Insurers’ Obit Could Be Premature
As 2009 draws to a close, the outlook for the municipal bond insurance market is looking uncertain.
Insured bonds reached a peak of 57.1% of new issuance in 2005, but as most insurers were downgraded after they unsuccessfully ventured into the hazardous territory of structured finance, that number dwindled to just 8.7% this month, according to Thomson Reuters.
However, the one company still writing new insurance believes the market is far from dead. Assured Guaranty Ltd. — parent of Assured Guaranty Corp. and Assured Guaranty Municipal Corp., formerly Financial Security Assurance — believes the insured portion of new issuance will more than triple in the next five years to eventually become a third of the issuance pie.
They are not alone. Other companies are working to enter the market, vowing to stay within the confines of public finance and reiterating the mantra that they will insure only investment-grade debt.
One example is Municipal and Infrastructure Assurance Corp., an insurance neophyte backed by Macquarie Group and Citadel Investment Group. MIAC has recently received financial strength ratings but has not released the information to the public yet, according to vice chairman Richard Kolman. He said the company plans to enter the market in the first quarter of 2010, backed by capital “multiples above” statutory requirements.
Other possible entrants are former players in the game tired of sitting on the bench.
MBIA Inc. — which saw its portfolio implode and company stock tumble by more than 94% from January 2007 owing to its backing of mortgage-related structured finance bonds — has created a public finance-only entity, National Public Finance Guarantee Corp., with hopes to begin writing new policies “sometime in 2010,” according to spokesman Kevin Brown.
Ambac Assurance Corp., which currently is at risk of having its stock delisted by the New York Stock Exchange, also attempted to reenter the market with a new public finance subsidiary earlier this year, but it was unable to raise enough capital for the restructuring. More recently, the company warned that it may have to file for bankruptcy protection as liquidity could dry up by mid-2011. Ambac declined to comment for this article.
Financial Guaranty Insurance Co., once the fourth-most active bond insurer, was suspended by New York state regulators in late November from paying claims until it repaired its tattered balance sheet. The company, which did not return calls for comment, has until Jan. 5 to submit a “surplus restoration plan.” Meantime, most of their public finance business has been reinsured by NPFG.
For all potential players, the lure of the market is clear. To start with, the risk is relatively small. Moody’s Investors Service data from 1970 to 2006 show the historical default rate of investment-grade municipal bonds — rated Baa or higher — was just 0.07% over a 10-year horizon, compared with 2.09% for corporate debt. Secondly, insurance can be a triple-win situation for all parties in the transaction. The insurer earns a premium for wrapping the credit, the lender gains the security of timely payments, and the borrower saves money by entering the market at a lower yield.
And it shouldn’t be forgotten that none of the fallen insurers left the market because of events within the public finance market. It was tasting the toxic flavors of structured finance that fatally compromised them.
Still, a number of analysts have doubts that the market for municipal bond insurance can be revived. After all, the low default rates that attract insurers are also a reason why borrowers can skip out on insurance altogether.
Michael Pietronico, chief executive officer of New York-based Miller Tabak Asset Management, predicts that the insured market “will continue to dwindle as a percentage of outstanding debt” as investors will prefer to purchase bonds based primarily on the underlying credit.
“When you’re contemplating, as an issuer, buying insurance, the first assumption would be that it would lower borrowing costs, but we haven’t seen any indication that insurance — in the primary or the secondary market — lowers borrowing costs,” he said.
“If anything, the case can be made that it raises borrowing costs, because investors are trying to diversify away from insurers,” Pietronico said. “So it becomes a situation of why would you be looking at it in the first place, as an issuer, when you could borrow, on your own merits, at an overall lower interest rate without it?”
The argument is borne out by recent market data. A prime reason to buy insurance is that it pushes down yields and saves the borrower money, yet despite heightened default concerns in the wake of a massive, global financial crisis, uninsured bonds are coming to market at historically low yields.
In mid-December 2006 — well before the credit crisis — the triple-A scale in 10 years was at 3.64%, according to Municipal Market Data. Today, a world where about 90% of the muni market is uninsured, similar bonds come to market at just 2.88%.
It would seem that a market without insurance is certainly viable, just as it was before the product was introduced in 1971 by the American Municipal Bond Assurance Corporation, or Ambac.
But responding to claims that the insurance market has a much-diminished future, Dominic Frederico, chief executive officer of Assured Guaranty Ltd., has a pretty simple reply.
“If there are naysayers, I would say, 'Okay, then: explain my third quarter,’ ” he told investors in a conference call last month.
Assured, which operates the only two legacy insurers to have made it through the recession with investment-grade ratings, saw operating earnings — excluding net-realized investment gains and losses — jump to $70 million last quarter, compared to $26 million in the third quarter of 2008.
