Shielding local goverment: A look at bond insurance
In 1971, the Greater Juneau (Alaska) Borough approached the Ambac Assurance Corp. with a novel idea. The borough wanted Ambac, whose primary concentration was insuring portfolios, to insure general obligation bonds. Nearly 30 years later, the idea has taken a firm hold in the world of municipal finance. More than 10 companies comprise the financial guaranty industry, which has upwards of $1.1 trillion bonds in its aggregate portfolio.
In Wall Street parlance, bond protection has become “sleep well” insurance. That is because a bond insurance policy provides an unconditional and irrevocable obligation to pay the debt service on a bond if the borrower cannot.
Disasters spur growth
In 1973, Armonk, N.Y.-based MBIA Insurance convinced rating agency Standard & Poor’s that its claims-paying ability was worthy of a Triple A rating. Ambac followed in 1978. Achieving the AAA rating helped the two companies kick-start the bond insurance business. (Bond insurers get their credit ratings by passing a stress test by the rating agencies that simulates the economic conditions of the Great Depression. The test looks at whether an insurer can handle claims and come out of the Depression as a “going concern.”)
A bond insurer’s rating affects the types of bonds it is willing to insure and the level of risk it is willing to take. Most insurers are rated “AAA,” but exceptions exist, and some companies actually opt out of the higher designation. ACA Financial Guaranty, for example, chose a single-A designation because of the flexibility it offers. That designation allowed the company to insure $20.8 million worth of debt for Deadwood, S.D., which used the money to boost tourism by restoring historic sites. As an unrated issuer, Deadwood would have been snubbed by Wall Street. “The insured single-A put Deadwood on investor’s radar screens,” says ACA Chairman Russell Fraser.
Even with the AAA ratings, however, it took a number of financial disasters to really propel acceptance of the idea of bond insurance. In 1975, when financially strapped New York City imposed a moratorium on its debt repayment, just under 2 percent of all municipal bonds sold at the time were insured.
The bond insurance industry grew as it became more accepted. Financial Guaranty Insurance entered the market in 1983, Bond Investors Guaranty Insurance (BIG) emerged in 1984, and Financial Security Assurance (FSA) followed in 1985. Each was rated AAA. (BIG no longer exists; its portfolio was sold to MBIA in 1989.)
Three new companies entered the U.S. market in 1986. College Construction Loan Insurance Association (Connie Lee) was set up to insure institutions of higher education and financially weak hospitals. Enhance Reinsurance became the first “monoline” U.S. company to offer reinsurance in the financial guaranty market. (A monoline company does just one type of business, such as financial guaranty, compared with a “multi-line,” which may provide property and casualty insurance and life insurance as well as financial guaranty insurance.) Capital Guaranty Insurance also was founded that year. (Unless otherwise indicated, all companies are based in New York.)
Bond guarantees grew to 10 percent of the total bond market by 1983, the year of the $2.25 billion default by Washington Public Power Supply System (WPPSS, a convenient acronym that was pronounced “Whoops”). Ambac had insured a small percentage of those defaulted bonds, and, unlike the majority of investors who waited years for the courts to parcel out pennies on the dollar, the insured bondholders were paid on time and in full. Within two years, the proportion of insured bonds doubled.
Other events continued to rock the bond market. The 1994 bankruptcy of wealthy Orange County, Calif., alerted municipalities to the potential risks of an aggressive investment strategy – the cause of Orange County’s downfall. Other local governments in Texas and Florida lost ratings and suffered financial upheavals for similar reasons. However, while those events left municipal and financial services markets in trying times, bond insurers emerged essentially unscathed.
Bond insurers took a hit, though, during the 1998 bankruptcy filing by the Pittsburgh-based Allegheny Health, Education and Research Foundation (AHERF), which resulted in a reorganization of the foundation’s five Philadelphia hospitals and its medical university. MBIA had insured $256 million of AHERF’s outstanding bonds and had shared $170 million of that risk among reinsurers. Consequently, the bankruptcy affected a number of companies’ balance sheets.
