Bond Insurers: We Still Have a Future

Bond insurance executives yesterday argued that their product should still have a role in the future of the municipal market, saying it provides value beyond just the guaranteeing of interest and principal payments in the event of default.

Executives from Financial Security Assurance Inc. and Ambac Assurance Corp.'s Everspan Financial Guarantee Corp. told market participants gathered at the Securities Industry and Financial Market Association's Municipal Bond Summit in New York that bond insurance also helps create enhanced liquidity for bonds and adds credit surveillance, among other benefits. They say that it will still make sense for smaller, lesser-known issuers and lower-rated credits to purchase bond insurance in the future.

"Is credit enhancement the municipal bond market's eight-track tape?" asked FSA president and chief operating officer Sean McCarthy. "I don't think so."

Bond insurance penetration has plummeted as most of the industry's legacy insurers have seen their formerly triple-A ratings downgraded. Just 12.5% of new issues came to the market with insurance through May 31, compared to a peak of 57.1% of new issues in 2005, according to Thomson Reuters.

Everspan chief executive officer Douglas Renfield-Miller said the downturn in penetration rates has had more to do with the lack of available capacity than a contraction in demand. Letters of credit filled some of the gap last year, but their use has fallen this year as there are fewer banks rated highly enough to provide them and prices have jumped for the remaining providers.

Renfield-Miller also pointed out that while municipal default rates have been low, they don't reflect situations where the bond insurers may have helped work out a solution to avoid an actual default to the investors. In addition, those default studies may not be a sufficient representation of how municipal issuers will be affected by pressures they will face based under current economic conditions.

"People need to be cognizant that while municipal bonds have been very risk-free historically, one can not predict that in the future," he said.

But Colin MacNaught, assistant state treasurer for debt management for Massachusetts, presented a much more grim outlook for the bond insurance industry, questioning its value to the municipal market. He said investors and issuers feel they didn't get their money's worth from insurance they bought in the past, and that his sense is that credit enhancement will be unnecessary for issuers rated single-A and better in the future.

Much of the need for bond insurance comes from rating scales that have rated municipal credits lower than corporate credits with comparable or worse rates of default, MacNaught noted. Bond insurers made money arbitraging the differences between their triple-A ratings and the artificially lower municipal ratings.

"With all due respect, it seems like a bit of alchemy," he said.

Issuers will use bond insurance if it saves money, but MacNaught says he hasn't heard any real demand for it from investors. Massachusetts has not considered using bond insurance recently, even though when he took his position with the state last year it had outstanding debt guaranteed by each of the seven insurers that were all once rated triple-A.

Without bond insurers to homogenize credits, investors will have to do more careful analysis of underlying credits and issuers will need to improve their investor relations and disclosure efforts. For smaller issuers and lower-rated credits, a pooling system or bond banks may make sense.

Cityview Capital Solutions LLC managing director Matthew Roggenburg said that although the diversification into other markets such as structured finance has led to some "disastrous results" for some bond insurers, their core municipal books have performed well. As bond insurers return to that core business, the widening credit spreads can produce attractive premium rates for insurers.

But the insurers face challenges moving forward, he said. The lack of any legal covenant requiring bond insurers to maintain a rating, the non-refundable, full upfront premium payment structure, and the uncertainty of whether bond insurers will be able to have high enough leverage ratios to earn sufficient returns for private-equity investors present challenges for new and existing insurers, Roggenburg said.

Moody's Investors Service managing director Gail Sussman reiterated comments her agency made last year that a municipal-only insurer would face difficulty attaining a triple-A rating. Franchise values are "extremely sensitive" to risk profiles, she said, and the market has learned that even a small downgrade can have big impact on a bond insurer's future business prospects.

While insurers have been a historical mainstay, issuers have other options, according to Sussman said. Letters of credit, state pension funds, bond banks and pooling efforts are all possibilities for increasing support for issuers trying to gain market access.

With the market in flux, it's difficult to know where insurance penetration rates will ultimately end up, Sussman said. Issuers will use insurance if it helps their bonds price and saves them money.

"At the end of the day ... it's going be the investor's voice that ends up speaking," she said. "Bond insurance - or any kind of credit enhancement - makes sense for the issuer if the math works."

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