“With all sorts of issues hanging over our heads, we still had a very strong production quarter,” Frederico added. “As a matter of fact ... for the combined companies, it will be the greatest year on record for municipal production save for 2008.”
The implications of that likely go far beyond earnings projections for next year, he said. But who, exactly, is buying insurance, and why?
NOT SO SWEET SPOTS
For issuers rated triple-B and below, the desirability of insurance is clear.
Data from Thomson Reuters show that in January 2007, months before the credit crisis, the spread between 10-year triple-B rated credits and insured bonds was around 25 basis points. As of this week, that spread is now 142 basis points, indicating that lower-graded credits entering the market without insurance are paying a hefty penalty.
“The problem is, if it turns out that those are the only sectors where bond insurance is going to be in demand, bond insurers are going to have a problem,” said Richard Larkin, director of credit analysis at Herbert J. Sims & Co., an investment banking firm headquartered in Southport, Conn.
He noted that the issuers in most need of insurance are those that do have risk behind them, such as hospitals, nursing homes, private colleges and senior living facilities. But if insurers are only involved in those sectors they won’t be able to build up capital and receive high ratings, even though Moody’s default rate on Baa-bonds averaged just 0.13% on a 10-year timeline between 1970 and 2006.
Small surprise, then, that in the third quarter of 2009 Assured wrote insurance on 340 issues, but no more than 20 credits, or less than 6%, were rated triple-B or lower by Standard & Poor’s or Moody’s. And according to Assured’s third-quarter investor presentation, standards are being tightened.
Similarly, MIAC only plans to “insure investment-grade municipal credits,” and executives at NPFG have said the “sweet spot” is the single-A range.
In Larkin’s view, the insurers will only put a large footprint into the triple-B market if much of their portfolio stems from backing general obligation, utility, and education bonds.
But that looks to be a bygone era. For each year in the 2004-2007 period, over 40% of MBIA-insured U.S. public finance debt was double-A rated or higher. But in the final month of 2009, credits with double-A ratings currently come to market at a yield 52 basis points lower than an insured bond, according to Thomson Reuters.
“The market has basically bifurcated and said they will support [double-A] credits at levels where, basically, insurance would make no sense,” said Mark Young, a principal at Gardner, Underwood & Bacon LLC, an independent public finance advisory firm. “I really don’t see those types of issuers and credits needing bond insurance going forward.”
Larkin added:“I think the bond insurers and the rating agencies killed the goose that laid the golden egg when they got messed up in structured finance.”
Even so, Young called it reasonable to assume that insurance could, within five years, absorb up to 30% of total new issuance based on the needs from smaller, lower-rated issuers.
“I think there’s always going to be some market for the lower underlying rated and less frequent issuer,” he said. “It would surprise me if that part of the market wouldn’t always have some benefit from the insurers.”
Indeed, small-scale, single-A issuers are a target market for insurers.
According to Assured’s record of primary market deals for the third quarter, 75% of issues rated by Standard & Poor’s wereA, while 19% were AA. Of the credits rated by Moody’s, 83% were A and 4% were Aa.
At first glance, the concentration on single-A credits seems to make little sense for the issuer, at least in terms of saving on borrowing costs in the market.
For a 10-year bond issued in late December, the yield improvement between an insured credit versus an uninsured single-A rated issuance was only 16 basis points, according to MMD. So the market gain from wrapping bonds is relatively insignificant in that range — the compression of yields and the low absolute levels means the savings might not justify paying an insurance premium.
However, those numbers miss the fact that many single-A, small-scale issuers cannot actually come to market at the single-A scale, according to Nicholas Sourbis, managing director of NPFG.
Many issuers would like to issue debt in that range but there are too many credits for investors to keep track of, he said, so even with high ratings “a lack of familiarity among investors normally results in wider credit spreads.”
That’s where insurance comes in. Beyond lowering yields, Sourbis said what bond insurance does is create “a distinguishing characteristic” that can “improve the security’s liquidity in the market.”
Aside from anecdotes, confirming that many small-scale issuers are unable to enter the market is a bit tricky, but in 2006 the average single-A or lower-rated deal in the primary market was $29.0 million, according to Thomson Reuters. By contrast, through Dec. 15 this year the average deal was $50.9 million, which could imply that smaller-scale borrowers are indeed having difficulty entering the market.
The target deal for insurers going forward, Sourbis said, is roughly in the $17 million to $25 million range, compared with MBIA’s average deal size of $38 million in 2006 and 2007.
“Almost regardless of their rating,” he continued, “issuers with less name recognition will likely always be interested in utilizing bond insurance.”
If so, the future of bond insurance could be quite bright. While only about 5% of the new issuance market is rated triple-B or below, according to Thomson Reuters, issuers rated single-A and below make up about 25% of issuance, which gives plenty of room for the insurance industry to grow.
