Felix Salmon

On Friday, I said that there’s a strong case to be made for the existence of municipal bond insurance, "since these bonds are generally bought by retail investors who can’t be expected to do sophisticated credit analysis". Commenter efranco then asked a good question: what happens if and when the municipalities start getting triple-A ratings, as Moody’s has indicated is going to happen? Bloomberg’s Michael McDonald says there’s a good chance that demand for bond insurance will plunge, and even the insurers seem to agree:

"If rating agencies level the playing field in terms of how they rate municipal versus corporate obligations, there will be little need for a financial guaranty insurance marketplace as we know it,” Ajit Jain, head of Warren Buffett’s Berkshire Hathaway Assurance Corp., said at a congressional hearing in March.

If this is true, then there shouldn’t be a market for bond insurance. Bond insurance, if there’s any point to it at all, is an insurance product, not a ratings enhancer: issuers buy it because investors are reassured by it, and can sleep safely at night in the knowledge that their bond coupons will be paid in full and on time – by someone.

After all, there’s a world of difference between a credit rating, on the one hand – which is simply an opinion regarding probabilities – and a monoline wrap, on the other – which is a hard-cash guarantee that you’ll get your money back.

And these days the money-back guarantee should be even more valuable than a triple-A rating than it was in the past, seeing as how the ratings agencies seem to have been very good at handing out triple-A ratings where they weren’t deserved.

But there’s a problem, of course. If you thought banks and hedge funds got highly leveraged, just wait until you look at insurance companies, whose claims-paying abilities are a minuscule fraction of their total potential claims. If municipalities for some reason started behaving a bit like the housing market and all defaulted at once, no monoline, not even Berkshire Hathaway, could come up with the money it needed.

So municipal bond insurance is insurance against any given municipality defaulting; it’s much weaker as insurance against municipalities in general facing enormous difficulties which end up forcing them into default.

All the same, it’s a useful thing to have, for one big reason: the monolines are much more involved and engaged in municipal finances than the ratings agencies are. When a municipality goes to a monoline to be wrapped, the monoline will make certain demands, similar to covenants on loans, which actively make the municipality more creditworthy. And if the municipality still ends up running into fiscal difficulties, the monoline has both the ability and the desire to step in early and force actions to avert default. Ratings agencies, by contrast, can do none of that, and certainly don’t keep a close eye on municipalities after they’ve been rated, if they’re not issuing anything new.

Municipal defaults are often caused by treasurers getting out of their depth in terms of derivatives they don’t understand (Orange County, Jefferson County). If the deal with the monoline precludes such activity, then the county’s bonds will become that much less risky. So it’s a useful thing for investors to have.

On the other hand, if municipal bond insurance is really just a ratings arbitrage masquerading as an insurance product, then it deserves to die.

The irony here is that municipalities are finally getting their long-coveted triple-A ratings just as those ratings have never been less valuable. Maybe investors, used to having a contractual guarantee of repayment, rather than just a ratings-agency stamp of approval, will continue to pay a premium for wrapped bonds, even if the municipality in question has a triple-A rating. But in order for that to happen, they’re going to need to rekindle their faith in the monolines first.

I got a phone call Thursday afternoon from MBIA spokesman Kevin Brown. He mainly wanted to clear up one thing about my blog this morning: MBIA Insurance Corp is not, technically, "going into run-off". It’s just not writing much in the way of new business right now, that’s all.

Given that an insurance company in run-off is one which isn’t writing new business, you’d think this is a distinction without much of a difference, and you might be right. But there is a difference: an insurance company in run-off will never write new business. And, for the time being at least, MBIA is keeping its options open. Once what Erin Callen might call "visibility" improves, it could resuscitate its existing insurance subsidiary and get it up and running again.

Here’s MBIA CEO Jay Brown, explaining how that might happen:

In the short run we expect that the de-leveraging of the insurance company will accelerate as more issues are refunded and our liability is extinguished, more installment policies are cancelled and minimal new business is added to the portfolio. In an ironic twist, the actions of the rating agencies will accelerate the speed with which we exceed the target levels of capital required for a Triple-A. In addition, we continue to believe that rating agencies’ stress cases will begin to move down over the next 12 to 18 months as more hard data demonstrates the actual severity of projected mortgage-related losses. Bottom-line, we believe that the capital required to support our existing insurance company portfolio will continue to decrease over the next few years in a dramatic fashion.

