Since last fall, new issues of less than double-A rated municipal bonds have been severely constrained. Why should we care? Because these bonds are typically issued by governmental and tax-exempt entities, often to fund shovel-ready projects ranging from bridges to hospitals - and the failure of that market continues to seriously crimp a national economic recovery.
The problem came about with the en masse downgrading of all of the major municipal bond insurers beginning in 2007 and accelerating since September 2008.
Bond insurance is used where the credit rating of the issuing entity - in this case, a municipality or other public entity or nonprofit corporation - was insufficient to allow the bonds to be rated triple-A. Since the higher the rating, the lower the interest rate, bond insurance was in effect a way for the issuer to rent the balance sheet of the insurer and thus pay lower interest rates.
Virtually every bond insurer saw their investment ratings drop from triple-A, some dramatically so. The reasons for the downgrades are varied but include the fact that some of the insurers had insured the same kinds of securities that took down many other financial institutions.
The magnitude of the problem is huge: in 2005, fully 57% of muni bond issues carried insurance. By 2007, that had declined to almost 47%, representing 5,448 issues worth $210 billion.
The second half of 2008 saw a jaw-dropping decline to 8% of issues insured, representing 865 issues worth $18.4 billion; and through the end of August, 10.8% of muni issues have been insured this year, or $27.67 billion of the $255.6 billion sold.
As those numbers suggest, the effect of the insurers' downgrades on small and mid-sized muni issuers has been profound. Practically speaking, bond insurance was simply no longer available for many planned financings and the interest rates of the now-uninsured bonds put an even greater strain on already-stressed public agency budgets and- the spendable proceeds for projects.
The result was a die-off of bonds issued with less than triple-A ratings, a market that in 2008 represented fully 97% of dollar amounts of the municipal market, according to a May 2009 National League of Cities report.
With the evaporation of a significant segment of the bond market came a quick stop to any infrastructure or other public works projects that the bonds would have funded.
The catastrophe has not gone unnoticed. Part of a four-bill legislative package aimed at reinvigorating the muni market was HR 2589, designed to create a new federally backed reinsurance company that would theoretically allow investors to regain confidence in bond insurers and thus allow the market to further thaw.
HR 2589 remains in committee, but bailout fatigue apparently has stalled its progress. Bailout politics aside, some see this legislation as yet another expensive incursion of the federal government into a private-sector business in which it has no experience. They ask: do we need yet another sector of the private economy nationalized? And if so, at what cost to the taxpayers?
The National League of Cities convened a blue-ribbon commission to look at this emergency and proposed the creation of a new issuer-owned "mutual bond assurance company." With this new mutual company, municipal and nonprofit bond issuers could bypass private bond insurers entirely, pool their resources and reserves (helped by an anticipated $5 billion no-interest loan from the federal government), and thus serve as their own insurers.
The NLC's plan has received attention but fails to address a very important point - the bond insurers previously active in the marketplace did more than simply provide credit protection.
They have expert research and analysis services, each with their own particular expertise, theoretically freeing bond buyers from doing their own full-blown research on an issuer before buying their bonds. As a result, they provide liquidity to the muni bond market, since traders can put bids on bonds without having in-depth knowledge of the underlying issuer.
Bond insurers monitor issuers for covenant compliance while the bonds are outstanding, an often-overlooked but critical function. And insurers provide homogeneity to bond markets, since there is a dizzying array of issuers, each with their own issuing and other statutory authority. By dealing with almost the entire universe of muni issuers, bond insurers traditionally provided some assurance to investors even with a multitude of issuers at work.
For the long run, the NLC's idea is a good one - let the muni bond issuers take charge of their own creditworthiness. In the near term, though, it's hard to see how the plan could replace the expertise and experience of private bond insurers.
We have a different idea. We think that the federal government, through the Treasury Department, should establish a guaranty program to backstop municipal bond insurance policies issued by muni-only private bond insurers.
Make no mistake - this is not the same as guaranteeing the issuers themselves, as some have suggested. Nor is it a variant of HR 2589's reinsurance concept, which some have criticized as another bailout.
Instead, this would be a guarantee provided for individual bond insurance policies issued by muni-only insurers, at their election and for a fee, allowing the insurers to enhance their own creditworthiness in the marketplace.
The muni-only private bond insurers themselves would continue to bear 100% of every first loss. Structured correctly, it would be a zero-loss program for the government, generating sufficient premiums to cover any losses.
Those losses would occur only if a bond insurer could not pay the entire amount of interest and principal as it comes due with respect to a defaulted bond issue. Of course, bond defaults are the crux of this discussion. As the NLC's commission attests, the historic risk in municipal bond protection has been negligible - fully 20 times lower than investment-grade securities in the corporate sector.
Backstopping policies issued by existing muni-only bond insurers (or the new muni-only subsidiaries of other bond insurers) would ensure that the federal government would not need to duplicate an existing market service, structure, or overhead.
Remember that unlike the relatively discrete corporate bond market, there are approximately 50,000 small issuers in the municipal market, with a multitude of different financing structures and varying credit risks. Most investors aren't prepared to or capable of doing their own research and analysis for each credit.
Under our approach, private muni-only bond insurers would pay an up-front, risk-rated premium to the federal government. If structured properly, such a guaranty program should cost us - the taxpayers - nothing.
There are other elements that could make this program even more powerful, such as minimum five-year loans to private muni-only bond insurers (only on request, unlike some forced loans under the Troubled Asset Relief Program) to provide them with sufficient short-term credit to meet market demand for new policies.
We believe that our proposal will allow a vital link in the economic recovery plan to begin functioning again, with little interference from - or expense to - the federal government.
Robert C. Barnes is a real estate transactional senior counsel of the firm of Fulbright & Jaworski LLP. Donald L. Hunt is a partner and heads Fulbright's public law and administration practice group. Both are in the firm's Los Angeles office.