About a week ago, I had the opportunity to hear Sean McCarthy, CEO of the fledgling Build America Mutual, speak about the outlook for muni bond insurance. That got me thinking about the profound impact financial guarantors have had on our industry over the last few decades. It also got me waxing nostalgic for the good old days.
Early in my career, back in the mists of time, I was fortunate enough to be involved in MBIA when it was still a multi-line company. Circa 1983, MBIA was basically a consortium of five insurance companies: Aetna, CIGNA, Travelers, Continental and Fireman’s Fund. Its bond insurance business was managed by a service company, appropriately called Municipal Issuers Service Corp. or MISC. Together, the five- member insurance companies constituted MBIA’s Underwriting Committee (I represented Cigna on the Committee). The underwriters and analysts at MISC would go out and generate the credit enhancement business, perform the initial credit analysis on issuers who wish to obtain credit enhancement and then submit such candidates to the Underwriting Committee for approval.
Clearly, the next few years should bring both opportunities and challenges for the muni bond insurance industry as it strives once again for market relevance.
Back in those days, each of the member companies also maintained their own research staff, so that each underwriting decision had to endure the scrutiny of not one, but six credit teams, counting MISC’s. If nothing else, it was an excellent checks-and-balances system. If a member company failed to see the merits of any single insurance candidate, it had the ability to decline to participate in that particular transaction. Most importantly, even in a sector with a ridiculously low historical default rate (although the New York City fiasco was still fairly fresh in our minds at the time), we were writing business to a “zero-loss” standard. We were in the credit enhancement business, lending our AAA rating to lesser-rated issuers to lower their cost of capital. And, like your friendly local banker, we weren’t keen on extending credit to people who actually needed it.
Perhaps due to such an exacting underwriting standard, I believe the financial guarantee industry has been a great training ground for municipal analysts (pardon my obvious and shameless bias). The thought of committing your company to an “unconditional” and “irrevocable” long-term obligation for as long as 30 years brought out the best in all of us. With all due respect to our colleagues in other areas of public finance, once the policy was written, you didn’t have the luxury of changing your rating or selling out of your holdings. You had to live with your credit decision for the long run.
The rest, of course, was history. I left Cigna in 1985 to go join the budding high yield muni fund industry. After spending 18 months as a subsidiary of Ryder Systems (yes, the trucking company, but don’t ask me why), MISC was repurchased in 1986 by the new MBIA Inc., which had reconstituted as a monoline insurer. The new company went public a year later, on July 1 , 1987.
With the benefit of hindsight, once MBIA (and most of its competitors) became publicly-held companies, it was only a matter of time before they felt the pressure from shareholders to meet return-on-equity targets and started venturing into sectors they had little experience with: first corporates and then structured financings. Arguably, it was this kind of “mission creep,” leading insurers to stray well beyond their initial muni comfort zone that ultimately led to their undoing during the 2008 crisis.
The demise of the bond insurers brought an end to almost two decades of muni market “commoditization:” at its peak, bond insurance accounted for as much as 60% of the tax-exempt market. The tremendous expansion of the insured sector drove credit spreads to cyclical tights and basically removed credit as a performance lever for most investment grade investors. Furthermore, one could argue credit commoditization was also a major factor in the explosion of leveraged muni strategies in the early 2000s, and we all know how that ended.
In the aftermath of the financial crisis, only one legacy bond insurer was left standing: Assured Guaranty, with an A2/AA- rating for its muni policy. Among the other former industry leaders, Ambac had to file for bankruptcy and MBIA has been, for all practical purposes, downgraded out of the financial guarantee business (although its rating is slowly recovering as key litigations related to the financial crash are settled). This once-dominant industry has seen its market penetration decline every single year since 2005 to just around 3% by par value in 2013.
Another byproduct of the bond insurers’ implosion: instead of relying solely on the insurer’s rating, investors now feel compelled to evaluate the underlying credit also. Needless to say, this trend has negatively affected market liquidity and led to some rather odd phenomena: for most highly-rated muni issuers, using bond insurance would result in interest cost penalties, instead of savings.
The key to bond insurance is that it has to be straightforward and simple to understand. That’s what investors are paying for. That’s why other more innovative but overly complex approaches have struggled to gain market acceptance: as a case in point, upstarts such as BondFactor, which tries to adapt risk-pooling methodology formerly used for collateralized debt obligations instruments (CDOs) to munis, have reportedly had little success in raising sufficient capital, at least thus far.
Not that the industry couldn’t accommodate a little innovation, just not too much of it. The newest entrant into the field, Build America Mutual or BAM, has successfully adapted the mutual ownership concept to financial guaranty, turning insured municipal issuers into owners. In 2013, its first full year of operation, AA-rated BAM claims to have captured a 38% market share based on par value of transactions.
BAM’s entry into the business has brought competition back into bond insurance but has also depressed profitability. According to a recent study by S&P, “the implied premium rate for the industry is about 20% lower in 2013 than it was a year ago and is falling short of Standard & Poor’s Ratings Services’ expectations. Moreover, historically low municipal yields, volatile interest rates, and low demand for insurance have negatively affected the insurers’ risk-adjusted pricing (RAP) ratios. For the first nine months of 2013, the industry average RAP was 3.53%, down from 4.47% in 2012.”
So what lies ahead for muni bond insurers?
Given the rising liquidity concerns currently facing the fixed-income market, one can easily see a renewed need for some type of credit commoditization, particularly when it comes to smaller issuers and/or issues aimed at direct retail investors. Last year’s headlines about Detroit and Puerto Rico should lead investors to reconsider the value of bond insurance. A rising rate environment is also believed to make the savings from insurance more valuable, although it may also hurt refunding volume.
Given the right interest rate and credit spread environment, it’s not inconceivable for muni bond insurance to regain a 10-15% market share, particularly if National Public Finance Guarantee, the muni-only subsidiary of MBIA, re-enters the fray.
This time around, however, the insurers are facing a completely changed credit environment. Depending on the outcome of key muni bankruptcy cases around the country – Detroit among others – traditional risk assumptions could easily fall by the wayside.
It’s fair to say that Puerto Rico is currently the largest single threat to the health of the financial guarantee industry. The rating agencies are already on record saying they believe the leading bond insurers have sufficient capital to withstand the potential stress from Detroit, Puerto Rico and perhaps even another major city credit. However, this analysis probably assumes that, in the event of default, insurers only make payments to investors when due. An actual debt restructuring involving actual haircuts to principal would probably make a more significant dent in the bond guarantors’ capital.
No wonder the stocks of the leading insurers, Assured Guaranty and MBIA, took a big hit on Wednesday at the mere mention of a potential debt restructuring for Puerto Rico, even if such rumor came from a misguided media report. Although such restructuring scenario was promptly denied by the Commonwealth, the market’s hysterical reaction did show how nervous financial guarantor stockholders are about their PR exposure.
Clearly, the next few years should bring both opportunities and challenges for the muni bond insurance industry as it strives once again for market relevance. At a minimum, bond insurers will be expected to incorporate the latest credit developments into their underwriting standards and risk management practices. Failing that, the industry may find itself in the credit guarantee instead of the credit enhancement business. That would certainly not be the most desirable outcome, for its shareholders as well as for the public finance sector at-large.
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