S&P Global Ratings placed two of the three active municipal bond insurers – Build America Mutual and National Public Finance Guarantee Corp.,– on credit watch negative, saying it “may adjust certain ratings based on a company's competitive strengths or weaknesses relative to its peers.”
In the report Tuesday, S&P said the review may lead to a downgrade of both insurers and that the process will take three months. BAM, and larger rival Assured Guaranty Ltd. carry AA ratings, while National is rated AA-minus.
“We expect to review each bond insurer's competitive position and relative performance in depth. If we determine that a downgrade of BAM is appropriate, we do not expect to lower our ratings by more than one notch. If we determine that a downgrade of National and MBIA Inc. is appropriate, we do not expect to lower our ratings by more than three notches.”
S&P also said that the credit watch placements are based on its view that BAM and National's competitive positions may be sufficiently weaker within the industry than Assured's operating subsidiaries, making a rating differentiation appropriate.
"Clearly, the insurers' fortunes are tied to the rating agencies and if downgrades occur, that would have a significant and negative impact on their already low market share," said Howard Cure, director of municipal bond research at Evercore Wealth Management, LLC. "Back in 2007-08 when insurers were undergoing their various downgrades, investors that held paper that didn’t have an underlying rating were subject to significant trading losses."
The three insurers provide guaranties on about 5.96% of municipal bonds, down from before the financial crisis, when more than 50% of munis carried insurance. With overall insurance penetration so low it helps generate confidence in the industry to have three rather than just one remaining insurer, Cure said
"Part of the problem is that interest rates are still at historic lows and spreads are so tight that it is difficult to charge premiums to take an economic portion of the spread and still be viable," he said.
BAM released a response, saying that the move represents a departure from S&P's stated criteria and previous communications to the market. BAM’s managing directors said they intend to engage with S&P during the CreditWatch period to demonstrate that BAM’s financial strength and low-risk, low-volatility strategy of insuring only U.S. municipal bonds from essential public purpose issuers supports BAM’s current rating.
“Maintaining durable ratings has been the most important consideration for every operating decision we’ve made in the five years since BAM’s launch, and we will continue to prioritize that during this CreditWatch period,” said Bob Cochran, BAM’s chairman. “We have provided additional information to S&P that we expect them to consider between now and the annual review of BAM’s rating, and we will take the time between now and then to educate the rating committee about the strength inherent in our capital base, municipal-only business model, and pristine insured portfolio. BAM has never incurred an insured loss in its lifetime, and does not anticipate any losses from its existing insured portfolio.”
Although BAM has increased business volume year-over-year, S&P said, its share of the amount of industry insured par and premiums written, as well as its risk-based pricing, may not support the rating. In addition, S&P said an underwriting strategy focused solely on the U.S. public finance market and not all sectors within that market--may limit BAM's competitive position more than analysts originally thought.
“BAM is fulfilling the mission we set out when the company was launched: Providing the market with the ability to choose a guarantor with robust and growing capital strength that is exposed only to municipal risk,” said Sean McCarthy, BAM’s CEO. “Our portfolio strategy does not limit BAM’s competitive position: Only 3% or less of the U.S. insured municipal market is sold in sectors that BAM does not insure, and diversification outside the municipal market has historically exposed bond insurers to excessive risk of loss. According to municipal market default studies by Moody’s and S&P, 70% of the defaults by credits that were rated investment grade at issuance were from the sectors BAM has chosen not to insure. In contrast to the industry’s past, we will not change our risk tolerance in response to rating agency pressure.”
BAM also said that in its 2016 annual report, S&P set benchmarks for BAM’s performance and that the insurer has achieved each one Since BAM's inception, S&P Global Ratings has repeatedly cited the value of its municipal-only underwriting strategy, BAM said.
“BAM has clearly satisfied S&P’s criteria and expectations and BAM’s financial performance has been gaining momentum through the past five quarters,” Cochran said. "We will continue to explain those facts to S&P during the CreditWatch period, and encourage everyone in the market who values a municipal-only guarantor to join us.”
S&P said that the rating actions on National and MBIA Inc. are based on its view that National has been struggling to gain wide market acceptance. In addition, its risk-adjusted pricing, although improving, is currently the lowest within the industry. With an underwriting strategy also focused on the U.S. public finance market, National is exposed to volatility and the macroeconomics of a single market,S&P said, adding that the rating on MBIA reflects its structural subordination to National.
"National is still struggling to re-establish its position from their MBIA days. An additional downgrade to below the “AA-“ category will hamper them even further to the point of not being able to write new business, particularly if interest rates remain low," said Cure.
S&P also said that it is unlikely to take a rating action on Assured's bond insurance subsidiaries as part of this review, and has therefore not placed those ratings on CreditWatch. Assured's strong competitive position is built on a proven track record of credit discipline and market leadership in terms of par insured, premiums written, and risk-based pricing, S&P said.
Although much of the company's business has been in the U.S. public finance market, it has the most diverse underwriting strategy of any bond insurer, as it also conducts business in the global structured finance and international markets, according to S&P. The diversity gives it flexibility to capitalize on growth trends and pricing opportunities in one sector while others see less-favorable trends, the rating agency said.
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Corrected June 6, 2017 at 2:45PM: An earlier version misstated National's rating.