As we have mentioned before, one of the dirty secrets of the bond insurance business was that the original product, municipal bond insurance, was as close as you could get to free money. States and municipalities never defaulted on principal, so the most an insurer would pay would be a few interest payments. That turned out not to be a big enough business for the bond insurers, who then branched out into areas that involved bona fide risk assumption, as they are now learning to their dismay.
A Bloomberg story tells us that investors and issuers appear to be wising up as to the negligible benefit of municipal bond guarantees. Another reason for issuers to sell more uninsured bonds is that the cost of insurance has gone up considerably, calling its value into question. This development is another negative for bond insurers, since it forecloses the option of them retreating to their original business.
From Bloomberg:
State and local borrowers are discovering that buying municipal bond insurance from MBIA Inc. and Ambac Financial Group Inc. is a waste of money.
Wisconsin sold $154.6 million of general obligation bonds last month at interest rates usually available only to borrowers with the highest credit ratings. Wall Street firms didn’t require the state to insure the bonds, even though Wisconsin is graded four levels below AAA, amid signs that bond guarantors may lose their own top rankings.
“Either the Street or investors didn’t see the underlying value of the insurance,” Frank Hoadley, Wisconsin’s director of capital finance, said in an interview.
Wisconsin, California, New York City and about 300 other municipal issuers sold bonds without buying insurance in recent weeks, avoiding premiums that are as high as half a percentage point of the bond issue, according to data compiled by Bloomberg. The amount of insured bonds sold fell about 15 percent in November from a year earlier, according to Thomson Financial figures cited in the Bond Buyer, an industry trade publication.
Municipal issuers paid an annual average of $1.99 billion in premiums over the past five years to gain the AAA ratings granted by insurers on $1.86 trillion of interest and principal payments, Standard & Poor’s says.
States and local governments with investment-grade ratings default on less than 1 percent of their debt because they can raise taxes and fees, according to a March report by Moody’s Investors Service. They may be better credit risks than their ratings indicate.
“Taxpayers give insurers $2 billion a year because of a dual-rating scale,” said Matt Fabian, senior analyst and managing director of Municipal Market Advisors, an independent municipal bond research firm in Concord, Massachusetts. “You could easily save taxpayers that $2 billion by rating them on the same scale as corporate bonds.”
States and cities will reduce the amount of debt they insure to as little as 35 percent of total borrowings in the first half of 2008, according to a Dec. 13 report by New York- based Bear Stearns Cos. That’s down from more than 50 percent over the past five years, based on Thomson data.
“Most people are looking at the underlying ratings,” Steven Shachat, who invests $1.2 billion for Alpine Woods Capital Investors in Purchase, New York. Issuers “are absolutely re-evaluating the importance of insurance,” he said.
The cost of protecting debt issued by bond insurers MBIA, FGIC Corp. and XL Capital Assurance Inc. against nonpayment using credit-default swaps rose more than fourfold over the past four months because of their guarantees of debt tied to subprime mortgages, according to CMA Datavision in London…..
Many investment-grade munis would have AAA ratings without insurance if they were ranked the same way as corporate debt. Every state except Louisiana would be Aaa, based on the scale for companies, which ranks borrowers on the probability of default, according to the report by Moody’s.
Municipal issuers are ranked on their fiscal health relative to other municipalities. Investors’ increased willingness to buy state and local government debt without guarantees suggests that borrowers may not require the backing of insurance companies.
“We have already begun to notice investors getting more comfortable with the primary payer and a willingness to forgo insurance for AA tax-backed credits,” Bear Stearns said in its Dec. 13 report….
When Wisconsin sold $154.6 million of bonds for highways, public buildings and water improvements on Nov. 15, it paid a yield of 3.87 percent for debt due in 2016. The same day, insured Wisconsin bonds sold in October with a similar maturity yielded 4 percent in the secondary market where existing issues trade.
“What insurers add is less valuable than it used to be,” said Philip Fischer, a municipal bond strategist with New York- based Merrill, in an interview.
Evidence of the waning value of insurance can be found in the shrinking yield gap, or spread, between insured and uninsured bonds. The spread between A rated uninsured bonds and top-ranked insured bonds has narrowed to 0.10 percentage point, or 10 basis points, from 20 basis points earlier in the year, Fischer said.
Municipal bond insurance is different from other guaranty businesses because while property-and-casualty insurers know they will suffer losses on some of their policies, bond insurers try to write policies they can be confident won’t result in any losses.
“The bond insurers are only insuring bonds they consider to be AAA,” according to a Nov. 9 report by Merrill.
California decided against insuring $1 billion of borrowings last month because of doubts about whether bond insurance provides any value, said Tom Dresslar, spokesman for California State Treasurer Bill Lockyer.
