WASHINGTON - Municipal bond insurers and the bond rating system came under fire yesterday from federal lawmakers and market participants at a House Financial Services Committee hearing as they debated how to resolve the current turmoil in the muni securities market.

Click here for testimony from the hearing.

Committee chairman Barney Frank, D-Mass., blasted the muni bond insurers for acting on "grevious misjudgments" by exposing themselves to subprime mortgage risk that has, in turn, led to "unfair excessive costs" for issuers. He insisted that issuers of general obligation debt, which rarely if ever defaults, "is like asking a vampire to buy life insurance" because in either case, the insurers are never going to have to pay. He said the differing rating systems for muni and corporate issuers are hurting muni issuers.

Leaders of the committee floated ideas for providing some kind of federal credit enhancement to municipal issuers saddled with increased costs and liquidity problems stemming from ratings downgrades of insurers exposed to the subprime mortgage market. Though they put several options on the table, including something akin to federal insurance for munis, lawmakers mostly expressed a deep sense of urgency in whatever they choose to do.

"This has got to be fixed," Frank said. "We cannot tolerate a situation where elected officials trying to build schools and comply with mandates from the federal government to improve the treatment of sewage and build highways ... are charged much more than they should be charged."

"This is nothing more than legalized extortion," said Rep. Michael Capuano, D-Mass, decrying the use of bond insurance for general obligation municipal debt that rarely, if ever, defaults.

Frank asked some panelists for their thoughts on the possibility of a federal "backstop" in which the federal government would reinsure bonds with existing insurance.

Eric Dinallo, New York insurance superintendent, who testified before the committee, said that he supports the idea, because it would insure liquidity in the event of a municipal default and allow bond insurers to release capital that they would otherwise hold to cover their municipal portfolio.

"That would elevate ratings across the board, including on the structured [finance] side," Dinallo said. "That would be extraordinarily helpful in a liquidity-crunch situation."

But Rep. Paul Kanjorski, D-Pa., said he and other members of the committee want the House Ways and Means Committee to move quickly to approve pending legislation that would allow the Federal Home Loan Bank system to provide letters of credit to municipal issuers on a temporary basis "as a surgical procedure to restart the municipal bond operation" until muni insurance is more widely available.

Kanjorski, who chairs the committee's capital markets subcommittee, said that while it could take many months to establish a federal agency to provide credit enhancement to muni issuers, Congress could enact the FHLB legislation in about 30 days.

Three state treasurers who testified said that they endorsed the idea, and multiple market participants have written members of Congress urging them to pass the FHLB bill.

But Tate Reeves, Mississippi's treasurer, said that it is more important, as a first step toward helping liquidity in the muni market, for the Securities and Exchange Commission to ease the credit requirements in its Rule 2a-7 for money market funds so that they can buy lower-rated munis.

"The least invasive solution in the short term is the relaxing of 2a-7," he said, noting that as insurers have been downgraded so have the bonds they have insured, making them ineligible for the money market funds.

Reeves made the remarks after SEC officials indicated they have no immediate plans to consider changing the rule.

Frank was exasperated at the state officials for not being more upset about muni bond insurance, which he contends has been an unnecessary expense for muni issuers that is now dragging down the value of their bonds.

He called muni insurance "the lead life preserver" for bonds and said, "you'd be better off without the preserver."

"I don't understand why you, the victims, would defend a rating system that has totally undervalued you and that has cost you money," he said, comparing the situation to the "Stockholm Syndrome," in which the victims identify with, and start to like, their captors.

Connecticut Attorney General Richard Blumenthal told members of the committee that the current disparities in the separate rating systems for muni and corporate bonds is "dangerously misleading and misguided" and "imposes a secret Wall Street tax on states, cities and school districts across this nation." He said it "costs municipalities....millions of dollars in unnecessary interest and fees every year."

Blumenthal also said he is investigating the rating systems, under which "municipal bonds receive substantially lower credit ratings than corporate bonds with the same or worse rates of default."

This "costly scheme" has "no legitimate business reason" and "is quite possibly illegal under our state and federal antitrust laws," he warned the lawmakers.

He urged Congress to "take action to expressly eliminate the unfair, discriminatory and abusive system that is currently in place."

