Municipal Bond Insurers: More dangerous than you realize

I've written before about bond insurers, and I reiterate my view that the big 4 (MBIA, FSA, FGIC, and AMBAC) will survive. But its certainly not impossible for any of them to falter. There is some non-zero probability that one of the four had weaker credit standards, and wound up underwriting policies on all the worst RMBS/CDO deals. I have no evidence that this was indeed the case, but then again, I can't prove it wasn't the case.

Anyway, as readers undoubtedly know, the big bond insurers were known primarily for insuring municipal bonds, and their CDO/ABS insurance business was merely a sideline. So just for the hell of it, let's consider what would happen if one of the big 4 bond insurers failed.

First, let's talk a bit about the municipal market. Its by far the least efficient of the major bond sectors. There are several reasons for this:

• Munis are hard to short, so if munis become overvalued, its hard to bet against them.
• The tax advantage of municipals can't be arbitraged. Or put another way, if municipals become undervalued, you could go long munis and short Treasuries, but because munis retain a tax advantage, such a trade would still have negative carry even before considering financing costs.
• Muni demand is still mostly retail, either directly or through funds. Retail demand for bonds tends to be erratic.
• Municipals from different states have different supply and demand conditions, causing trading levels to vary significantly.
• No two municipals are exactly alike in structure, especially long-term municipals which are almost always callable. Since exact maturity, coupon, call price and call dates vary, two structures are never the same.
• Deal sizes are too small for there to be frequent trading in all but a few issues. This makes it hard to determine the going level for a bond.
• There is very limited credit information on issuers. Most don't have to report anything about their financials to anyone other than ratings agencies. Some have to make occasional financial reports available, but only if bond holders demanded it at time of issuance.

Despite all these limitations, the municipal market does have one key advantage over other sectors: bond insurance. Insurance on a municipal bond deal is pretty simple. The issuer pays an up-front fee and in exchange, the insurer agrees to pay timely principal and interest in the event that the issuer cannot. If the original issuer remains solvent, then the insurance policy never comes in to play. Since a large percentage of deals are insured, investors take the credit quality of municipals for granted. (Are alarm bells going off? Good.)

We've seen what happens when a group of investors thought they could take credit quality for granted, then suddenly they couldn't. For example, AAA Home Equity...

What if one of the major insurers defaults? Suddenly investors wouldn't take the credit quality of any insurer for granted. Could there be a repeat of the ABX price action in municipals? Well, not quite the same, since the credit quality of most municipal issuers is inherently pretty good. Moody's reports that there has never been a general obligation issuer (meaning a issuer with theoretically unlimited taxing power like a state, county or city) actually default on its obligations. Including Orange County CA, which defaulted on some pension obligations but never a general obligation.

But considering the inefficiency of the municipal market, having an insurer default would create serious and probably permanent repercussions in the muni market. Remember that unless the issuer is simultaneously bankrupt as well, the default of the insurer doesn't cause any interruption of cash flow. In fact, in most cases the ratings agencies issue a "underlying" rating, which tells investors what the rating would have been sans insurance. If the insurer was suddenly out of the picture, the bond would merely be downgraded to its underlying rating. Perhaps surprisingly to those not in the muni market, most insured bonds have an underlying rating of AA or A.

Anyway, so what would happen if an insurer was bankrupt? First of all, retail investors would likely call up their brokers and demand to sell any bond insured by the defunct insurer. The result would be that the (formerly) insured bonds would trade weaker than uninsured bonds with the same underlying rating. Don't believe me? Radian insured bonds are already trading weaker than their underlying, and Radian is still in business.

The other immediate effect will be a price searching process for insured bonds, particularly in sectors considered more risky, like health care and project financings. Much like what went on in ABS this summer, potential sellers of bonds will have to feel out where the bids are, and potential buyers of bonds will be extremely cautious and extremely cheap when bidding.

Next, muni buyers would start questioning the value of bond insurance in general. If the insurance doesn't absolve the buyer of doing credit research, buyers will want to be paid for their efforts. If buyers won't assign a substantially lower rate to insured bonds, then issuers won't bother to pay for the insurance. All insurers, regardless of their actual financial strength, will see new business plummet.

All this will cause a very murky market to become murkier. That will create a wonderful buying opportunity for those with the cash and the confidence in their analysis. Wider bid/ask spreads tend to favor long-term buyers over other players, because wide bid/ask almost always indicates fear. You'll have to have the stomach and the job security to live through a bumpy ride.

What will be the long-term consequences? Possibly a decrease in retail buyers owning bonds directly. If retail investors don't feel confident in the quality of what they're buying, you'll likely see them rotate into funds.

Like I said in the beginning, this is a low probability scenario. But its not impossible.