Municipal Bond Insurance - Then and Now
By Stan Provus
Since late 2007, the municipal bond insurance industry has been unstable as a result of their loss exposure to collateralized debt obligations (CDO’s) and related concerns. Many questions exist regarding the value and utility of bond insurance and how this industry will reinvent itself after the turmoil is resolved. This article provides an overview of bond insurance prior to its decline, how bond insurance is being used now and what might be expected in the future.
Bond Insurance: Then
Financial guaranty insurance for tax-exempt bond issues is one of the oldest, if not the oldest, form of third party credit support or security for municipal bonds. Over the last two decades, the municipal bond insurance industry has experienced exceptional growth. In 1980, only about five percent of new municipal bonds were insured. By 1984, their market share had increased to about 20 percent, and it was up to 46 percent in 2007 before the decline in December. The use of bond insurance by issuers has been driven by several factors, including:
Issuers mainly use bond insurance because it reduces their borrowing cost. In fact, IRS regulations require computations that show the cost of bond insurance (premiums paid upfront, 5-15 basis points) is cost-effective in reducing an issuer’s borrowing cost. Cost effectiveness can be determined by looking at present value calculations under different interest rate assumptions, with and without insurance.
Simply stated, the bond insurance company insures the bondholder. In the event that a bond defaults or the underlying credit/issuer does not pay the debt service on a bond, the bond insurer pays the principal and interest. In most cases, a bond insurer will continue to make debt service payments to bondholders over the life of the issue. It is important to note that this is different from a letter of credit provider, who typically calls the bonds and pays off bondholders when borrowers default or do not reimburse Letters of Credit (LOC) draws to pay debt service.
In addition, bond insurance supports both variable rate and fixed rate bonds, while LOC’s secure variable rate bonds because they are not written to provide coverage over the life of the issue and, therefore, have to be renewed periodically. Issuers of Variable Rate Demand Obligation (VRDO) bonds, however, do enter into fixed rate interest rate swaps to access synthetic fixed rates.
In the past, AAA-rated insurers largely underwrote municipal issues with a “minimal loss claims” expectation. Historically, these insurers chose very low risk general obligation and essential service bonds, typically municipal activities such as water and sewer projects, because the underlying issuer was very unlikely to default. The overwhelming majority of issues that are insured are investment grade (BBB or better) or near investment grade on a stand-alone (uninsured) basis. For this reason, very few, if any, qualified small issues for manufacturers have ever been credit enhanced by the bond insurers because the IDB borrowers are often closely held smaller firms that do not have a rating.
To date, losses incurred by the bond insurers on tax-exempt bonds have been minimal because the loss rates on these types of bonds have historically been extremely low. From 1970-2000, the average credit loss rates on Moody’s-rated municipal bonds have been extremely low—lower than the loss rate on AAA-rated corporate bonds. Over this period, among thousands of issues, there were only 18 long-term bond defaults. The ten-year cumulative default rates for all Moody’s-rated municipal bond issues have been 0.0420 percent versus 0.6750 percent for AAA-rated corporate bonds (Special Comment, Moody’s US Municipal Bond Rating Scale, November 2002).
Because of the disparity of the default rates between municipal and corporate bonds, many observers think the process for rating these bonds is unfair. In a commentary in The Bond Buyer, Jon Fiebach, managing director at Duration Capital, highlighted this point saying: “It seems strange that double-A corporate debt is money market eligible, while single-A municipal is not (SEC rule 2a-7), even though the cumulative default rate for double-A corporate debt is approximately 10 times that of single-A municipal debt.” In effect, he argued for a more equal playing field between corporate and municipal bonds so that bonds across all asset classes would be rated using the same structure.
More recently, Bill Lockyer, California State Treasurer, among other public officials, has been a strong advocate for establishing a global equivalent rating scale. Many issuers would likely be upgraded if such a system was established, and the need for bond insurance could decline among higher rated issuers. A global equivalent scale would blend existing municipal and corporate rating scales.
Bond Insurance: Now
For the past twenty years, the bond insurance business has been simple, profitable with scale, and has generally helped issuers save money by lowering interest rates. However, because of the large losses that the bond insurers have incurred due to CDOs, the long-term viability of the bond insurance industry has come into question.
Most bond insurers have been downgraded, and their losses on CDO’s could reach $50 billion. While some bond insurers have raised additional capital to help maintain their ratings, the rating agencies continue to examine the adequacy of the bond insurer’s reserves given the mounting CDO losses.
