WASHINGTON - The National League of Cities is seeking $5 billion in seed money from the Treasury Department to establish an issuer-run mutual bond insurance company, according to a draft business plan NLC plans to release today.

The issuer-owned mutual insurance company - which will seek to fill the gap left by the 15 commercial municipal bond insurers that were downgraded in the last two years - would insure investment-grade general obligation and revenue bonds "for essential municipal services," the business plan said.

In addition, it would back short-term municipal notes and leases related to essential municipal services. It would not insure private-activity bonds or municipal paper sold on behalf of corporations.

The draft plan leaves the door open to providing insurance to some variable-rate demand notes, "but only where there are ceilings on the interest rates that are a fixed number: they cannot be linked to any indexes," it said.

"In today's market, there's a need for an additional insurer," said Bob Inzer, county clerk of Leon County, Fla., who is chairman of a blue-ribbon commission formed last year to study the idea of creating an issuer-owned, mutual credit-enhancement company.

Of the $5 billion in seed money, the NLC would seek $3 billion up front and $2 billion of "call capital" that would only be used if needed. That figure is much higher than the initial estimate of about $1.5 billion in capital supporters of the project felt was needed, but it is believed to be comparable to the capital of Berkshire Hathaway Assurance Corp.

"It is a long-term investment that we would be hoping to repay over a period of time based on premiums that we would be charging and other income streams, like interest income," Inzer said.

The proposal comes after downgrades to bond insurers have caused problems for many issuers, requiring them to either pay a high premium to access the municipal market or denying them access completely.

Cathy Spain, director of league's center for member programs, noted a research brief the NLC published in February that said 46% of city finance officers had difficulties accessing credit and 28% had cancelled or delayed projects because of the market tumult.

She also noted that the research report only surveyed finance officers from cities with populations of 50,000 or higher, "so it may understate problems in the marketplace because that's not including the smaller issuers."

Historically, a significant number of investors who consider buying muni bonds relied solely on the rating of the bond insurer that wrapped the municipal credit. But with fewer top-rated insurers in the market, issuers - particularly municipalities and school districts with underlying ratings below double-A - have been forced to pay a much higher premium to attract investors, Inzer said.

As of April 30, insurance penetration fell to 12.6% year-to-date, from a historical average of about 50%, according to Thomson Reuters.

The NLC-led plan would base the insurer in New York. It would be rated triple-A and charge an up-front premium equal to 70 basis points of principle and interest on a 25-year bond at a 4% interest rate. On a $1 million bond, this equals $11,202, which is 1.1% of par, the document said.

The business plan estimates that the mutual insurer would be able to guarantee 50% of the insured muni market after five years, assuming no other private insurers come back into the marketplace.

Though the business plan does not estimate the size of the insured market, it argues that the availability of low-cost insurance might induce more issuers to sell bonds.

The idea of an issuer-owned mutual insurer has drawn mixed reaction from market participants, some of whom are skeptical about using taxpayer money on an issuer-run insurer, especially while new commercial entrants are trying to raise private capital.

Thomas Hoens, executive vice president of HRF Associates LLC and the former chief financial office of ACA Financial Guaranty, cautioned that the NLC plan leaves the door open for the mutual insurer to contract a third-party to perform its underwriting.

While Hoens, who has been involved in the development of the NLC plan, is generally supportive of it, he warned against outsourcing the underwriting to third parties.

"That is the central mission of a municipal bond insurance company," he said. "It has got to be owned, operated and controlled by the [company]."

Hoens also noted that the proposal comes just as the House Financial Services Committee is poised to consider legislation that would authorize the Treasury Department reinsure up to $50 billion of credit-enhanced municipal securities in each of fiscal years 2011 through 2015.

It may be difficult to ask Treasury for up to $5 billion in seed money for a brand-new insurer while it is also trying to start a separate program to provide reinsurance, he said.

But Spain, who cautioned that she had not studied the bill, said the NLC believes the reinsurance program would benefit - rather than compete with - the mutual insurer, because reinsurance is something the mutual insurer would use, if it is eligible.

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