Munis Should Form Cooperative Entity to Self-Insure

Munis Should Form Cooperative Entity to Self-Insure…

The Prince has been following the troubles of the bond insurance business for the last few weeks. Many thanks to Naked Capitalism, Alea Blog, and Information Arbitrage for their commentary to supplement The WSJ. It now appears that many of the largest monolines (bond insurers), if they are able to raise additional capital and follow through with the recommendations of the rating agencies, may maintain their AAA ratings. The possibility of keeping the top rating seemed highly unlikely for MBIA and Ambac, the two largest monolines, just a few weeks ago.

The recent failures of many municipal bond auctions combined with the pulling of many expected municipal bond issuances has created more turmoil in the market related to the insurers. The spike in rates has caused the cancellation of one bond offering planned for this week. The Houston Independent School District said that it had withdrawn a planned $385.4 million municipal-bond issue, saying the rapid rise of interest rates had made the cost of such an offering prohibitively expensive. For those who are unfamiliar, municipal issuers finance such things as hospitals, road construction, schools, sewer systems and sports facilities. Local governments seek bond insurance to reduce the perceived risk of owning their debt. That can attract more investors, resulting in lower borrowing costs and saving taxpayers money.

Now had the bond insurers not moved beyond their municipal bond insurance roots by insuring more leveraged and complicated securities most municipalities would not be facing higher borrowing costs on new issuances and refinancings. To give everyone some idea of how bad things have become in the secondary market for municipal bonds check out these numbers from two recent WSJ articles here and here:

Municipal debt generally pays out interest that is 10% to 20% less than comparable U.S. Treasurys because holders don't pay federal taxes on the interest income. Friday, top-rated 30-year municipal debt was yielding about 16% more than 30-year Treasurys, and two-year municipal notes were paying out 60% more than comparable Treasurys.

When the tax benefits are taken into account, the result is eye-popping yields. At an average yield of 5.14% on triple-A-rated 30-year municipal bonds, a California resident in the top federal income-tax bracket earns the equivalent of 8.72%.

As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond. In normal times, municipal-bond yields are much lower than Treasurys.

No wonder many veteran bond investors love the state of municipal bond, so long as they were not long before the sell-off (the average long-term national municipal-bond fund is down 3.83% this year). These investors have little doubt they see the greatest buying opportunity of their careers. Think about this trade, which only an institution could undertake, you go long against municipal notes and you financing by borrowing in the Repo market against your lower yielding Treasurys of comparable maturity. Needless, to say The Prince is sure that many of the best brains in credit investing are now employing similar strategies or far more sophisticated strategies. If you need evidence look at these quotes from the WSJ articles:

Shelia Amoroso, a portfolio manager at Franklin Templeton Investments, says she has never seen anything like this in her 21 years in the market. "It's a compelling buying opportunity."

Hugh McGuirk, head of the municipal-bond division at T. Rowe Price Group Inc., Friday bought bonds issued by the state of Florida yielding 5.85%. Two weeks ago they were at 5%. "We've been waiting for a market like this."

This puts the municipal market in the odd place of competition with struggling stocks. "Munis are offering a risk-adjusted return that probably exceeds equities under more normal circumstances," Cumberland Advisors said in a weekend market update.

A number of players said they also are looking at an area known as "pre-refunded" municipal debt, in which interest payments are effectively guaranteed by a pool of U.S. Treasurys or other government securities held in an escrow account.

Late Friday, the average 5-year pre-refunded bond yielded 3.23%, compared with 2.47% on a five-year Treasury. Throw in the tax benefit, and for a New Jersey resident, the pre-refunded debt pays the equivalent of a 5.31% yield on Treasurys. George Goncalves, an interest-rate strategist at Morgan Stanley, calls it "the dislocation of a lifetime." The market, he says, "has thrown out the good with the bad."

"The muni market is at relative values that I have not seen in my career before," said Evan Rourke, municipal-bond portfolio manager at MD Sass in New York. At current valuations, he said, investors can earn 5% or more on tax-exempt municipal bonds, roughly equivalent to an 8% taxable yield. "At that level, you're approaching long-term stock returns," he said.

Brokerage firms issued all-points bulletins to their sales forces Friday suggesting they send clients into municipal bonds. One Morgan Stanley strategist described it as "the dislocation of a lifetime." Bill Gross, managing director of Allianz SE's Pacific Investment Management Co., or Pimco, said Friday the bond titan is moving out of Treasurys and corporate debt into the muni market.

It is worth noting that these municipal bonds do look attractive since the fundamentals have not changed. The credit quality of municipal borrowers has not changed substantially even though the pricing in the secondary market for municipal debt has fallen off a cliff. Default rates on municipal bonds tend to be low, even without the bond-insurer guarantees. S & P says municipal debt carrying a BBB rating has a long-term default rate of about 0.32% of outstanding bonds. That is lower even than the 0.6% default rate on AAA rated corporate bonds. Buying municipal bonds looks better than buying high yield corporate debt, which also has exceptionally high yields right now, since corporate defaults may substantially rise in the wake of the credit crunch and slowing economy.

