S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Moral Obligation BondsMoral Obligation BondsMoral obligation debt differs from other debtobligations in that there is no legal requirementto make debt-service payments. A moral obligationpledge represents a promise by a governmentobligor to seek future appropriations for debt servicepayments, typically in order to make up deficitsin a reserve fund should it fall below its requiredlevel. Usually a government official will request anappropriation and the legislative body may grant it.In practice, moral obligation debt is customarilyissued by the following municipal entities:■ State governments wishing to enhance the creditworthinessof their agencies’ revenue indebtedness;■ State bond banks that lend bond money to localmunicipal subdivisions for infrastructure projects;and■ Local units for financing projects, ranging fromdowntown redevelopment, to job training, topublic housing.Standard & Poor’s Ratings Services criteria formoral obligation debt are strict, and all requirementsmust be met to achieve a rating based on theobligor. Moral obligation bonds are typically ratedone full category below an issuer’s GO bond rating.Rating MethodologyIn rating any moral obligation bonds, Standard &Poor’s expects a standard structure to be in place:■ A reserve fund, funded at maximum annual debtservice at the time of issue, either by proceeds orother available moneys;■ Language in the resolution (local) or statutes(state) that outlines the duty and process of monitoringthis fund and notifying an appropriateofficial in the event the money in the reserve fundfalls below the required level. Such notificationmust be made in a timely manner as to meet thebudgetary requirements of that government;■ A requirement that the appropriate budgetaryofficial request an appropriation to return thereserve fund to its maximum debt-servicerequired level whenever there is a draw on thatfund; and■ Language that provides the appropriate bodyof elected officials the option to make suchan appropriation.In assigning a rating, Standard & Poor’s not onlywill verify that this structure is in place, but willevaluate the essentiality of the financing’s purposeto the issuer. The legislative history will be evaluated—howimportant it is to ongoing operations, andhow motivated the issuer would be to live up to itsmoral obligation, even if it comes under politicalpressure to allocate scarce resources in other ways.The government must also:■ Represent that it fully intends to satisfy futuremoral obligation payments; and■ Provide evidence of legislation authorizing the projector program being financed, also detailing therequirements with respect to deficiency payments.Most bond issues supported by a moral obligationpledge are structured to be fixed rate instrumentswith a debt service reserve sized to maximumannual debt service. In some instances, bonds havebeen issued in a variable rate mode, which suggestssome unique credit concerns and issues. Since variablerate debt payments may fluctuate over timegiven changing interest rates, the appropriate sizingof the debt service reserve is an issue.In order for Standard & Poor’s to base the ratingof such debt on the moral obligation pledge ofthe government obligor, one solution is to set thedebt service reserve at the maximum allowableinterest rate or cap rate under the transaction.Such a solution would eliminate the concern thatin a rising interest rate environment the debt servicereserve would not be sufficient to cover a fullyear of debt service. Another method of resolvingthis issue is to increase the times that a request toreplenish a debt service reserve that has beendrawn upon is made. This would require the abilityof the government obligor’s appropriate budgetaryofficial to seek interim appropriations fromthe elected officials. Sufficient time must be presentfor those elected officials to meet and react tosuch a request. The timing of these events must bewritten into the appropriate documents supportingthe bonds.In general, moral obligation bonds are included inan issuer’s debt ratio if the underlying non-moralobligation security stream is not self-supporting onits own. Similar to appropriation-backed debt, amoral obligation bond default could result in adowngrade of a state or local government’s GO rat-www.standardandpoors.com111