THE FATHER LIFE | the men's magazine for today's fathers

The Bond Insurance Boondoggle

By: Nick Henry
Image By: Thomas Picard
June 16, 2008

Of all the storms that have spun out of the initial sub-prime mortgage crisis storm system, the one that engulfed the (so-called "monoline") insurance companies arguably has the biggest potential for long-term impact. That's because it has the ability to materially impact two large industries within the financial markets (the bond insurers and the third party ratings organizations), both of which are firmly entrenched in the American psyche, cloaked in self-serving mystery, and extremely good at marketing themselves to an unsuspecting and naďve consumer. In the first part of this article, we'll take a look at the municipal bond insurance industry.

First, how did we get here? To make a long sub-prime mortgage (SPM) story short, as the real estate bubble grew and grew, many financial institutions decided to get in on the action by extending home financing loans to people whose credit history suggested they might not be the best candidates to begin with. To make matters worse, these financial institutions devised a loan structure that was purposefully deceiving and ended up trapping the new homeowners in a morass of "small print" fees, with skyrocketing adjustable interest rates being only the most visible. These financial institutions then made a deal with the devil, packaging these things up so as to obfuscate the inherent risks, then foisting them upon their clientele.

The question of why any financial institution would get into this SPM business in the first place is for a different day. But, again, that initial storm system spawned another major storm that the monoline insurance companies got swept up in.

These insurers had been humming along nicely for a few decades, thriving on a single business line: insuring municipal bonds (munis). To be sure, insuring munis is a pretty sweet business model. Why? Because it's quite rare that a municipality falls on hard times sufficient to cause it to default on one of its bonds. So, as an insurer, you can collect premiums without fear of a claim. In a 2002 study, Moody's Investors Service found that munis default at a rate of 0.042%ą. As in, less-than-half-of-one-percent. (By comparison, corporate bonds default at a rate of 9.836%, according to the same study.)

Think of it like this: when a corporation falls on hard times they might not be able to raise the price of their widget in order to meet their financial obligations/debts. If that's the case then they could end up going out of business – and any people that had lent them money could be left empty handed. But, when a government falls on hard times, they could (and do) certainly raise taxes, for example. Simply put, it's much harder for a government to go broke than it is for a company.

So, if muni bonds are so "safe," why do they need insurance in the first place? The simple answer is: they don't. We've already established just how rare it is that a municipality decides to walk away from a debt obligation. So, if the overwhelming odds are that a muni will be "money good" for its entire life, then, as a bondholder, day-to-day price changes shouldn't really bother you, right?

You're looking to buy a new car. You go to one dealer and he tells you about the great financing options right now. You go to another dealer and he tells you about the great leasing plans right now. But then you go to a third dealer and he tells you that if you buy the car up front right now, drive it around for x-many years and then return it at the end of that time, he will give you your money back in full. There's no depreciation factor. If you pay $15,000 for the car new, you get $15,000 back at the end of the term. Now, you could try to sell the car before the end of the term, but at that point you're left at the whim of current market value – which could be higher OR lower than what you paid originally. That's the whole enchilada. Monty Hall has nothing on this guy.

What would you want to consider before signing on the dotted line and driving your new car off the lot as fast as possible before Monty changes his mind? Maybe his ability to make that payment to you at the end of the term? What if all the research available said that you had a 99.958% (see Moody's study) chance of getting your money back? Time to start talking trim level and color!

Well, that's essentially what a muni bond is. The municipality is a car dealer offering to pay you back - in full - after x-years. And, in the case of munis, that dealer's record of actually making that payment is 99.958%. In the meantime, you get to drive a car around (which is, ostensibly, what you were looking for in the first place) for however long, but armed with the knowledge that you're going to get back all the money you paid for it at the end of the term of your arrangement with the dealer.

So, you drive off the lot and everyone's happy. Then, a couple years into the term – mind you, you're still driving around every day – someone publishes a report that says that the new models of the same car you have are more desirable than the one you're driving. Suddenly, "your" model year is less-desirable, so other owners of cars of the same model year are starting to sell them. And the current market value of your car is suddenly lower than it was yesterday.

