Bond insurance: Do muni investors still care?

We know the monoline insurance business has been one of the great flaming disasters of the Great Subprime Collapse of 2007. Unlike some other businesses which have taken big losses, like mortgage lenders or brokerages, its not clear the world really needs bond insurers at all. We know that there will be such a business as home building in 2010, but are we so sure anyone will want bond insurance in 2010?

Let's look at the monoline insurer's bread-and-butter (municipals) for some guidance. According to data from Thomson Financial, only about 28% of municipal bonds issued in January carried insurance from a monoline insurer. That's down from 46% in 2007. Meanwhile, according to Merrill Lynch, new insurance was dominated by FSA and to a lesser extent, Assured Guaranty. FSA insured $3.8 billion of new issues, about 70% of all new issue munis which carried insurance. Assured picked up most of the remainder ($1.3 billion or 23% of new insured issuers).

The argument against insured municipals is pretty simple. Municipal default rates are extremely low, with most issues backed directly or indirectly by state and local governments. Issues backed by operating entities (e.g., private hospitals) are not commonly insured. So why buy insurance against a security that very rarely defaults?

And yet until recently, municipal bond buyers routinely demanded bond insurance. Why? Individual municipal credits are difficult to analyze. Its hard to get up-to-date financial information on some small school district in Indiana. Bond insurance (it was thought) eliminated the need for analyzing specific credits. Instead, the buyer could rely on the insurance policy to cover the small possibility of a default.

This attitude hasn't changed. Muni buyers are the same people they've always been. Put it another way: what percentage of muni fund managers wish the insurer problems would just go away, that we could go back to the old way of doing things?

And maybe we can go back. This morning, Warren Buffett was on CNBC outlining a plan to reinsure $800 billion in municipal bonds currently insured by FGIC, Ambac, and MBIA. In theory that would make the insurance problem (from muni buyer's perspective) just go away. He said that one insurer already turned down his plan, but his proposal remains significant. It means that there is private sector capital ready to get into the municipal insurance business.

The fact is that confidence in insurance has never been lower, and yet buyers continue to demand insurance at all tells you something. MBIA and Ambac may never be able to regain AAA levels of confidence, but municipal bond insurance as a concept will survive.