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Richmond, Virginia

*®m mm

October, 1940

viewpoints on municipal credit«

One of the first questions which comes to mind in connection
with the classification of securities in bank: examinations is what do
we mean by a Group 1 classification*

Or perhaps the question can best

be stated negatively, what does a Group 1 classification not imply?
A group 1 security is a bond which can be expected to ride through a
considerable amount of financial trouble without default*

The fin­

ancial position and income of the issuer are such that, in our opinion,
interest and principal requirements can be met according to the terms
of the contract, in spite of depression or other financial difficulties,
Group 2 securities on the other hand are either in immediate danger of
default or without an adequate margin of protection.

Lack of good

faith on the part of an issuer casts a shadow which makes a Group 2
classification necessary*

W© do not think Group 1 securities are

riskless, but we do believe they have a margin of protection ample to
carry them, through all but the most serious financial storms.

Group 2

securities will not necessarily default, but the margin of protection
is inadequate*




We should make it clear to everyone that a Group 1
classification is definitely sot a recommendation on our part*


is nothing quite so fallacious or dangerous as the sale® argument
used by some that a given bond is a safe investment and a good buy
because bank examiners put it in Group 1» or because the F. D* I* C.
has passed upon it for of course we never pass on anything*

I have

nev r heard anyone in the bank supervisory agencies even intimate
that he considered all bonds classified in Group 1 -as* safe investments,
and I am sure we all know of bonds now being placed in Group 1 which
we would not think of recommending*

In view of the fact that we are spending three half days
discussing evidences of weakness in municipal bonds, it seems wise at
this point to reaffirm our belief that municipal obligations as a class
are high grade investments*
has been excellent*

Their record over the past half century
Defaults have been relatively few sad recoveries

in quite a number of instances hare been excellent*


considered, it is doubtless fortunate that many basks haw® confined
their purchases of bonds, other than U. S. Governments, to municipals
because their record as a class is considerably better than the run of
corporates acquired by basks*



furthermore, it should be clearly understood that w© have
no particular apprehension at the moment about the future of municipals*
Municipal debt has remained relatively stable in the last decade, and
it is a pleasure to note that many local officials are giving thoughtful
consideration to the important problems of finance*
Since the general situation is so good, some questions may
be asked as to why we should be giving so much consideration to
municipal bonds at this time*

While the volume of defaults has been

small compared with the volume outstanding, defaults have been common
enough to make Investors cautious*

In certain classes of municipal

bonds, such as irrigation, drainage and special assessments, the percentage
of defaults has been extremely large, and in some cases the losses have
been substantial*

Consideration should also be given to the fact that

municipal governments are being affected by the profound economic changes
which are occurring throughout the whole world*

Some situations are

changing for the better, while the outlook for some cities is definitely
less good than it was.

In other words, it is important that a careful

credit analysis be made before a municipal bond is purchased.

When one

thinks about the matter, it seems incredible that bankers otherwise regarded
as prudent would risk substantial sums by purchasing large blocks of
municipals about which they know nothing except that someone said they
were good

Moreover, the proper time to consider the credit quality
of a class of assets Is when conditions on the whole are satisfactory
so that adjustments when desirable can be made without upsetting the
entire market*

Incidentally, an important by-product of our consideration

of municipal bonds will doubtless be an improved market for the obli­
gations of s d f i i the less well-known but soundly financed municipalities*

The analysis of municipal credits is a subject which, until
very recently, has attracted little attention.

Sxoellent books have

been written about corporation finance and analysis of corporate
securities, but there is no published book on the analysis of municipal

Until very recently the limited material on municipals

obligations has dealt almost exclusively with the legal aspects of the

The reason for this seems to have been the general feeling

that taxes could be increased if necessary, and that a municipal
obligation was therefore safe if it were legal.

Though this may have

been true in the past it cannot be counted upon now*

Local governments

have assumed new and expensive responsibilities and taxes have been
increased so much that there is reason to question the ability of local
governments to continue this process indefinitely.