“It didn’t make sense,” said Dressler. California, the largest borrower in the municipal market, insured 23 percent of the $12.1 billion of general obligation bonds it sold this year, including the November offering.
New York City, the largest borrower among U.S. cities, decided in November to sell $100 million of uninsured variable- rate demand obligations instead of auction-rate securities, which are usually insured. The city sold the bonds Dec. 4.
Central Puget Sound Regional Transit Authority, located in Seattle, sold half of a $450 million bond offering in November without backing from a financial guarantor. Some investors said they didn’t want the insurance because of doubts raised about the insurers’ ability to pay and maintain ratings, said Tracy Butler, treasurer of the transit system.
The AA rated agency, also known as Sound Transit, insured only those maturities where the guarantee cut its borrowing costs. Sound Transit paid about 4 basis points, or 0.04 percentage point, more in interest over the life of the debt in the maturities it sold without guarantees, said Butler. After deducting the premium, its total cost was no more than it would have been with insurance, Butler said.
“Cost was one factor,” Butler said. “This is a market we have never seen before and there were some investors who just did not want insurance bonds.”
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My guess is that ,when this mess is contained, at least three business models will disappear:
1) Bond insurance except in special conditions
2) Off balance sheet SIVs
3) CDO’s and other tranched instruments
So some in the muni market seem to be preparing for the demise of an insurer by convincing themselves that the insurance has always been worthless. Ergo prices shouldn’t fall and borrowing shouldn’t be constrained. Interesting psychological mechanism.
The history of munis is not quite as pretty as the BB article suggests. When WPPS blew up in the early 80’s, MBIA covered the bonds ($2.3B if I remember). Good thing, because the ensuing zillion-party litigation went on for years and involved the largest document production in history. Before Orange County went bankrupt in ’94, it had a AAA rating and issued uninsured bonds. I seem to recall (I’m old) that a) there was significant political support in OC for repudiating the debt; b) bondholders discovered that a muni cannot be compelled to raise taxes in a Ch. 9 proceeding; c) the ensuing panic in the muni market affected rates and liquidity for quite some time, with prices of some CA issues plunging 30%. The state rigged up a clever bailout and the bondholders were eventually made whole. Insurance became quite popular. If you go back further to ’30-’33, you’ll find that in times of severe economic stress, munis have political risk reminiscent of developing country debt. I doubt that equilibrium pricing of munis if a major insurer suddenly disappears will be the smooth transition to small yield captures implied by the BB article.
Steve,
I am also old enough to remember WPPSS, and I Googled pretty extensively before making my comments. I’ve seen no evidence that any of the WPPSS deals were insured in a large scale way (the only one is Ambac insuring $25 million in face value, to which I found multiple references. How there was an oddball piece of that size in a multibillion deal is beyond me).
WPPSS also wasn’t a classic muni deal, guaranteed by tax revenues, but by the revenues from power generation. It was basically an industrial revenue bond deal. My dim recollection is those weren’t typically credit enhanced, at least in the early 1980s (no idea re current practice).
WPPSS also eventually paid 40 cents on the dollar, or less, depending on the bond issue, after all the litigation, again inconsistent with the a guarantee (if one performed that poorly when tested, it would be valued much less going forward).
This story on the final settlement makes no mention of insurance or guarantors. I looked at quite a few others and similarly found no reference.
It was Ambac, not MBIA, that was exposed, and not the the degree you suggested. In fact, this history says the failure of WPPSS gave the industry a huge boost:
In 1983, the Washington Public Power Supply System (WPPSS) defaulted on its debtpayments, and investors holding uninsured WPPSS bonds experienced a host of delays and reductions in payments, while holders of insured bonds received interest payments in full, on schedule. The WPPSS default was a turning point in the municipal market, as it made clear to a broad swathe of the market how beneficial bond insurance could be in a distressedsituation. Given the increased visibility due to the WPPSS crisis, by the end of 1983, 10% of newly issued municipal bonds were insured.
Feel free to show me otherwise, but I have gone hunting, and have found no evidence that anything beyond a trivial amount of WPPSS bonds was insured.
Yves,
You are correct, the insurer on WPPSS was Ambac and only for a tiny portion of the bonds. Sorry for the misinformation. But I think the losses on WPPSS strengthen my point that muni bond insurance was demanded by investors for good reason. WPPSS debt was muni debt, issued by a municipal corporation of Washington State—there are tons of municipal corporations that issue debt against specific non-tax revenue cashflows (bridges, hospitals, water systems, affordable housing, etc.) So I don’t think WPPSS was in any way unusual in the muni world, except for its size and default.