THE POSITIVE OUTLOOK
Several other factors could help bond insurers blossom. One of them is if leverage returns to the municipal market. Leveraged investors, who use borrowed money to invest — for example, with tender option programs — helped commoditize muni bonds earlier in the decade, according to Matt Fabian, senior analyst at Municipal Market Advisors.
“The current class of investors who are buying bonds value insurance a lot less than they used to, like the mutual funds or the separately managed account guys,” he said. But “when you have more of a leveraged based investor … those people may rely on [insurance].”
With more reliance on leverage, investors may want an easy way to purchase bonds in bulk without performing meticulous research on each credit. Before the financial crisis, when insurers had triple-A ratings, investors often ignored the underlying ratings of issuers under the assumption that insurance acted like a credit substitution.
Fabian said it would be a mistake to return to that style of thinking, but added that markets have short memories.
“People won’t, like they did before, completely disregard the underlying rating, but if the rating agencies can come to grips with putting high, stable ratings on the bond insurers, then over time, the over-reliance on the underlying rating will begin to fade away,” Fabian said. “So long as insurance could provide a higher or more stable rating, then people will buy it.”
Executives from Assured, however, said the future of the business is not in any way dependent on whether leverage returns to the market. Of more significance is greater recognition that insurers provide more than just a guarantee of remediation in the case of default.
Sean McCarthy, Assured’s chief operating officer, said the insurers also analyze risk, structure products, and perform constant surveillance for the full term of the bond.
“Our view would be that municipal credits are going to be under greater stress in 2010 and 2011 than 2009, and the benefits we provide in addition to our guarantee are our surveillance and proactive remediation to fix problems even before they occur,” he said.
Similarly, NPFG’s Sourbis said that when an issue is close to defaulting, an insurer can speak with one voice on behalf of the investors rather than have “dozens or even hundreds of different investors” try to get the issuer back on track.
One recent example where insurers have stepped in was in mid-November when the Rolling Meadows Park District in Cook County, Ill., was unable to make a $300,000 debt service payment on a $4.46 million issuance from 2004. NPFG, which last year reinsured the debt originally secured by FGIC, acted to make sure investors were paid on time while the district waited for property taxes to flow in.
Another factor that could boost the outlook for insurance is, quite simply, the successful entry of competitors.
“Obviously, there [are] not many industries of one, so we would not at all be opposed to seeing competition,” Assured’s Frederico told investors last month. He said the market “is attractive enough to bring in new players and we would expect to see them start to emerge hopefully sometime in 2010.”
In fact, the market has already seen how new competition can help. When billionaire investor Warren Buffett opted in with the creation of Berkshire Hathaway Assurance Corp. in early 2008, regulators expedited the company’s licensing process to help tame turmoil in the market.
Since then the stabilization impact has been minimal, as Berkshire — rated AAA by Standard & Poor’s — has not insured any municipal securities in the primary market since mid-April, according to Thomson Reuters. The company did not return calls for comment.
In a recent interview Frederico said that, given the risks for municipalities emerging from the financial crisis, insurers able to receive ratings and enter the market should see high demand.
“When credit issues are paramount, spreads gap out, and we then become the method of choice to put an issuance out to the marketplace,” he said.
MIAC’s Kolman said it is already clear that the market is indicating a preference for corporate bonds, which highlights the need for municipal insurance to play a role in lowering yields.
A recent research note from JPMorgan, for instance, shows that the spread between taxable municipal issues and corporate bonds rated triple-B widened to more than 125 basis points in December, compared with less than 80 basis points three months before. The spread for single-A issues widened about 15 basis points in that same period.
“With the decline in revenues and tax receipts as well as falling property values, I think there’s a feeling that it’s going to take longer for state and local issuers to come out of this recession, which puts a premium on the need for insurance, particularly for mid- to small-size issuers in the A-rated category,” Kolman said.
ABSENCE OF ALTERNATIVES
Another factor in favor of an optimistic scenario is simply the lack of credit-enhancement alternatives.
When multiple insurers experienced grave difficulties in late 2007 and 2008 — including MBIA, Ambac, Financial Security Insurance, FGIC, Radian Asset Assurance Inc., Syncora Guarantee Inc., CIFG Assurance NA and ACA Financial Guaranty Corp. — it looked as though letters of credit might fill the void.
Use of LOCs, a guarantee of payment usually issued by a commercial bank on behalf of the borrower, rose by more than 240% to an all-time high of $71.5 billion in 2008, covering nearly one-fifth of the market compared with just $20.7 billion in 2007.
But through Nov. 30 this year LOC enhancements fell 74% to $18.7 billion — about 5% of the market, according to Thomson Reuters.
“LOC banks have not demonstrated an ability, or at least a willingness, to pick up where bond insurance left off,” said Thomas McLoughlin, chief executive officer of NPFG.