You might check with the dealer to see if they are still feeling okay about their ability to make good their end of the deal and pay you back in full at the end of the term. If they tell you they are...then do you really have a problem? If your prospects for getting your money back in full x-years in the future are still 99.958%...then what does a day-to-day change in the "current market value" of your car really mean to you?

Absolutely nothing - as long as you intend to drive that car back onto the lot on the last day of the term.

Some people get nervous, and sell their car on the open market when bad news hits (and, sometimes, dealers are not able to make good their end of the deal – 99.958% being less than 100%). But, if the market is only willing to bear a price lower than what those people would have gotten had they held onto the car, then the only thing they do when they sell on a price drop is lock in a loss.

So, back to insurance. Adding insurance to a muni bond is like driving in your (new) car past a lake...while wearing a life jacket. Is there a chance that a big semi sideswipes you, or the Mistral picks up and knocks/blows you in to the lake? Sure. There has to be some kind of odds on that happening. And if it does, would you be happy that you have the life jacket on? Definitely. But, in the meantime, does driving around with a life jacket on really improve your odds of staying dry, and do those (already great) odds really need to be improved upon in the first place? 99.958%?!

Of course not.

But here's the problem: the average muni investor. If we were playing a word-association game and I said "muni bond," chances are one of the first words out of your mouth would be "safe" - possibly right up there with "boring." And that's the point. People look to munis for the stultifying predictability of NOT being in high yield corporate junk bonds or small-cap growth stocks. In the average investor's mind, the perceived lack of volatility is the draw – is the basis on which "total return" can and should be judged – for munis. So, the addition of an extra layer of safety only makes a muni bond more attractive to the average investor.

Let's make up a municipality: the Town of Anywhere. Anywhere needs to build a new fire station. The town comptroller runs the numbers and reports to the town board that they can issue a muni bond to pay for the fire station, but the current market rate on such a bond is 5.00%. In other words, in borrowing the money to build this fire station, Anywhere would have to pay 5.00% interest to lenders. But, if Anywhere decides to buy an insurance policy on that bond, the market will now be willing to receive 4.75% interest – same underlying borrower (Anywhere), same project, arguably the same lenders! But Anywhere's borrowing cost is less because the market thinks the bond is "safer" – and the market thinks it needs that additional safety.

If the premium that the insurance company would make Anywhere pay on that insurance policy is less than the amount they could reduce the coupon on the bond by...then it makes solid fiscal sense for Anywhere to slap the insurance policy on the bond and bring that bad boy to market as an insured bond with – ta-da! – a 4.75% coupon. Maybe that means the fire station costs $480,000 instead of $500,000. Well, to many towns in America, $20k goes a long way.

So, despite the fact that they shouldn't have to, municipalities have been going out and buying insurance policies on more than half of the bonds brought to market. Like any insurance policy, municipalities have been paying those premiums to keep them in good standing. And, while there's an end benefit to the municipality (potentially lower project cost), the insurance companies were laughing all the way to the bank (it is thought that one of the insurers has amassed a $10B nut specifically earmarked for claims – talk about a cash cow!).

With all due respect to Gordon Gecko, while greed, for lack of a better word, may be good, it's also a sin.

The monoline insurers got greedy and subsequently went from being "monoline" (read: munis only) insurers to being "multi-line" (read: munis and SPM-backed debt) insurers – and, while it was an epic party for a couple years, some cranky neighbor finally decided to call the cops, who busted it up – by blowing up the entire neighborhood.

An insurance company, like a municipality, is given a third-party credit rating. When you buy insurance from someone else you only do so if that insurance makes your credit standing look stronger. So if Anywhere has an A-rating, it's pointless to pay for an insurance policy on their bonds that is BBB-rated, for example. In this way, an insurance company is only as good as its credit rating. And if the sanctity of that rating comes into question, such as when one of your two business lines evaporates into a fine mist of potential claims and litigation, it becomes very easy for the average investor to assume that your other business line is also in danger – even if it's not (remember: 99.958%).