There is an excellent article on a typical CDO issue at http://money.cnn.com/2007/10/15/markets/junk_mortgages.fortune/index.htm. While CDOs vary in terms of structure and underlying assets such as subprime mortgages or commercial loans, a CDO is a corporate entity, called a Special Purpose Vehicle, structured to hold assets as collateral and to sell the cash flows from these assets to investors. The Special Purpose Vehicle buys assets like subprime mortgages or mortgage backed securities and then issues various classes of bonds called tranches. The tranches are pieces of all the assets that have different security and yield features. For example, some investors may choose AAA-rated tranches with a lower yield than BBB rated tranches. As a result of the turmoil in the bond insurance industry and downgrades of a number of insurers, many of the CDO tranches that were sold as AAA-rated investments are now rated BBB or lower.
The market has reacted by disregarding the bond insurance secured by troubled insurers and, instead, only considers the underlying rating of the issuer/conduit borrower. Essentially, the market is giving no value to the credit enhancement provided by some bond insurers.
This volatility has critically wounded the auction-rate security (ARS) market, where most bonds are credit enhanced by the bond insurers. This $330 billion market has witnessed many failed auctions in recent months and issuers are scrambling to convert their ARS to Variable Rate Demand Obligation (VRDO) bonds or other interest rate modes. When auctions fail and ARS investors can not sell their bonds, issuers, for the most part, are required to pay above market interest rates stipulated by formula in the bond documents.
Auction rates continue to rise relative to VRDO bonds, and the gap, or spread, between the two is at historic highs. In the past very little, if any, spread existed. The following chart illustrates recent spreads.
- Bond insurance gives smaller issuers access to the market on better terms and can be cheaper than getting a rating
- Bond insurance largely takes away the “story bond” features of complex issues since bondholders focus primarily on the bond insurance and not the underlying issue/credit
- The growth of AAA-rated bond insurers
- Bond insurance is attractive to retail investors
- Periodic flights to quality
- An increase in the number of issues eligible for insurance
- Bond insurance is usually a cost-effective product
- The development and growth of auction-rate securities, many of which are secured by bond insurance
- The use of bond insurance for liquidity facilities.
*Municipal Market Data Index for these dates (http://www.sifma.net/story.asp?id=1882)
**SIFMA Swap Index rate for these dates (http://www.sifma.net/swapdata.html)
The use of bond insurance has continued its decline from a year ago. According to The Bond Buyer (April 1, 2008 article by Dakin Cambell) there were 225 new issues totaling $9.8 billion that had bond insurance in March of 2008 compared to 550 issues totaling $19.7 billion in March of 2007. This is a decline of some 50.3%. Obviously, while the use of bond insurance by issuers has declined, it nevertheless is still being used. Today, there are now three bond insurers with AAA financial strength ratings, for both primary and secondary bond markets, and stable outlooks from at least two rating agencies—Assured Guaranty Corporation, Financial Security Assurance, and, most recently, Berkshire Hathaway Assurance Corporation.
Bond Insurance: The Future
The bond insurers are trying to address the challenges the markets have presented. The insurers can increase their capital by securing additional equity investments from banks or other corporations, or they can consider reinsurance. According to the Association of Financial Guaranty Insurers (http://www.afgi.org), “reinsurance expands the capacity of the bond insurers and helps individual insurers manage single and aggregate risks in their portfolios. Approximately 18 percent of bond insurance in force has been reinsured. Monoline reinsurance companies provide about half of the reinsurance. Multiline companies provide the rest.”
The rating agencies recognize reinsurance as a type of alterative to primary capital. The bond insurers must have sufficient capital plus a cushion to absorb possible losses calculated by the rating agencies using somewhat complex assumptions and cash flow projections grounded on the types of credits they insure. While reinsurance “treaties” vary, most provide for some type of stop loss insurance coverage that says if the primary insurer sustains losses up to X, the reinsurer will provide additional coverage up to X.
New bond insurers are also emerging. Warren Buffet created a new monoline insurance company, Berkshire Hathaway Assurance Corporation (BHAC), which focuses exclusively on municipal bonds. The state insurance commissioners are simplifying the approval process for Berkshire in all 50 states under a new pilot program, because insurance regulators, particularly in New York, are searching for immediate solutions for bond insurance in their states.
While there has been some talk in Congress about providing some type of backstop insurance for the bond insurers, this is an unlikely scenario, particularly in light of the subprime mortgage crisis and need for federal assistance. Breaking up the monoline bond insurers into two parts—municipal and structured products, is something some of the state insurance regulators have suggested. Breakups, however, would undoubtedly cause numerous lawsuits. This course is also not very realistic. The most likely outcome is that new monoline bond insurers will develop, like Berkshire, if some of the existing insurers that need more capital are unable to raise it. Since the subprime crisis triggered the bond insurance turmoil, the municipal market has begun to recover with new issue volume rising substantially in March—third busiest ever, and long rates coming down from their highs of just a few months ago.
While bond insurance may not return to its market dominance, where over 50 percent of municipal bonds were insured, it certainly will remain a strong presence filling the needs of small issuers, story book bond issuers and others.
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