Real Estate Lender Implosion

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Do Bond Insurers Need CPR?

Fears of a muni market meltdown may be overblown

February 6, 2008
by Matthew Goldstein

Just a few months ago, bond insurers blended into the background of Wall Street. Now, as the credit crisis plays out, MBIA (MBI), Ambac (ABK), and others that guaranteed subprime bonds are at the center of the drama. Vultures and hedge funds are circling their shares. Credit rating agencies are contemplating downgrades. And New York State Insurance Superintendent Eric R. Dinallo is feverishly searching for deep-pocketed investors to fund a bailout, making it seem as if the health of the U.S. financial system depends on it.

The fears, though, may be overblown. Certainly, if an insurer loses its vaunted AAA rating there will be fallout. The industry guarantees $800 billion in asset-backed securities, such as those troublesome collateralized debt obligations (CDOs), and more importantly, $1.5 trillion in municipal debt. But Wall Street has already taken billions in writedowns on risky subprime securities that insurers agreed to cover in the case of default. And given all the problems, insurers won't cover those fancy finance products anymore. Meanwhile, the muni markets, which state and local governments depend on to fund new roads and schools, are more resilient than regulators believe.

Plenty to Fill the Void
In fact, insurance on municipal bonds didn't exist before the mid-1970s. And the concept only caught fire after the 1994 bankruptcy filing of Orange County, Calif. Ever since, bond insurance has largely been used by local governments to put nervous investors at ease about the risk of defaults. By buying such protection, state and local governments, in effect, piggyback on the top-level ratings of bond insurers and thereby raise their own grades. For example, with insurance, tiny Chemung County in upstate New York can boost its normally low investment-grade rating to AAA—attracting big investors and lowering the interest rate it pays.

But critics, including some government officials, say a big chunk of muni bonds don't need coverage. Most large cities and states already have top grades from the rating agencies. Some 84% of the muni-bond insurance MBIA sold was purchased by cities with either an A or AA rating. And the risk of default by a municipality is minuscule. Even battered Orange County paid back its debts. So bond insurers, which collect some $2.3 billion a year in premiums from munis, have rarely shelled out a claim payment. "It's something of an artificial construct that so many munis have to be insured," says Frank Hoadley, Wisconsin's director of capital finance. "By and large, the decision is made by the investor." Adds Matt Fabian, managing director of research firm Municipal Market Advisors: "It's not about credit quality. It's just a bureaucratic cost municipal issuers have to pay."

If dominant players such as MBIA and Ambac are permanently sidelined by the credit turbulence, there seem to be plenty of others ready to fill the void for places like Chemung County. Warren E. Buffett, for one, decided to start his own muni bond insurance operation. And Dexia, a European bank, is pumping $500 million of new capital into its bond insurer, Financial Security Assurance, which has emerged relatively unscathed from the mortgage mess. That fresh backing has allowed FSA to capitalize on the problems of its peers. On Jan. 24, Chemung County tapped FSA to guarantee a $3.9 million offering after its previous insurer, Financial Guaranty Insurance (FGIC), was downgraded to AA. Since the summer, FSA has doubled its share of muni bond insurance, to 50%.

There's no doubt the fragility of the insurers has caused some disruptions. In January, muni bond issuance fell 48% from a year ago, to $16 billion, the worst month since September, 2001. Only about a third of the bonds had insurance, vs. the usual 50%. Prices for some municipal bonds remain unstable because the guarantees are in question. That dislocation has also helped roil the market for so-called auction-rate securities used by local governments and others to raise $250 billion in short-term financing.

Little Bailout Support
New York's Dinallo, a former prosecutor and architect of the 2003 Wall Street research settlement, will have to move fast to save the biggest insurers. The credit ratings of several, including FGIC and ACA Financial Services, have already been slashed. And on Jan. 18, Fitch Ratings downgraded Ambac to AA. Analysts says it's only a matter of time before Moody's Investors Service (MCO) and Standard & Poor's (MHP) lower the grades of Ambac and MBIA, which plans to raise $750 million to protect its rating. If the two are downgraded, the game is pretty much over for them, since munis are only interested in buying AAA protection. "Once a firm is downgraded to AA, it's hard for them to do any more muni business," says Fabian.

So far, though, New York's insurance chief is having a tough time finding support for a bailout of companies that, in part, got themselves into this mess by branching out into risky securities they had no experience insuring. Investments banks would seem to be natural backers of a rescue. If the ratings on insurers drop, guarantees on another chunk of risky debt could disappear, forcing more write-offs. Last month, Merrill Lynch (MER) took a $2.6 billion hit from exposure to CDOs after the ratings on ACA and others slumped.

But banks have been preemptively slashing the values on their subprime-linked securities, figuring many of those guarantees won't materialize. And unless the ratings of Ambac and MBIA fall several notches to junk status, the additional losses for big banks would total between $30 billion and $40 billion. It's not an insignificant sum. But it's still far less than the $100 billion in writedowns Wall Street has already taken. As a result, many banks may be calculating that any losses they suffer could be less than the tens of billions Dinallo is demanding to prop up Ambac and MBIA.

Investors, then, may have to brace for more pain, though it's not likely to be crippling. "A bailout is not going to happen," says Robert B. Lamb, a professor at New York University's Stern School of Business. "The downgrades are inevitable, and investors will have to take losses."

http://www.businessweek.com/magazine/content/08_07/b4071020418218_page_1.htm