Thus, while there

is general agreement on the necessity for determining that m issue
is legal, we think this should be only the beginning of the investigation.




Bònft let my long memorandum and Mr. Wayne *s six page form
frighten you*

Municipal credits are very similar to other credits and

your experience with notes and discounts provides & useful background*
Also, you are already familiar with some of the material requested in
the form*

X know, because I have been able to find much of the

information needed on economic background in reports of examination*
The analysis of a municipal obligation is not as formidable a task as
the size ©f the form and memorandum would indicate*

The Uniform Credit File outlines the information we would
like to have in analyzing municipal obligations, but we must recognize
that it is often necessary to get along with much less*

When the

information is incomplete, the only thing we can do is to make the best
classification possible, resolving all doubt® against the municipality*
There is no reason why bankers should not be required to support their
municipal bonds with adequate credit filMs when the information is not
otherwise readily available.

It should be made clear to everyone that

we will not place a bond in Group 1 on the basis of mere hearsay*



For purposes of classification, it is not necessary in most
instances to prepare as complete an analysis as is necessary when a
bcmd is being considered for purchase*

It 1® doubtful if all the

questions on this rather lengthy list which has been distributed are
important in any particular case,

Superficial investigation sometimes

reveals weaknesses so clearly that a detailed analysis becomes

It is only in borderline cases that it is imperative to

study the situation thoroughly.

The case of the investor, however, is

It is not prudent to purchase municipal obligations without

a rather definite idea concerning all of the important questions raised
in these discussions.

Those of you who have followed the various revisions of my
memorandum have doubtless noted a shift in point of view.


months ago I accepted the popular view that municipal obligations
were a type of credit all to themselves and that it was necessary to
develop new principles of analysis.

Am our work progressed and more

material came over my desk, I slowly changed my mind, and today I
believe the general concepts of credit analysis which you use every
day in analyzing business credit should be applied, with appropriate
adjustments, to the analysis of municipal credits.


The ability to pay is the all important consideration, both

in corporate and municipal obligations*

Any debt is high when debt

service absorbs a large proportion of total income*

Due notice must,

of course, be taken of the possibility of increasing income If necessary#
If taxes are low, the income of a unit can, in all probability, be
increased by raising the tax rate, and if public utility rates are
unusually low, there is the possibility of Increasing them*


only significant difference is that taxes can be raised somewhat more
easily than utility rates*

In one of the loose chapters which have

been distributed, you will find what is, as far as X know, the first
attempt to adept to the analysis of municipal credit the concept of
coverage so universally used in analyzing corporate bonds*

Will you

please read this chapter critically and give me the benefit of your

I would appreciate it, if you will annotate your copy

and return it to me*

On© of the most misunderstood topics in finance is the
proper type of maturity schedule*

In the early days of corporation

finane®, the accepted principle was to have the entire bond issue
mature two generations hence, or, if this were not possible, at least
one generation away*

A whole volume of literature grew up justifying

perpetual debt on the grounds that constant maintenance would keep a
property efficient indefinitely*

Ho one seriously questioned the

assumption that the public would always want the services provided by
the property#

Today the only refutation needed to that doctrine Is

to point to the traction companies and the railroads#

The popular

theory of level debt service is only a little better#

The typical

schedule calls for small maturities in the early years when interest
costs are high and larger maturities in the later years as the principal
has been reduced and interest costs become less#

The only good thing

to be said about this is that it is better to pay off a little on the
principal than not to pay anything#



What is a reasonable maturity schedule?

In my judgment, the

only sound maturity schedule is one which combines cost of maintenance
and debt service, so that the total declines as the property grows older.
In the early years when the property is new, efficiency is highest, and
repairs are light, bond maturities should b© heavy, and as the need
for maintenance increases debt service should decline.

