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Quantitative Or Qualitative Analysis?

The question: What works best when evaluating the credit risk of local and regional governments?

The answer: Combining both approaches to avoid missing some important trends

Today’s market for local and regional governments is increasingly complex. Fiscal imbalances, slower tax revenue growth, and increased spending on social services have contributed to a challenging economic landscape.[1] With bankruptcy situations like Puerto Rico and Detroit still fresh on people’s minds, this is raising concerns for issuers, intermediaries, and investors alike, calling for an in-depth approach to credit analysis that considers a wide variety of factors.

A 360-degree look at credit risk

Our U.S. State and Local Government and Non-U.S. Local and Regional Probability of Default (PD) Scorecards for assessing the creditworthiness of public finance-level debt issuers takes a deep look at seven important risk dimensions:

  • Institutional framework
  • Economy
  • Financial management
  • Liquidity
  • Budgetary performance
  • Budgetary flexibility
  • Debt and contingent liabilities

Bob introduces these seven important risk dimensions in this three minute video.

Bob_Durante

How does it work? Each risk dimension is assigned a weight,[2] with all seven weights totaling 100%. A range of factors are evaluated for each dimension, and seven scores are created. The weighted average of the scores calculates a PD expressed as a numerical score between 1 (“strong”) and 10 (“weak”).

"Overriding factors” are considered, which can adjust the numerical score up or down. For example, the decentralized and autonomous nature of local governments creates a strong link between management and credit quality. As a result, a score that suggests limited or weak management for cities or counties could lower the score, plus limit its maximum value. The final score is broadly aligned with the S&P Global Ratings’ scale or to your own internal credit rating system, with an associated PD estimate.

Five important qualitative factors

Quantitative factors play an important role in creating each score—but that isn’t enough for local and regional governments. Our approach takes into account five important qualitative factors that can have an upward or downward effect on the score: 

  1. Depth and diversity of the economic base: Personal income and the unemployment level are good historical indicators of a local economy’s stability, but the structure of employment can point to its vulnerability to economic and business cycles, as well as its competitive characteristics and growth prospects. Evaluating how broad and diverse an employer base is can help determine the ability to weather economic ups and downs.

  2. Organizational and financial flexibility: While limits on revenue flexibility are almost universal, many local governments have some discretion on expenditures. For example, management teams usually have a degree of choice over the starting of pay/go capital projects and can make budget cuts, especially for non-essential items. If a local government has a high degree of financial flexibility it’s more likely to be in a position to relieve financial stress when needed, and vice versa.

  3. Budgetary performance: Just as a diversity of area employers can smooth out the local business cycle, a diversity of revenue sources can smooth out a local government’s budgetary performance. Assessing revenue sources can help reveal potential cyclical volatility.

  4. Expected financial improvement or deterioration: The current fiscal balance of a government is an important indicator of budgetary performance, but future credit quality also needs to look at the years ahead. Actions or events after the date of the measure, such as new budgets or budget amendments featuring approved revenue or expenditure adjustments, can suggest more positive future results.
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    Conversely, uncertainty associated with governments facing increased volatility in revenues can cloud the outlook.

  5. Unaddressed exposure to large unfunded pension obligations: In today’s environment, it’s critical to look at unaddressed exposure to large unfunded pension or other retirement benefit obligations. This could lead to accelerating payment obligations over the medium term that represent significant budget pressure. 

Combining quantitative and qualitative factors based on in-depth market knowledge, forward-looking analyses, and a transparent scoring framework is essential to fully understand possible credit risks with local and regional governments.

For more information on how you can leverage our U.S. State and Local Government and Non-U.S. Local and Regional PD Scorecards and associated workflow tools, please request a demo.

[1] “Fiscal Resilience Among U.S. States Varies As Economic Expansion Surpasses Seven-Year Mark”, S&P Global Ratings, August 2016.

[2] The weights used for the risk dimensions for cities and counties are replicated from the Criteria: “U.S. Local Governments General Obligation Ratings: Methodology and Assumptions”, published by S&P Global Ratings on September 12, 2013. The weights used for the risk dimensions for states are replicated from the Criteria: “U.S. State Ratings Methodology”, published by S&P Global Ratings on October 17, 2016. The weights used for the risk dimensions for school districts are based on expert judgement.

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