With the crunching of credit and meltdown of the mortgage market in 2007, the "golden age" of municipal bond insurance is likely over. Municipal bond insurance got its start as a way to protect investors if their bond issuer defaulted. But as the industry matured it became attracted to risky, exotic structured finance products. In this article we'll trace the roots of municipal bond insurance, showing how this dull, but safe industry was seduced by the risk and intrigue of collateralized debt obligations (CDOs) and mortgage-backed securities (MBSs), and how a losing gamble may have crippled an entire industry.

Early History - It's a Long Walk to Alaska
In 1971, MGIC Investment Corp. of Milwaukee formed a subsidiary called American Municipal Bond Assurance Corporation (NYSE:ABK) expressly for the purpose of providing financial guaranties to municipal bond investor. That same year, the first municipal bond was insured by Ambac to build hospital facilities for the town of Greater Juneau, Alaska.

The location dramatized an important benefit of this new type of insurance; after all, how many investors have ever visited Juneau? More importantly, how many would want to travel so far to perform due diligence on municipal hospital facilities? (To learn more, see Due Diligence In 10 Easy Steps.)

Public Debt Revolution
Once Ambac attached its insurance guarantee to the bonds, long expeditions became less necessary. The insurance was purchased by the bond issuer (Greater Juneau) when the bonds were issued, and it continued as long as any bonds in the issue remained outstanding. If any insured bonds should ever default on principal or interest payments, Ambac guaranteed to make up any defaulted or late payments to the investor. In effect, the high credit rating of Ambac (which was 'AA' from S&P in 1971) trumped the credit rating of the bond issuer. Once investors became satisfied that Ambac was a high-quality insurance company, they didn't have to worry as much about the due diligence on municipal bonds issued in Juneau, Laredo or Anytown, USA.