Since obsolescence

makes old properties, even those in good repair, less desirable than
new properties, the total of debt service and maintenance should decline.
The rapidity with which this total should fall o ff depends, of course,
upon the type of property, but I fail to see how one can question the
general principle that debt service plus maintenance should decline a®
the properties grow older.

The latest style in maturity schedules which

provide for serial maturities over periods as long as sixty years with
a balloon maturity at the end is absurd.
which were constructed in 1880?

How useful are most properties

Is it not true that with very few

exception® such value as these properties possess is due to extensive
repairs mad© rather recently?



The us« of revenue bonds, or quasi~municipals as they are
sometimes called, Is increasing so rapidly that It seems wise to
sketch sota© of the problems involved in their classification*
type of financing, when properly used, is sound*


Some of the earlier

projects were well set up and can be expected to pay out, but as so
often happens in finance, when a type of security becomes popular,
new projects are promoted which are not as sound as the earlier ones*
Revenue bonds, you will remember, are not supported by the taxing
power and must stand on the earnings of the project alone.

There are

many serious engineering problems involved in constructing a sound
public utility plant and I have heard rumors that, in isolated instances
at least, the plants were not designed by competent engineers.


the question as to whether the area can support the new utility is one
which should be carefully considered before making commitments*

The prospectuses of the new enterprises usually carry an
estimated income account for the next sixty years and almost Invariably
these estimates show ® nice coverage*

In many instance®, such coverage

is predicated upon high rates and low cost of operation.
failure to use prudent business judgment•

This shows a

Even though a project has a

monopoly in an area, there is reason to question its ability to collect,
year after year, rates substantially above those charged in neighboring

I am afraid of utilities (public and private) -«hose financial

success rests upon a high rat© structure*
in forecasting costs of operation*

Conservatism is also needed

Although it is true that capital

costs are a large percentage of the total costs of a utility* regular
operating expenses are considerable* and should not be underestimated*
There la a temptation in particular, to under-estimate the costs of

In spite of the example of the irrigation projects of the

last generation, which were wrecked because of the failure to provide
for ample maintenance, many revenue projects today make a negligible
allowance for this item*

It is a good guess that all of thee# publicly

owned projects will need a considerable amount of repairs before they are

25 years old and very few will escape at least on© unforeseen contingency
In that time*

The most foolish talk of all centers around the amount of
coverage necessary to make a revenue bond safe*

One banker gar© a

speech last Spring at a bond conference in which he stated that a
coverage of one was sufficient for revenue bonds.

What would you do

with a note of a maker who was barely earning interest?
a question is to answer it*
satisfactory investments*

To ask such

The obligations of such a maker are not

There is no good reason for demanding lower

credit standards for publicly owned revenue projects than for comparable
private utilities




W© now com© to our most serious criticism of revenue financing.
In tli© corporate fieldt lip service Is being given to the propositions
that corporate structures ought to be simple and that many corporation©
need more equity capital.

At the very same time, an incredibly

complicated system of Government finance is developing by the use of
authorities and overlapping districts.

One® these entities have been

created| simplification can be accomplished only at groat inconvenience
and expense.

It Is just assumed nowadays that a local government should

bond for tbs full cost of an improvement*

In fact, it is current

practice to arrange temporary financing so that any unexpected costs
can be included in the bond issue.

Sine© a large percentage of the special revenue bonds are
excellent investments, we cannot arbitrarily classify them all In
Group 2, but I hope that we will be able in tbs near future to give
serious study to this entire problem.

In the meantime, wherever there

is reason for doubt, revenue bonds should be classified In Group 7, on
the basis of low coverage, or lack of an established earning® record.
This leaves the question of what to do about the cases where estimates
of earnings do not appear reasonable.
basis ©f an adjusted schedule?

Should we try to analyse on the

I think not.

It would consume a large

amount of time and besides we do not have the Information to work out
a reasonable schedule.
record of earnings.

My suggested answer is Group 2 «— no established