*Sidebar*

Generally speaking, the breakdown of credit ratings is:

AAA
AA
A
BBB
BB
B
CCC
CC
C

With BBB and higher considered "investment grade" and BB and below considered "below investment grade".

So SPM blows up, the big banks get into massive trouble and then the ratings organizations call into question the credit rating of the insurers themselves. And investors freaked out. They apparently felt that a downgrade in the credit rating of the insurance (that they didn't need in the first place) meant that the credit rating of the underlying municipality (99.958%) was also under duress. And they ran for the hills – leaving behind a vacuum in which bond prices were sucked down with nearly indiscriminate alacrity.

The insurance companies absolutely should have to lie in the bed they made. From the perspective of the municipalities whose bonds the monolines insured, the insurance companies are at best indirectly responsible for violently disrupting the public finance marketplace. Bottom line: if the monolines had kept their hand out of the SPM cookie jar and just went about their business getting filthy rich off insurance policy premiums paid by municipalities, SPM has a much smaller scope.

If part of the final analysis by the general public is that bond insurance isn't needed – or at least not worth getting as hung up on, then that might allow for a level of isolation from this kind of problem in the future. Yes, that could also lead to higher borrowing costs for municipalities – and therefore more expensive projects. But bond insurance for municipal bonds is so vestigial that a general enlightenment of the average investor is probably needed anyway.

However, in the absence of that kind of rational thinking, bond insurance – the one good business line the monolines still have – is probably not going anywhere. Let's just hope the insurers themselves have learned their lesson.

Nick Henry is the father of two little girls. He grew up in the Midwest, went to college on the east coast, ran around Colorado for a few years and has since settled in Rochester, New York. A music major in college, Nick chose the financial industry for his "day job."

1. From Special Comment: Moody's US Municipal Bond Rating Scale, published by Moody's Investors Service, November, 2002. 0.042% refers to the published 10-year cumulative default rate for all municipal bonds.