So why are municipal bonds so cheap? The market chatter says that two hedge funds (Duration and 1861) have been doing recent forced selling (to meet margin calls on bad trades in other securities) by having their broker dealers shop sell lists of these hedge funds' municipal securities for bids to their clients. The WSJ remarks that, "in recent years hedge funds had flocked to a trading strategy that hinged on the normally reliable wide gap between yields on short-term and long-term municipal securities. The hedge funds sought to profit from that gap by borrowing at the lower short-term rates, buying longer-term higher-rate municipal debt and pocketing the difference. They magnified this trade by borrowing heavily to make this bet, sometimes using 10 times debt for every dollar of investor money they were putting to work. At times they also layered on bets against U.S. Treasury securities." This trade would be a terrible place to be lately since both sides of this trade would bleed money as Treasurys strengthen and Municipal debt weakens. Clearly the weakening of municipal debt has been partially caused by the struggling bond insurers. Yet, forced selling is playing a role. However, if the likes of PIMCO start buying municipal bonds en masse then we can expect the yields to drop on the bonds. The current pricing of municipal bonds related to Treasurys is about the clearest market inefficiency The Prince has ever observed.

Yet, what The Prince is most interested in right now is the future of insurance for municipal bonds. Is it necessary? Can it be used to achieve a lower cost of borrowing for municipalities, governments, school districts, and the like? First, we have to ask if being in the business of insuring solely Municipal bonds right now is a good business. Warren Buffet seems to think so. He recently launched a bond insurer that would help state and local governments lower their borrowing costs, and possibly lure business from established rivals struggling with failing credit markets. Berkshire Hathaway Assurance Corp guarantees the bonds that cities, counties and states use to finance public works. The new company avoids investing in structured products, such as bonds backed by cash-generating assets such as mortgages and credit-card receipts. Berkshire Hathaway Assurance Corp., or BHAC, has effectively been taking market share from incumbents such as Ambac and MBIA which have been struggling to keep their triple-A credit ratings. In recent days, rating agencies have bestowed triple-A ratings on municipal bonds insured by the new Berkshire venture, months before competitors and some analysts predicted. Last Friday, Maryland's insurance department granted BHAC a license to do business in that state. The company has already guaranteed more than 100 municipal-bond offerings, including debt issued by New York City, where it received its first license. The Prince would have to agree that business is good for an insurer with a strong balance sheet, that isn't trying to raise new capital, and is not taking a six month hiatus from issuing new paper at the behest of the rating agencies.

If we accept as a first premise that issuing bonds with insurance issued by a well capitalized insurer does lower borrowing costs, then The Prince thinks he sees a better way to lower borrowing costs. While The Prince is not an expert on this topic, he would love to get some feedback on this idea. Why do we not see the big issuers of municipal bonds i.e. the Port Authority of New York and New Jersey, the State of California, tollways, etc., forming a coop together to issue insurance. This coop would take the form of a public "utility". Why give all the rents to Warren Buffet's insurer or another insurer when the issuers can effectively cut the middle man out. In theory, if we could get the top 100 issuers of municipal bonds to contribute capital to an entity controlled by the contributors that entity could then provide insurance to the members at a lower cost than private insurers. The contributions would serve as the assets that would insure the bonds from default. The effective borrowing costs for issuers would have to decline under this cooperative self-insurance scheme. Under this scheme Tom Dresslar, spokesman for California state Treasurer Bill Lockyer, wouldn't have to say "we're prepared for higher rates than we've paid in the past." California could buy insurance from this cooperative public "utility" entity which would lower the State of California's cost of borrowing even when you consider the fact that California had to buy shares in the cooperative entity. The market may be pricing insurance from unsound insurers as if it doesn't exist right now but they could not ignore insurance issued by a well capitalized public "utility" like the one The Prince has outlined above. If nothing else there would be serious savings for those that still want to issue debt that has insurance. This is the case, because Before the bond-insurer crisis, bond insurers charged about 30% of the interest-rate savings an issuer would get. This has climbed to about 80% or 90% as the bond insurers try to extract as much premium as possible. For the issuers, though, that has reduced the value of the coverage.

If all the major issuers setup the scheme The Prince has discussed above, not only could they save the premium that insurers extract, but the value of their bonds' insurance would not be subject to the poor business decisions of a third party bond insurer choosing to insure riskier non-municipal instruments. All the questions in the market like those intoned by California's deputy state treasurer, Paul Rosenstiel, "as to the value of insurance and whether it would save us money" would be silenced. Please, to those who are more knowledgeable about this than The Prince, tell him why his scheme above would not work. He wants to believe that a scheme as this simple can't work in our time of sophisticated and evolved finance.

-The Prince

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