On Friday, I said that there's a strong case to be made for the existence of municipal bond insurance, "since these bonds are generally bought by retail investors who can't be expected to do sophisticated credit analysis". Commenter efranco then asked a good question: what happens if and when the municipalities start getting triple-A ratings, as Moody's has indicated is going to happen? Bloomberg's Michael McDonald says there's a good chance that demand for bond insurance will plunge, and even the insurers seem to agree:
"If rating agencies level the playing field in terms of how they rate municipal versus corporate obligations, there will be little need for a financial guaranty insurance marketplace as we know it,'' Ajit Jain, head of Warren Buffett's Berkshire Hathaway Assurance Corp., said at a congressional hearing in March.
If this is true, then there shouldn't be a market for bond insurance. Bond insurance, if there's any point to it at all, is an insurance product, not a ratings enhancer: issuers buy it because investors are reassured by it, and can sleep safely at night in the knowledge that their bond coupons will be paid in full and on time - by someone.
After all, there's a world of difference between a credit rating, on the one hand - which is simply an opinion regarding probabilities - and a monoline wrap, on the other - which is a hard-cash guarantee that you'll get your money back.
And these days the money-back guarantee should be even more valuable than a triple-A rating than it was in the past, seeing as how the ratings agencies seem to have been very good at handing out triple-A ratings where they weren't deserved.
But there's a problem, of course. If you thought banks and hedge funds got highly leveraged, just wait until you look at insurance companies, whose claims-paying abilities are a minuscule fraction of their total potential claims. If municipalities for some reason started behaving a bit like the housing market and all defaulted at once, no monoline, not even Berkshire Hathaway (BRK.A), could come up with the money it needed.
So municipal bond insurance is insurance against any given municipality defaulting; it's much weaker as insurance against municipalities in general facing enormous difficulties which end up forcing them into default.
All the same, it's a useful thing to have, for one big reason: the monolines are much more involved and engaged in municipal finances than the ratings agencies are. When a municipality goes to a monoline to be wrapped, the monoline will make certain demands, similar to covenants on loans, which actively make the municipality more creditworthy. And if the municipality still ends up running into fiscal difficulties, the monoline has both the ability and the desire to step in early and force actions to avert default. Ratings agencies, by contrast, can do none of that, and certainly don't keep a close eye on municipalities after they've been rated, if they're not issuing anything new.
Municipal defaults are often caused by treasurers getting out of their depth in terms of derivatives they don't understand (Orange County, Jefferson County). If the deal with the monoline precludes such activity, then the county's bonds will become that much less risky. So it's a useful thing for investors to have.
On the other hand, if municipal bond insurance is really just a ratings arbitrage masquerading as an insurance product, then it deserves to die.
The irony here is that municipalities are finally getting their long-coveted triple-A ratings just as those ratings have never been less valuable. Maybe investors, used to having a contractual guarantee of repayment, rather than just a ratings-agency stamp of approval, will continue to pay a premium for wrapped bonds, even if the municipality in question has a triple-A rating. But in order for that to happen, they're going to need to rekindle their faith in the monolines first.
This article has 7 comments:
Arvanitis
When bond "insurance" was more of a service to muni issuers, like title insurance for example, it may have been worth a few bps.
When bond insurers began to take all the credit risk for half the credit spread in corporates, that was the end.