Other potential alternatives to an entirely private insurance market have included a proposal from the National League of Cities to establish a bond insurer funded by the U.S. Treasury. Another idea, floated by Denver-based financial consulting firm HRF Associates LLC, was for $25 billion of TARP funds to be used to create a public-private insurer.
Also, in a move aimed to increase the capacity of private insurers, Rep. Barney Frank, chairman of the House Financial Services Committee, drafted legislation to provide $250 billion in federal reinsurance for new credi- enhanced muni bonds over five years.
In recent months though, none of these proposals have gained much traction, and according to Fabian they are unlikely to ever advance beyond the drafting stage.
“I think the government’s interest in intervening in our market is abating,” he said. “I don’t see them interested in funding up the National League of Cities, I don’t see them funding up another private insurer or providing guarantees themselves.”
THE NEGATIVE OUTLOOK
One scenario that could hurt the potential for bond insurers to grow their market share is if rating agencies introduce global-scale ratings — the effort to recalibrate muni ratings to a scale that is uniform across asset classes.
Supporters of the scale argue that if muni ratings were in line with corporate sector ratings, municipal credit quality grades would rise due to their lower default risks. Higher ratings on municipal debt, relative to corporate debt, would be expected to lower the cost of borrowing for municipal issuers, thereby reducing the need for insurance.
“If a lot of triple-B and single-A issuers now start getting rated double-A and possibly triple-A, you can make the case: what does the bond insurance give you?” Sims’ Larkin said.
“I thought over a year ago that if the rating agencies seriously went to these global scale ratings, that ultimately could be the final nail in the coffin for bond insurers,” he added. “I think that’s going to come, I just don’t know when.”
Still, executives at NPFG aren’t too concerned about the ratings scale, noting that the idea has been around for five years with little tangible development.
And even if a global scale is implemented, the market could be more confused than enthused, according to McLoughlin.
“If everybody’s a double-A, what’s a double-A?” he said, noting that the market has never been in that position. “Is this going to make it harder or easier for investors?”
Moody’s said in March 2007 it was implementing a global scale but plans were postponed with the onset of the financial crisis. Earlier this month, the agency said it was back on track to recalibrate the scale, adding that guidelines could be issued as early as next quarter.
Fitch Ratings also postponed implementation plans last year and more recently has said it continues to review the municipal rating framework. Meanwhile, Standard & Poor’s maintains that is already uses a uniform scale.
A more immediate concern for the insurance market is Build America Bonds, the popular taxable program which, under the Obama administration’s American Recovery and Reinvestment Act, gives a 35% subsidy to qualified offerings.
Since BABs hit the market in late March $64 billion has been sold, accounting for 15.8% of all issuance this year and more than one-fifth of deals since the program’s inception. To put that into perspective, $64 billion is almost double the $35.3 billion of debt insured in the primary market through Dec. 22, according to Thomson Reuters.
The popularity of BABs, which to date have sold largely without insurance, poses three problems for insurers. One, the subsidy allows BABs to come to market at higher yields, which can be attractive enough to investors without an insurance wrap. Two, as taxable bonds they garner a broader base of investors than traditional munis. And three, most BABs are high-grade — more than 65% of deals to date have been rated double-A or better, according to Thomson Reuters.
Assured’s McCarthy acknowledged that insurance penetration in the BAB market has been minimal, but he said “we will play an active role” in the program if issuance “expands beyond the double-A credit category.”
MIAC’s Kolman added that lower-graded BABs pay a higher yield than comparable corporate bonds because some investors are unfamiliar with the municipal market. With insurance, borrowers could save money by coming to the market at a lower yield but retain investors because of the added security.
“Potentially, you have a group of BAB investors that could use insurance because it’s an extra set of eyes that do know the credits and can help them understand that there is value here,” he said.
Jerry Ford, president of Ford & Associates Financial Group LLC, a financial services firm in Tampa, Fla., said the public finance market can be highly adaptive and it is possible for other enhancement products to replace insurance. So far, though, he hasn’t seen a credible alternative.
While insurance penetration stays around 10%, the market is craving stability, he said. And if bond insurers can convince investors and rating agencies that they are strong, demand for insured securities will return.
“I wouldn’t characterize myself as an optimist,” Ford said, “but I would say my sincere hope is that these guys make a comeback and that they come back strong because I think that would be good for the marketplace — it adds greater access for issuers.
“I don’t think you’ll see a day again — at least I hope not — where purchasers in the market, be they institutions or individuals, ignore underlying ratings and just say 'it’s insured so it’s fine,’ ” he said. “It shouldn’t have happened before and it certainly shouldn’t happen again ... [But] the market has fundamentally changed in the past and it could fundamentally change in the future ... The jury is still out.”