in perpetuating
inconsistent rating methodologies—as discussed below.
If rating agencies were primarily concerned with providing greater di”erentiation among
municipal bonds, they could have used a di”erent set of symbols for these securities. !ey could
have even assigned governments a fiscal score on a 0–100 scale.8 Joseph Pimbley notes that rating
agencies already use di”erent scales for short term debt and preferred stocks.9 Pimbley continues:
Had the CRAs truly wished to rate municipal bonds with di”erent meanings for the
ratings, they would have created rating scales with distinct symbols and explained
them clearly. A good faith attempt to explain to investors, issuers, regulators and
other stakeholders that municipal and corporate ratings are entirely dissimilar
and incomparable would have required at the very least the imposition of distinct
rating symbols (Pages 7–8).
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Municipal Bond Insurance
LOWER BOND RATINGS tend to be accompanied by higher interest rates. !us, relatively harsh municipal
bond ratings raise state and local government debt service costs. Governments have often ameliorated
these extra costs by purchasing bond insurance. When a municipal bond issuer purchases
bond insurance, its bonds carry the insurer’s rating. State and local government borrowers—which
receive ratings lower than that of a given municipal bond insurer—may be able to reduce borrowing
costs by purchasing an insurance policy.
However, the performance of municipal bond insurers during the financial crisis was quite
poor, and very inconsistent with their high ratings.10 !e bond insurance business began with
the formation of Ambac in 1971. By 2008, Moody’s rated eight of the nine active bond insurers.11
!ese ratings are shown in Table 2.
Seven of the eight insurers were rated Aaa at the beginning of 2008. Five of these seven were
forced to restructure their obligations by the end of 2010. In two cases, the insurers declared bankruptcy.
In the other three cases, they entered “commutation agreements” with certain creditors
under which some of the insurers’ obligations were liquidated for less than 100 cents on the dollar.
With the benefit of hindsight, it is clear that the ratings of states and bond insurers were highly
inconsistent. Of course, rating agencies do not have the benefit of hindsight when publishing their
assessments, so individual ratings cannot be guaranteed to be accurate. !at said, the failure of a
majority of Aaa entities within a given asset class should give cause for concern.
One fact that was obvious before the financial crisis was that bond insurers had a much shorter
track record than US state and local governments. Lack of operating history for an organization or
an industry should be seen as a source of credit risk. By the time the bond insurance industry began,
US states already had three decades of pristine credit (a 1933 default by Arkansas was resolved
in 1941), but many states were rated below Aaa. By contrast, a new bond insurer could obtain a rating
agency’s highest rating shortly after opening for business. For example, CIFG—one of the failed
insurers—formed in 2001 and received top ratings from all three agencies by 2002.12
Finally, criticism of Aaa bond insurer ratings pre-dates the financial crisis by several years. In
her book, Confidence Game,13 Christine Richard documents the activist investor William Ackman’s
e”orts to convince rating agencies to downgrade bond insurer MBIA. Although Ackman
clearly had a vested interest in the outcome—he was selling MBIA stock short—his research on the
matter was quite thorough as can be seen from his 2002 report Is MBIA Triple-A.14
Given the relative performance of governments and bond insurers during the financial crisis,
Company
Moody’s Rating
as of 1/1/2008 Default Event
Ambac Aaa Chapter 11 Filing on Nov. 8, 2010
Assured Guaranty Corporation Aaa
CIFG Aaa Commutation on Jan. 21, 2009
FGIC Aaa Chapter 11 Filing on Aug. 4, 2010
FSA Aaa
MBIA Aaa Multiple commutations in late 2010
Radian Asset Assurance Limited Aa3
XL Capital Assurance Aaa Commutation on July 17, 2009
TABLE 2
Moody’s Ratings for Monoline Bond Insurers on 1/1/2008
Sources: Moodys.com, company filings and press releases.
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the economic benefit of insurance is subject to question. In particular, it is worth noting that bond
insurance is not common in the corporate bond market. If corporations could reduce their borrowing
costs by purchasing insurance, it would be rational for them to do so. So the absence of
corporate bond insurance suggests the absence of an economic benefit. Seen from this vantage
point, it appears that municipal bond insurers are taking advantage of rating scale discrepancies—
e”ectively arbitraging between the relatively lenient standards for corporate bond issuers and the
relatively harsh standards for municipal bond issuers.
In the next three sections, I estimate the cost of the credit rating system beginning with extra
interest costs borrowers incur due to harsh ratings. After considering—but not quantifying—the impact
of low ratings on interest rate swaps used by many issuers, I total up the insurance premiums
paid by municipal bond issuers. Finally, I estimate the direct cost of the rating system which take
the form of fees paid by issuers to the rating agencies.
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Extra Interest Expenses
THE EXTRA INTEREST COST estimated is based on the interest rate spread across rating categories.
Estimating rating spreads can be challenging because bond yields are a”ected by numerous
factors other than ratings. Examples of these other factors include trade time and size, issuer state,
and maturity date.