Dinallo said he has developed a three-point plan for the insurance industry that involves bringing in new capital and capacity, preparing to deal with any chronically distressed insurer, and developing new regulations to avoid a repeat of such problems.

Dinallo said that while "time and the market will determine the need for bond insurance" in the future, he thinks some muni issuers, especially the smaller ones, will continue to need it.

In his prepared testimony, Dinallo said he is considering rewriting state insurance rules that would prohibit insurers from guaranteeing certain collateralized debt obligation products or that would either limit the amount of structured business that a bond insurance could do or require the insurer hold certain levels of capital for structured exposure.

Ajit Jain, with Berkshire Hathaway Assurance Corp., who also testified, said he remains "very concerned about the long-term viability of [the insurance] business in general and for us in particular."

"The product that is being sold is nothing more than a future promise to pay," he said "It's value relies heavily on the creditability of the promisor."

Jain said that "if rating agencies level the playing field in terms of how they rate municipal versus corporate obligations, there will be little need for a financial guaranty insurance marketplace as we know it."

He said he is amazed that experts in the insurance business continue to consider municipal bond insurance as "almost a zero-loss business."

While there have been relatively few defaults during the past 50 years, both Jefferson County, Ala., and Vallejo, Calif., have received publicity lately about possible defaults, he said, adding, this "could just be the tip of the iceberg as municipalities are coming under increasingly unfavorable economic conditions, including reduced real estate and sales-generated tax revenues and underfunded future pension and healthcare costs."

Also yesterday, Moody's Investors Service announced that it would issue corporate equivalent ratings to any outstanding municipal issuer if requested by the issuer, starting in May. Last year, the ratings agency became the first to map its muni ratings to its corporate, or global, scale.

Though some market participants greeted yesterday's Moody's announcement favorably, Frank appeared disturbed and suggested it was only a ploy for the rating agency to get more money.

"You're going to offer them a second item for which you can charge them more. You're going to continue to abuse them," he told Laura Levenstein, senior managing director of Moody's global public, project and infrastructure finance group, who also testified.

Meanwhile, the Government Finance Officers Association and five other issuer groups sent the committee an eight-page letter, which Kanjorski put into the public record, that said: "Our principal concern is for the taxpayers, who ultimately bear the burden of increased bond issuance and interest costs. These costs are rising for reasons which are completely extrinsic to events in our market."

The letter stresses that there are no problems with the underlying credit of the governments themselves, and that "negative psychology currently pervading the markets, as well as the lack of liquidity, are responsible for the represent volatility, not because states and municipalities are in danger of default."

Government issuers - "and thus taxpayers" - and paying the price for the municipal bond market decline in the overall market downturn, it says.

The groups said that while a "silver bullet capable of calming the turbulent marketplace is unlikely to appear, a variety of legislative, regulatory and marketplace changes should be discussed that could ease the pressures on state and local government issuers."

The recapitalization of the bond insurers "is extremely important" to "stabilize the entire market," the groups said. The possibility of the federal government providing a backstop to the bond insurers also should be considered, among other options, they said.

The groups urged that the bank-qualified debt limit be raised from the current $10 million level to $30 million and for it to be indexed for inflation. They called for an increase in the private sector investment incentives for purchasing tax-exempt bonds. Issuers should be permitted an additional advance refunding, on a limited basis, they said, adding that the Federal Home Loan Banks should be allowed to offer letters of credit and issuers should be allowed to bid on their own auction rate debt on a temporary basis.

The groups also stated that the idea of having the Federal Reserve Board purchase auction-rate securities to increase] "liquidity and price stability in the market during these extraordinary times" is worth reviewing.

Meanwhile, it said that an equitable credit rating system that would help issuers and investors alike should be created, arguing that the current double standard that exists for muni and corporate bonds "adds to the hardships which issuers face in the current marketplace."

The groups said that applying corporate-equivalent standards to the investment grade requirement of Rule 2A-7 would "expand the market for tax-exempt money market funds" and would benefit both issuers and investors. The groups asked that the U.S. Department of Education work with state student loan agencies to help them ensure new loans can be made before the next school year starts.

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