The death of muni bond insurance

Joe Mysak of Bloomberg thinks that the muni bond insurance market died with the onerous requirement placed by Moody's, as outlined in their report The Changing Business of Financial Guaranty Insurance (Nov 20 2008).

Municipal bond insurance, which at one time covered more than 50 percent of the bonds sold by states and localities in the U.S., died last week at age 37.

The death was confirmed by Moody’s Investors Service in a research report titled “The Changing Business of Financial Guaranty Insurance,” published on Nov. 20. Municipal bond insurance had been in failing health since March 2007, after short-seller William Ackman questioned the business practices at MBIA Inc., then the biggest insurer.

“To achieve a stand-alone rating of Aaa, a municipal-only financial guarantor would need to demonstrate competitive advantages that allow it to generate consistently strong underwriting results, maintain its financial health and defend against encroachment upon its franchise,” Moody’s said, observing that it would be “quite challenging” for such an entity to survive.

Born in 1971 when the American Municipal Bond Assurance Corp. insured a $600,000 general obligation bond issue by Greater Juneau Borough, Alaska, municipal bond insurance spent its early years marred by extreme skepticism on the part of old bond men, who doubted the need for such a product. Even in 1981, a full decade after the sale of the first policy, insurance covered only 5 percent of the municipal bonds sold annually.

It is quite possible that the past leaders, MBIA and Ambac, may be permanently sidelined. I hope that isn't the case for my sake but they are in a big hole and survival is the name of the game for them. The question is what happens to the current leader, Assured Guaranty, as well as the market outside North America.

I have a suspicion that bond insurance is going rise up from the ashes in a decade. There is so much uncertainty over the CDS market, which is a distant relative of bond insurance, that the market will start to demand more formalized bond insurance. Although investors such as Warren Buffett have downplayed concerns about the CDS market, primarily because it is a zero-sum game, I have my doubts. The monoline bond insurers have problems even though they had capital (turned out to be inadequate for some of them) backing the contracts. In contrast, everyone and their dog have been writing CDS, which is unregulated, and who knows what is actually backing up their contracts. It was so bad that even AIG, the largest insurance company on earth (if I'm not mistaken) and a company that actually has billions of excess capital, didn't have enough money to post collateral as required by their contracts. If the US government didn't drop money from helicopters on top of AIG, you would have seen a massive dislocation in the CDS market. Now, think about all those non-insurance companies writing CDS contracts, such as hedge funds and investment banks. How many of them have the capital to back up their contract?


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