March 12 (Bloomberg) -- U.S. Representative Barney Frank gave ratings companies a month to fix standards applied to state and local government debt that are burdening taxpayers with unfair costs.

``I don't think this is a situation we can tolerate,'' Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, said at a hearing in Washington on municipal ratings, bond insurance and rising debt costs for local governments. ``If this doesn't get corrected, we will have to intervene.''

More than a dozen states, cities and public agencies led by California and Connecticut are calling for Standard & Poor's, Moody's Investors Service, and Fitch Ratings to change a system they say costs taxpayers by exaggerating the risk that municipal issuers will default on their debts.

Every state except Louisiana would be AAA if measured by the scale used for corporate borrowers, according to research by Moody's. Scrapping the municipal scale might save California $5 billion in debt costs on $61 billion of voter-approved debt the state plans to sell over the next 30 years, according to state Treasurer Bill Lockyer.

``The rating agencies have two scales,'' said Frank, during the second of two hearings on the municipal market since bond insurer downgrades in January pushed higher the variable interest rates many cities and towns pay. ``This is not a minor, technical matter because schools, highways, sewers are now costing the public more.''

Rising Rates

Frank's committee took testimony on how states, local governments and other tax-exempt borrowers, which have $2.6 trillion of debt outstanding, are being hurt by the crisis in confidence in U.S. financial markets. The interest costs on auction-rate securities, a type of debt used by municipalities, have almost doubled since January and investors have also demanded higher yields on tax-exempt bonds backed by insurers that are struggling to maintain their own credit ratings.

``The bad investments they have made have dragged down the value of the municipal issuers and cost money for people who want to build schools and roads,'' Frank said in a Bloomberg Television interview today before convening the hearing.

Lockyer at the hearing asked Congress to pressure the rating companies to change their system. Also testifying were Ajit Jain, the chairman of Berkshire Hathaway Assurance Corp., Laura Levenstein, a senior managing director for Moody's, and New York's superintendent of insurance, Eric Dinallo.

``I am not proposing that every municipality be rated AAA, but that the criteria be the same as for corporations,'' Dinallo said at the hearings. ``It should be judged by the same standard, not a dual standard.''

`Secret Tax'

Connecticut Attorney General Richard Blumenthal called the extra costs caused by the municipal ratings scale a ``secret tax'' on cities, states and school districts.

Because ratings are typically lower on the municipal scale, local governments have paid insurance companies to back their bonds with AAA ratings, seeking to reduce borrowers' costs. With insurers' ratings under pressure because of losses on mortgage debts, states, cities and hospitals have faced higher interest costs on floating-rate bonds backed by the guarantors.

The average rate for bonds whose interest is set at weekly auctions rose to 6.73 percent on March 5, up from 3.80 percent two months ago, according to an index compiled by the Securities Industry and Financial Markets Association.

Global Scale

Moody's plans to allow municipal issuers to request a corporate-equivalent rating for their tax-exempt bonds starting in May, Levenstein said. The so-called global scale ratings currently are only available on taxable bonds, and for an extra fee. Frank today called that extra cost ``abusive.''

``I find that unacceptable to charge them double,'' Frank said. ``We will legislate against that.''

Wilbur Ross, the chairman of New York-based WL Ross & Co., known for his bets on distressed companies, said in an interview today on Bloomberg Television that rating services aren't too strict in the way they assess state and local debt.

``If there was ever a wrong time to be more lenient on rating them, it is right now,'' said Ross, citing revenue shortfalls and underfunded pensions at states and cities.

The risk of guaranteeing municipal debt is increasing because the economy is slowing, said Jain, head of the new bond insurance company set up by Warren Buffett's Berkshire Hathaway Inc. Fiscal stress in Vallejo, California, and Jefferson County, Alabama, may be the ``tip of the iceberg,'' he said.

Widening Deficits

Twenty-one states face budget deficits in fiscal 2009, including 16 that are short at least a combined $30 billion, according to the Washington-based Center on Budget and Policy Priorities.

Frank, in the Bloomberg Television interview, said the federal government might consider offering guarantees against default to municipal borrowers for a ``very, very small percentage.''

``I guarantee that it will never cost much,'' he said. ``The insurance business was so profitable because you are insuring an entity where you almost never have to pay out.''

Historic values in the municipal market led Ross to buy $1 billion of bonds last week. He also recently committed $750 million of capital to Assured Guaranty Ltd., parent of one of two bond insurers that continue doing business in the primary market because of their stable AAA ratings.

While large issuers such as California can go without insurance, the guarantees give smaller, more infrequent municipal borrowers access to capital markets, Ross said.

`No Liquidity'

``The average municipal bond issue is $33 million and has no liquidity in the aftermarket,'' he said. ``Unless there is a guarantee of insurance, no one will buy it because no one has time to analyze $33 million of issuance.''

Michael Capuano, a Democrat committee member and former mayor of Somerville, Massachusetts, said a system that assigned the same rating to a city and a corporation, even though the company was 43 times more likely to default, was not defensible.

``Stop sticking it to us because you can,'' Capuano said.

Congressman Emanuel Cleaver, a former mayor of Kansas City, asked Moody's Levenstein for a refund of the city's rating fees.

Levenstein told the committee that the municipal scale, in use since the 1920s, is intended to provide investors with a ``relative ranking'' of municipalities.

To contact the reporter on this story: Christine Richard in New York at Crichard5@bloomberg.net; Michael McDonald in Boston at Mmcdonald10@bloomberg.net.

Last Updated: March 12, 2008 19:12 EDT