home \| forums \| links \| articles \| about us rss feed
	(sign up!)
The Bond Insurance Boondoggle By: Nick Henry Image By: Thomas Picard June 16, 2008 Of all the storms that have spun out of the initial sub-prime mortgage crisis storm system, the one that engulfed the (so-called "monoline") insurance companies arguably has the biggest potential for long-term impact. That's because it has the ability to materially impact two large industries within the financial markets (the bond insurers and the third party ratings organizations), both of which are firmly entrenched in the American psyche, cloaked in self-serving mystery, and extremely good at marketing themselves to an unsuspecting and naďve consumer. In the first part of this article, we'll take a look at the municipal bond insurance industry. First, how did we get here? To make a long sub-prime mortgage (SPM) story short, as the real estate bubble grew and grew, many financial institutions decided to get in on the action by extending home financing loans to people whose credit history suggested they might not be the best candidates to begin with. To make matters worse, these financial institutions devised a loan structure that was purposefully deceiving and ended up trapping the new homeowners in a morass of "small print" fees, with skyrocketing adjustable interest rates being only the most visible. These financial institutions then made a deal with the devil, packaging these things up so as to obfuscate the inherent risks, then foisting them upon their clientele. The question of why any financial institution would get into this SPM business in the first place is for a different day. But, again, that initial storm system spawned another major storm that the monoline insurance companies got swept up in. These insurers had been humming along nicely for a few decades, thriving on a single business line: insuring municipal bonds (munis). To be sure, insuring munis is a pretty sweet business model. Why? Because it's quite rare that a municipality falls on hard times sufficient to cause it to default on one of its bonds. So, as an insurer, you can collect premiums without fear of a claim. In a 2002 study, Moody's Investors Service found that munis default at a rate of 0.042%ą. As in, less-than-half-of-one-percent. (By comparison, corporate bonds default at a rate of 9.836%, according to the same study.) Think of it like this: when a corporation falls on hard times they might not be able to raise the price of their widget in order to meet their financial obligations/debts. If that's the case then they could end up going out of business – and any people that had lent them money could be left empty handed. But, when a government falls on hard times, they could (and do) certainly raise taxes, for example. Simply put, it's much harder for a government to go broke than it is for a company. So, if muni bonds are so "safe," why do they need insurance in the first place? The simple answer is: they don't. We've already established just how rare it is that a municipality decides to walk away from a debt obligation. So, if the overwhelming odds are that a muni will be "money good" for its entire life, then, as a bondholder, day-to-day price changes shouldn't really bother you, right? You're looking to buy a new car. You go to one dealer and he tells you about the great financing options right now. You go to another dealer and he tells you about the great leasing plans right now. But then you go to a third dealer and he tells you that if you buy the car up front right now, drive it around for x-many years and then return it at the end of that time, he will give you your money back in full. There's no depreciation factor. If you pay $15,000 for the car new, you get $15,000 back at the end of the term. Now, you could try to sell the car before the end of the term, but at that point you're left at the whim of current market value – which could be higher OR lower than what you paid originally. That's the whole enchilada. Monty Hall has nothing on this guy. What would you want to consider before signing on the dotted line and driving your new car off the lot as fast as possible before Monty changes his mind? Maybe his ability to make that payment to you at the end of the term? What if all the research available said that you had a 99.958% (see Moody's study) chance of getting your money back? Time to start talking trim level and color! Well, that's essentially what a muni bond is. The municipality is a car dealer offering to pay you back - in full - after x-years. And, in the case of munis, that dealer's record of actually making that payment is 99.958%. In the meantime, you get to drive a car around (which is, ostensibly, what you were looking for in the first place) for however long, but armed with the knowledge that you're going to get back all the money you paid for it at the end of the term of your arrangement with the dealer. So, you drive off the lot and everyone's happy. Then, a couple years into the term – mind you, you're still driving around every day – someone publishes a report that says that the new models of the same car you have are more desirable than the one you're driving. Suddenly, "your" model year is less-desirable, so other owners of cars of the same model year are starting to sell them. And the current market value of your car is suddenly lower than it was yesterday. You might check with the dealer to see if they are still feeling okay about their ability to make good their end of the deal and pay you back in full at the end of the term. If they tell you they are...then do you really have a problem? If your prospects for getting your money back in full x-years in the future are still 99.958%...then what does a day-to-day change in the "current market value" of your car really mean to you? Absolutely nothing - as long as you intend to drive that car back onto the lot on the last day of the term. Some people get nervous, and sell their car on the open market when bad news hits (and, sometimes, dealers are not able to make good their end of the deal – 99.958% being less than 100%). But, if the market is only willing to bear a price lower than what those people would have gotten had they held onto the car, then the only thing they do when they sell on a price drop is lock in a loss. So, back to insurance. Adding insurance to a muni bond is like driving in your (new) car past a lake...while wearing a life jacket. Is there a chance that a big semi sideswipes you, or the Mistral picks up and knocks/blows you in to the lake? Sure. There has to be some kind of odds on that happening. And if it does, would you be happy that you have the life jacket on? Definitely. But, in the meantime, does driving around with a life jacket on really improve your odds of staying dry, and do those (already great) odds really need to be improved upon in the first place? 