(In the wake of the AHERF crisis, MBIA has shifted its business philosophy, and other insurers have followed suit. Rather than reaching for ever greater market shares, insurers are tightening up on pricing and underwriting standards in an effort to bolster profitability.)
Retail replaces banks
In 1972, commercial banks held 51 percent of all state and local debt. Twenty years later, bank holdings had fallen to just 8 percent, with individual households holding about 40 percent. Money market and mutual funds hold another 25 percent, and insurance companies and other institutions own the rest.
Today’s household has a number of options for investing savings, retirement funds and short-term deposits that did not exist 30 years ago, and individual investors, whether on their own or through money market and mutual funds, welcome the protection and comfort of bond insurance. As a result, insured bonds topped 50 percent of the new issue market in 1998.
The New York-based Association of Financial Guaranty Insurers, a trade organization representing bond insurance companies, estimates that bond insurance has saved municipal and tax-exempt borrowers nearly $30 billion since 1971. AFGI calculated the savings by looking at the cost of comparable non-insured bond issues; savings are passed along to taxpayers through lower taxes and fees.
Bond insurance exposes a borrower to a larger national market. Enhanced liquidity and market access make the bonds more desirable to investors and, thus, less costly to borrowers than are uninsured bonds. Bond insurance also simplifies complex transactions or “story” bonds – important in today’s market, which is dominated by individual investors and mutual funds. While many investors continue to look through the insurance to the individual issue, the double layer of protection comforts them. Not only would the borrower have to run into financial trouble, but the insurer’s portfolio and ability to meet claims would have to be questionable for there to be a missed payment – two events that are unlikely to occur at the same time.
In the mid-’80s FSA wrote its first international insurance policy. Shortly afterwards, forays into international waters increased, and several companies established outposts in Tokyo and London, as well as in other European cities. The effects of the new philosophy on local governments within the United States are subtle but profound. As insurers diversify into new markets, cities and counties will find themselves in financial competition with foreign municipalities.
In 1995, MBIA and Ambac formed a joint venture to market and develop international business together. At the same time, bond insurers entered the asset-backed or structured finance markets in both the United States and elsewhere.
Structured finance involves the aggregation of certain types of assets that have cash flow, such as auto loans, home equity loans or credit cards. The repayments on the assets are pooled and matched to repay bonds. Municipal asset-backed finance is most common in the housing arena, but local government pools, pooled government equipment purchasing programs and government loan programs also fall under the category.
Both international public finance and structured finance have grown and matured through the last two decades. Today there is greater diversity and depth in both markets.
As financial markets become global, the U.S. financial guaranty industry is attracting greater interest from international participants. Last year, for example, the Dexia Group, a large European financial institution that traditionally has engaged in public sector lending, purchased FSA. Additionally, Capital Re was bought by Bermuda-based ACE Guaranty Re. Ironically, MBIA and Ambac, which started it all, recently disbanded their five-year alliance to go it alone.
As bond insurers have diversified into other areas, municipal finance has begun to play a less prominent role. Recently, insurers have begun to cover fewer new issues in the muni market. The majority of the industry’s portfolio of insurance has tipped toward asset-backed transactions for the first time in 1999.
According to a report by rating agency Fitch IBCA, bond insurance accounted for a peak share of 54 percent of new issues in 1998. In 1999, bond insurance accounted for 47 percent of all new issue volume in the municipal market. According to the Bond Buyer, a daily trade publication, in the first seven months of 2000, bond insurance had fallen to 40.5 percent of the market. In 1999, for the first time, bond insurers wrote less business in the municipal market than in the asset-backed and structured markets – 43 percent versus 48 percent. (International business made up 9 percent of principal insured.)
David Litvak, managing director of Fitch IBCA, says that prices – that is, premium rates – are up 15 to 40 percent since 1998. Bond insurers have become more selective about deals, accounting for the drop in the proportion of insured. Municipal officials can expect to see a more careful bond insurance industry over the coming months.