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Bond insurer exits put municipalities in a bind

Some experts foresee permanent decline in market penetration

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Many municipalities and other governmental entities are struggling to bring their bond issues to market given that only one AAA-rated municipal bond insurer remains in the United States, observers say.

Although there are several efforts under way to launch new municipal bond insurers, no one is sure how successful they will be (see story below).

Even if they succeed, there is a general consensus that the insured portion of the municipal bond insurance market never again will reach the 57% penetration it achieved at its height five years ago.

Previously, AAA-rated monoline municipal bond insurers conferred their own ratings on lower-rated municipal issues, which permitted the municipalities to pay lower interest rates. This more than offset the cost of the insurance.

The first municipal bond insurer, American Municipal Bond Assurance Corp., now AMBAC Financial Corp., began operations in 1971. Other insurers that followed included Municipal Bond Investors Assurance Corp., now MBIA Inc.; FGIC Corp.; and Assured Guaranty Ltd.

For a long period, municipal bond insurers thrived.

“One percent of the municipal bonds actually default, and they were enjoying 50% market penetration in terms of the new bonds being issued, so from that perspective, it was a pretty good deal,” said Dwight V. Denison, associate professor of public and nonprofit finance at the University of Kentucky in Lexington.

But in the 1990s, the insurers began to diversify away from the “plain vanilla” municipal bonds into structured financial products, including subprime home mortgages, experts say. Then the credit crisis hit in late 2007 and rating agencies began to downgrade municipal bond insurers.

Assured Guaranty Ltd., which has units rated AAA by a single rating agency, Standard & Poor's Corp., now is the only municipal bond insurer still actively writing new business, observers say. The Bermuda-based insurer, which acquired competitor Financial Security Assurance Holdings Ltd. last July, was less heavily involved in the structured market than its competitors.

About 9% of the municipal bond market is insured today compared with 57% at the business' height in 2005, observers say.

Municipalities, particularly smaller ones that infrequently come to market, have suffered as a result, observers say.

“They're basically just doing without,” said Richard Larkin, director of credit analysis at Herbert J. Sims & Co., a Southport, Conn.-based investment banking and brokerage firm.

“It's had a drastic impact on our program,” said Robert Lautenberg, managing director of the Richmond-based Virginia Municipal League/Virginia Assn. of Counties Finance. Mr. Lautenberg's association pools local governments' projects and then issues bonds.

In the past, municipal bond insurance allowed the Virginia governmental agencies to put different credits into one pool. “The bond insurance brought everyone up to the same level,” with the local governments sharing the insurance's cost, Mr. Lautenberg said.

The bonds traded better because they were part of a larger bond issue, but “now that's not really possible because of the lack of bond insurance,” Mr. Lautenberg said.

Eric Johansen, debt manager for the city of Portland, Ore., said most of the city's debt is rated AA or higher and bond insurance is not needed. However, certain bonds issued in urban development projects are rated A and “historically have benefited from having bond insurance available.” Its absence has led to higher borrowing costs for the city, Mr. Johansen said.

In addition, Portland has been unable to obtain surety bonds it previously purchased from municipal bond insurers, said Mr. Johansen.

“It's had a huge impact down here” in Florida, particularly among small- and medium-size municipalities, said Craig Hunter, public finance director for the Tallahassee-based Florida League of Cities.

“There is a meaningful portion of the municipal market that is not being served right now,” said Rodney A. Clark, an S&P analyst.

Mark Young, a principal at Gardner, Underwood & Bacon L.L.C., a Los Angeles-based public finance advisory firm, said some municipal bond issuers have not been able to access the bond insurance market at affordable interest rates. Others have issued bonds, but at “significantly higher rates than they would otherwise have paid” had there been more bond insurers, he said.

There are few viable alternatives aside from doing without bond insurance, observers say.

“There has been a limited amount of credit enactment available in the form of letters of credit from banks, but banks have tightened credit standards” and these letters of credit have “really diminished to a fairly small component of the market,” Mr. Clark said.

Meanwhile, Assured Guaranty is charging high rates and being highly selective, observers say.

Assured “knows the value of their guarantee” and has priced it appropriately, Mr. Young said.

“They're getting significant profitability on what's being issued today,” Mr. Clark said.

Sean McCarthy, Assured Guaranty's chief operating officer, responded to the pricing comments in a statement: “Our premiums have been consistent over the past two years. While we are the only active bond insurance market, we compete against alternative executions.”

Mr. Clark said if participants now in development enter the market in the near term, “then it is likely, we think, that the insured municipal issuance will increase, but it is difficult to say by quite how much.”

“We think the equilibrium is somewhere between” the 57% it reached in 2005 “and the 10% or so it is today, but it's difficult to say where the equilibrium will be, and a lot depends on the strength of the potential new insurers and how quickly they are able to launch,” Mr. Clark said.

Mr. Young said the market has become bifurcated, with large AA-rated entities not finding significant value in insured bonds. However, there will continue to be a market for insurance for lower-rated, smaller, infrequent issuers “where the insurance will, in fact, be a proxy for credit review” by the investor.

“I do not see a return” to a market where more than half is insured. Instead, there will be a 25% to 30% penetration accounted for by the smaller entities, Mr. Young said.

There also is the possibility the situation will remain essentially as it is today.

“One potential alternative is, the longer the period of time that persists with the market being underserved, the more the issuers and investors learn to go without bond insurance,” Mr. Clark said. “In that scenario, we could have a really long-term condition where very little municipal (bond) issuance is actually insured.”