99.958%?! Of course not. But here's the problem: the average muni investor. If we were playing a word-association game and I said "muni bond," chances are one of the first words out of your mouth would be "safe" - possibly right up there with "boring." And that's the point. People look to munis for the stultifying predictability of NOT being in high yield corporate junk bonds or small-cap growth stocks. In the average investor's mind, the perceived lack of volatility is the draw – is the basis on which "total return" can and should be judged – for munis. So, the addition of an extra layer of safety only makes a muni bond more attractive to the average investor. Let's make up a municipality: the Town of Anywhere. Anywhere needs to build a new fire station. The town comptroller runs the numbers and reports to the town board that they can issue a muni bond to pay for the fire station, but the current market rate on such a bond is 5.00%. In other words, in borrowing the money to build this fire station, Anywhere would have to pay 5.00% interest to lenders. But, if Anywhere decides to buy an insurance policy on that bond, the market will now be willing to receive 4.75% interest – same underlying borrower (Anywhere), same project, arguably the same lenders! But Anywhere's borrowing cost is less because the market thinks the bond is "safer" – and the market thinks it needs that additional safety. If the premium that the insurance company would make Anywhere pay on that insurance policy is less than the amount they could reduce the coupon on the bond by...then it makes solid fiscal sense for Anywhere to slap the insurance policy on the bond and bring that bad boy to market as an insured bond with – ta-da! – a 4.75% coupon. Maybe that means the fire station costs $480,000 instead of $500,000. Well, to many towns in America, $20k goes a long way. So, despite the fact that they shouldn't have to, municipalities have been going out and buying insurance policies on more than half of the bonds brought to market. Like any insurance policy, municipalities have been paying those premiums to keep them in good standing. And, while there's an end benefit to the municipality (potentially lower project cost), the insurance companies were laughing all the way to the bank (it is thought that one of the insurers has amassed a $10B nut specifically earmarked for claims – talk about a cash cow!). With all due respect to Gordon Gecko, while greed, for lack of a better word, may be good, it's also a sin. The monoline insurers got greedy and subsequently went from being "monoline" (read: munis only) insurers to being "multi-line" (read: munis and SPM-backed debt) insurers – and, while it was an epic party for a couple years, some cranky neighbor finally decided to call the cops, who busted it up – by blowing up the entire neighborhood. An insurance company, like a municipality, is given a third-party credit rating. When you buy insurance from someone else you only do so if that insurance makes your credit standing look stronger. So if Anywhere has an A-rating, it's pointless to pay for an insurance policy on their bonds that is BBB-rated, for example. In this way, an insurance company is only as good as its credit rating. And if the sanctity of that rating comes into question, such as when one of your two business lines evaporates into a fine mist of potential claims and litigation, it becomes very easy for the average investor to assume that your other business line is also in danger – even if it's not (remember: 99.958%). Sidebar Generally speaking, the breakdown of credit ratings is: AAA AA A BBB BB B CCC CC C With BBB and higher considered "investment grade" and BB and below considered "below investment grade". So SPM blows up, the big banks get into massive trouble and then the ratings organizations call into question the credit rating of the insurers themselves. And investors freaked out. They apparently felt that a downgrade in the credit rating of the insurance (that they didn't need in the first place) meant that the credit rating of the underlying municipality (99.958%) was also under duress. And they ran for the hills – leaving behind a vacuum in which bond prices were sucked down with nearly indiscriminate alacrity. The insurance companies absolutely should have to lie in the bed they made. From the perspective of the municipalities whose bonds the monolines insured, the insurance companies are at best indirectly responsible for violently disrupting the public finance marketplace. Bottom line: if the monolines had kept their hand out of the SPM cookie jar and just went about their business getting filthy rich off insurance policy premiums paid by municipalities, SPM has a much smaller scope. If part of the final analysis by the general public is that bond insurance isn't needed – or at least not worth getting as hung up on, then that might allow for a level of isolation from this kind of problem in the future. Yes, that could also lead to higher borrowing costs for municipalities – and therefore more expensive projects. But bond insurance for municipal bonds is so vestigial that a general enlightenment of the average investor is probably needed anyway. However, in the absence of that kind of rational thinking, bond insurance – the one good business line the monolines still have – is probably not going anywhere. Let's just hope the insurers themselves have learned their lesson. Nick Henry is the father of two little girls. He grew up in the Midwest, went to college on the east coast, ran around Colorado for a few years and has since settled in Rochester, New York. A music major in college, Nick chose the financial industry for his "day job." 1. From Special Comment: Moody's US Municipal Bond Rating Scale, published by Moody's Investors Service, November, 2002. 0.042% refers to the published 10-year cumulative default rate for all municipal bonds.