In both cases, Moody's cited declining use of bond insurance in general: "Bond insurance volumes in the municipal segment have also declined significantly, with insurance penetration rates dropping by a third or more." It seems Moody's has concerns that the decline of muni insurance in general is a negative for FSA and Assured Guaranty's long-term business models. Which is interesting since both FSA and Assured Guaranty have both increased their market share considerably. In Assured's case, they are writing substantially more business now than last year, and for FSA its at least close.
It still looks to me like FSA and Assured Guaranty have plenty of capital, especially given their lack of ABS CDO exposure. But it isn't my opinion that matters. So what should municipal investors do with their FSA and Assured Guaranty paper? And would a downgrade of either lead to an investment opportunity?
First, consider what "negative watch" means. In most cases, negative watch turns into a downgrade, unless some intervening event occurs. For FSA, its possible that Dexia contributes capital to bring FSA above Moody's target levels. But given that Assured is already above those levels, its not certain that a capital infusion would make any difference. So investors should assume that FSA and Assured Guaranty will be downgraded. I would also assume that S&P will eventually follow suit.
Within an existing portfolio, look at each credit in your municipal portfolio. Are there any that you own strictly because of the insurance? If so, you are probably best to get out now. Get the underlying rating of all your positions. If you are with a financial professional who cannot readily provide the underlyings... well, that should tell you something.
As far as looking for opportunities, they will be there for investors with long investment horizons. But be aware of liquidity. Institutional investors are going to be better sellers of insured bonds for some time to come. Scrutiny from the public (in the case of publicly reported portfolio) or from a board (in the case of insurance companies) will cause portfolio managers to shun bonds where a downgrade is expected. If you bid on a FSA insured bond today, the odds are fair that you are the only bidder. And what does that tell you about your ability to sell the bond yourself? If you are going to bid on a FSA insured bond, make sure you bid a price at which you are comfortable holding for the long-term.
Of course, if you do decide to look at a FSA insured bond, you need to look at the underlying rating. Until recently, the market didn't price A underlying bonds much differently than those with a AA underlying ratings. That's going to change in a big way. Investors will demand significantly more yield for an A-rated risk, even before FSA or Assured gets downgraded officially. Keep this in mind when bidding on bonds. Among non-insured bonds, the gap between A and AA is about 50bps, which is about 4% in price on a 10-year bond.
I had previously said I thought that municipal insurance would remain viable, despite the problems with FGIC, Ambac, and MBIA. I think the fact that a large percentage of new issues in 2008 have carried insurance bears that out. However, if Moody's (and S&P) cannot establish consistent guidelines for maintaining a top rating, then it will be impossible for insurers to plan for capital adequacy. Having the Aaa rating is crucial to that business, yet its unknown what the criteria will be from week to week. That's an impossible business to capitalize intelligently.
Ironically it won't be a lack of demand that kills muni insurance, but a lack of supply.