Because the municipal bond market is very illiquid—most bonds do not trade on any given
day—it is necessary to either compare bond trades that occur hours or days apart, or rely on estimated
pricing to determine yield spreads. Further, prices of individual trades may be distorted by
the relative market power and sophistication of transaction participants. For example, an individual
buying $10,000 of a given issue may receive a lower yield than an institution buying $1,000,000
of the same issue at the same time.
Municipal bond interest is taxed di”erently across
states. For example, California has a maximum personal
income tax rate of 13.3 percent and exempts California
municipal bond interest income from state income
taxation. By contrast, Texas and Florida have no income
tax, removing some of the benefit to owning municipal
bonds. A top bracket taxpayer in those two states receives
substantially less after-tax income from municipal bond
interest than her counterpart in California. Investors in
those states may be expected to demand greater yields to
o”set this tax impact.
Finally, longer term bonds usually have higher yields
than shorter term bonds. !us comparing the yield of a
bond rated AAA maturing in 2025 to a bond rated AA
maturing in 2020 can be misleading. !e term e”ect may
well overwhelm the rating e”ect.
Market data services such as Bloomberg and Municipal Market Data o”set this last e”ect by
constructing rating-specific yield curves, showing rates at di”erent tenors (i.e., length of time to
maturity). !e points on the yield curve represent average yields of bonds with the same rating
and same tenor. It should be noted that tenor is typically stated in a round number of years which
means that the 5-year point on the yield curve may include bonds with as little as 4.5 years to maturity
or as many as 5.5 years.
As of March 31, 2015, Bloomberg reported the following index yields for five year bonds at
various ratings:
By subtracting the AAA yield from the others, I can estimate the risk premium (or
spread) associated with lower ratings.
!ese spreads vary across tenors, and, in some cases, AA+
and AA bonds actually have lower yields than their AAA
counterparts.15 It is reasonable to assume that these anomalies
are the result of some of the e”ects described above. !e
five-year spreads appear to be more consistent than those for
other tenors.
As ratings decline from AAA to A+ yields increase by an
average of 6bp per notch. !ere are steeper yield increases
once ratings fall below A+. For the purposes of this analysis,
I will make the conservative assumption that each rating
Rating 5-Year Yield
(%)
AAA 1.25
AA+ 1.31
AA 1.37
AA- 1.46
A+ 1.49
A 1.71
A- 2.58
Source: Bloomberg Professional Terminal.
Rating
AAA
Spread over
AA+ 0.06
AA 0.12
AA- 0.21
A+ 0.24
A 0.46
A- 1.33
Doubly Bound: The Cost Of Credit Ratings haasinstitute.berkeley.edu
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notch is associated with a 6bp change in interest expense.
Further, let’s assume that municipal bond ratings are two notches too conservative relative to
other asset classes. (Later in the study I present an alternative rating methodology that can produce
a generalized two-step improvement while still assigning at-risk cities speculative grade ratings.)
For example, a municipal bond rated A- should really be rated A+ and one rated AA- should be
upgraded to AA+. Such an adjustment cannot be made to municipal bonds carrying the highest
AAA rating, and it is only possible for AA+ bonds to receive a one notch upgrade.
All this means that the interest penalty on bonds rated AA and lower is estimated to be 12bp:
the ratings on these bonds could be increased by two notches at an interest cost savings of 6bp per
notch. No interest savings are available for AAA bonds, which already have the highest rating and
lowest funding cost. Since AA+ bonds can only be raised by one notch, the interest rate penalty on
these bonds is estimated to be 6bp.
Now that I have the penalty rate, I need to determine the base against which to apply this rate.
!e appropriate base is some fraction of the overall amount of municipal bonds outstanding. For
each dollar of a”ected municipal bonds outstanding and rated AA or below, borrowers are paying
0.12 cents in extra interest.
According to Federal Reserve estimates, the overall size of the US municipal bond market was
$3.65 trillion at the end of 2014.16 Of this total, $2.91 trillion was issued by state and local governments,
$0.52 trillion was classified as industrial revenue bonds and $0.22 trillion were issued by
not-for-profit organizations including universities and hospitals.
Not all municipal bonds are rated, and estimates of the number of all rated bonds are di#cult
to find. Further, the breakdown of the rated universe by rating grade is also not readily available.
One way to roughly estimate the total number of rated bonds is to examine rating history files
that each rating agency is required to file under SEC rules. !ese files are published in a format
Rating Face Amount
($m)
Interest Penalty per
$ of Face
Interest Penalty for
Rating Cohort ($m)
AAA 289,623 0.0000 0.00
AA+ 176,770 0.0006 106.10
AA 273,197 0.0012 327.80
AA- 373,986 0.0012 448.80
A+ 293,348 0.0012 352.00
A 180,306 0.0012 216.40
A- 92,756 0.0012 111.30
BBB+ 15,278 0.0012 18.30
BBB 21,718 0.0012 26.10
BBB- 17,815 0.0012 21.40
BB+ 34,271 0.0012 41.10
BB 10,444 0.0012 12.50
BB- 8,453 0.0012 10.10
Totals $1,787,965 0.0009 $1,691.90
TABLE 3
Estimate of Extra Interest Costs Due to Harsh Ratings
Source: S&