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.

The invention of municipal bond insurance revolutionized the public debt markets over the next 36 years. In 1974, another new insurance company entered the market, the Municipal Bond Insurance Association (NYSE:MBI), and gained the highest possible rating, 'AAA'. In 1979, Ambac also achieved this rating. By 1988, 25% of all newly issued municipals carried insurance. In 1994, bond insurance helped to avert panic in the municipal market, when Orange County, California, declared bankruptcy. (For more on the corporate debt rating system, see What Is A Corporate Credit Rating?)

Two Types of Municipal Bonds
The U.S. municipal bond market grew steadily over several decades to about $2.6 trillion in value as of year-end 2007, according to the Securities Industry and Financial Markets Association (SIFMA). The market is subdivided into two types of bonds:

  • General obligation (GO) bonds - GO bonds are backed by the issuer's full credit and taxing ability, and are commonly issued by states, counties and municipalities.
  • Revenue bonds - Revenue Bonds are backed by specific revenue streams from license fees, tolls, rents, or special purpose tax assessments.

GO bonds are generally considered to be of higher quality, because the bond issuer has taxing power and can increase taxes to repay bonds, if necessary. For example, most states in the U.S. command either 'AAA' or 'AA' ratings, which indicates very high quality, even without bond insurance. The issuers of revenue bonds, however, tend to be smaller and lack discretionary taxing power, so their ratings are more varied and often lower. About two-thirds of all new municipal bonds issued are revenue bonds, according to the SIFMA. (To learn about investing in muni bonds, see The Basics Of Municipal Bonds and Avoiding Tricky Tax Issues On Municipal Bonds.)

Building Investor Confidence
By paying a premium to a municipal bond insurer at the time a bond is issued, GO and revenue bond issuers have been able to "enhance" the issue's credit quality to the highest 'AAA' level. This increases investor demand for the bonds in both the initial underwriting process and secondary trading market.

Historically, the leading bond insurers have pursued two other strategies that helped to increase investors' confidence in their guarantees.

  • Narrow focus - While many insurance companies pursue a variety of business lines (ex. life, auto, health and homeowner's insurance.), companies like Ambac and MBIA "stuck to the knitting". For this reason, these companies are often called "monolines". The narrow focus helped them avoid exposure to huge losses that have hurt other insurers, such as the vast property damage caused by Hurricane Katrina.
  • Zero-loss standard - The monolines have always emphasized that they conduct rigorous credit analysis of every bond issuer to maintain a "zero-loss" underwriting standard. In other words, they claimed to have confirmed that the insurance would not be necessary except in very extreme cases.

An Industry Flourishes
For a quarter of a century, the narrow focus and zero-loss standard worked for the monolines according to plan. For example, during the first half of 2007, $231 billion in long-term municipal bonds were issued in the U.S., according to the SIFMA. Within this issuance, roughly 48% of the nominal dollar volume had credit enhancement. About 90% of the enhancements were through monoline insurance, as opposed to other methods such as bank letters of credit or standby purchase agreements.

Meanwhile, default rates on municipal bonds were very low, averaging just 0.63% on a cumulative basis for all bonds issued between 1987 and 1994, according to a long-term study by Fitch Ratings.

In this environment, the municipal bond insurance industry flourished. MBIA and Ambac grew their annual revenues to $2.7 billion and $1.8 billion, respectively, and they were joined in the field by others including FGIC Corp., XL Capital Assurance (NYSE:XL) and ACA Capital Holdings (OTC:ACAH).

The Seductive World of Structured Products
In a search for increased profit, the monolines began to diversify their book of business into the lucrative world of residential mortgage-backed securities (RMBS) and other structured finance products. The RMBS products included both high-quality "prime" mortgages and lower-quality subprime mortgages. In the structured credit product line, monolines guaranteed the principal and interest on exotic CDOs that sliced and diced different cash flows of RMBSs, all of which were heavily leveraged to a continuation of the U.S. housing boom that persisted from 2002 until 2006.

Then in 2006, the housing boom went bust. The RMBS and CDO guarantees of the monolines became costly liabilities, and the credibility of their "zero-loss standard" went out the window, perhaps forever. (To learn more, see Why Housing Market Bubbles Pop.)

In late 2007 and early 2008, the tide began to turn against the monolines in three ways:

  • Standard & Poor's downgraded the credit rating of ACA Capital Holdings by 12 levels, to 'CCC' (highest risk). This downgrade came after ACA reported a $1-billion loss.
  • Fitch Ratings reduced the prized 'AAA' rating of Ambac to 'AA', while also putting the company on "negative watch," indicating the potential for further downgrades.
  • MBIA was forced to scramble for additional capital to shore up its losses, which were reported as $1.9 billion for 2007 amidst heavy balance sheet write-downs. (To read about other subprime casualties, see The Rise And Demise Of New Century Financial and Dissecting The Bear Stearns Hedge Fund Collapse.)

Tips for Investors in the Brave New World
Although the monolines did maintain their narrow focus on insuring credit risks, their foray into RMBS and CDOs proved costly to their stature as strong guarantors. The question then remains, what should municipal bond investors know, and do, about this type of insurance going forward?

  1. Insurance is only as good as the rating and credit underwriting policies of the monolines that stand behind it. It's important for investors to evaluate not only the quality of the underlying bond, but also that of the insurer.
  2. It may take some time for the monolines to shake out the mess from the worst housing market in decades.
  3. Perhaps most importantly, diversification can be just as valuable in municipal investing as in other areas. That means spreading risk among different issuers and regions of the country. A number of tax-exempt mutual funds offer diversified portfolios of municipal bonds, and one significant event of 2007 was the proliferation of exchange-traded funds (ETFs) that specialize in municipals.

The heyday of municipal bond insurance, where up to 60% of newly issued bonds were enhanced and the monolines were considered rock solid, is over. Now, insurance is just another feature attached to a municipal bond, and it no longer eliminates the need for investor caution or due diligence. The bond insurers gambled their reputations on exotic new products - they lost, and so, too, did investors.

For more on the subprime crisis, check out our Subprime Mortgage Meltdown Feature.

Related Articles
  1. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  2. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  3. Budgeting

    Preventing Medical Bankruptcy

    If you’re worried medical expenses could overwhelm you, there are some thing you can do to ease your concerns.
  4. Insurance

    Medicare 101: Do You Need All 4 Parts?

    Medicare is the United States’ health insurance program for those over age 65. Medicare has four parts, but you might not need them all.
  5. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  6. Professionals

    Credit Risk Analyst: Job Description and Average Salary

    Learn what credit risk analysts do every day and how much money they make on average, and identify the skills and education needed for this career.
  7. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  8. Insurance

    How Life Insurance Works in a Divorce

    Learn the implications of life insurance in a divorce situation, and identify the steps you should take to ensure your policies are sorted out post-divorce.
  9. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  10. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  1. How many free credit reports can you get per year?

    Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
  2. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
  3. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  4. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  5. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>
  6. Are 401(k) contributions tax deductible?

    All contributions to qualified retirement plans such as 401(k)s reduce taxable income, which lowers the total taxes owed. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  4. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  5. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  6. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
Trading Center