So, fast forward 12 to 18 months, and assume that Brown’s projections turn out to be accurate. At that point, in order for MBIA Insurance Corp to get up and running again, three things would probably have to happen, in no particular order: the markets would have to regain confidence in MBIA’s claims-paying abilities; the ratings agencies would have to give MBIA its triple-A rating back; and the markets would have to regain confidence in the ratings agencies’ triple-A ratings.

None of these things seems particularly likely right now, I have to say. But Brown did make a reasonably strong case that the present state of affairs is pretty unsustainable too.

For one thing, a lot of bonds are trading right now as though the MBIA guarantee is worthless. That’s just silly. Even if MBIA is less creditworthy than the entity it’s guaranteeing, the guarantee is still worth something. An insurance company doesn’t need a triple-A rating to pay out on its guarantees, it just needs to not be bankrupt. Remember that MBIA is still double-A: Bill Ackman might not agree with that, but as far as the ratings agencies are concerned, at least, you can still have as much confidence in MBIA as you can in any major bank.

And there’s also a case that someone should be writing municipal bond insurance, since these bonds are generally bought by retail investors who can’t be expected to do sophisticated credit analysis. If their bonds have a triple-A wrap, they can rest assured that they will get all their interest and principal payments on time. Might the insurer lose its triple-A rating at some point, in a highly stressed scenario? Sure. But there’s a very, very long way from there to a payment default, which would require not only the insurer but also the municipality going bankrupt.

Now MBIA is something of a tarnished brand at this point, and it’s unclear why municipalities should choose MBIA to wrap their bonds, or why retail investors should have faith in the company. If those people can get the same service from Warren Buffett, then it makes sense, at the margin, to go elsewhere instead.

So I’m not particularly bullish on MBIA’s future. But it does have some very good credit analysts, who have performed pretty well so far: it was basically the structured finance people who blew the company up. Whether those analysts end up working for a new triple-A subsidiary, or whether they manage to turn the current one around, there is a possibility that they’ll be able to add value somewhere. The risk to MBIA, of course, is that they’ll leave their current employer and wind up adding their value to another entity entirely. I’m sure there are quite a few new distressed-debt funds who would be happy to poach them away.

Yves Smith is very unhappy about the fact that MBIA isn’t throwing $1.1 billion of its shareholders’ money into the black hole that is its insurance subsidiary. She calls the decision "shameful" and "scandalous", but it seems simply sensible to me.

As MBIA CEO Jay Brown explains, now that the insurance subsidiary no longer has a triple-A rating, there’s no point in trying to shore it up with new capital in order to retain that triple-A rating. Instead, he would like to "use one of our two fully licensed subsidiaries as a Triple-A subsidiary for new public finance business".

MBIA is a monoline insurer, after all, and if it’s going to be allocating capital to an insurer, it should be allocating capital to one with a triple-A rating and good prospects of profitability going forwards. Alternatively, if it can’t put the capital to good use, it should return it to shareholders in the form of equity or debt buybacks – an option which Brown is leaving open.

But there’s really no point at all in injecting extra money into the old insurance company which is now going into run-off – especially since, as Brown writes:

The change in ratings does not trigger any liquidity issues for MBIA Insurance Corporation, as the construct of our business model has been specifically designed to protect against any liability acceleration from ratings downgrades.

In other words, the insurance subsidiary doesn’t need the money in order to continue operating in run-off. The only reason to recapitalize it would be to keep it operating as a going concern, writing new business – and that’s clearly not going to happen, now it’s lost its triple-A.

Much better, then, that the money be used elsewhere instead.

That said, however, there has been a significant drop-off in Brown’s letter-writing abilities. He’s now started slipping into jargon occasionally, which has got to be a bad sign:

Given that the agencies have taken the option of maintaining the Triple-A rating of MBIA Insurance Corporation off the table, we have turned our attention to what are the best steps we can take to increase shareholder value while maintaining our human resource strength and adequate capital for our existing policyholders and proceeding with our transformation plan to operate multiple business entities under a different franchise structure.

Still, he remains a much better letter writer – and leader – than the overwhelming majority of other CEOs. If I were an MBIA shareholder, I wouldn’t be happy about the stock price performance. But I wouldn’t be unhappy about Brown personally.

(HT: Jones)