The companies which insure municipal bonds have come under pressure since the extent of the damage from Katrina has become appearant. However, more downside could be on the way.
Joe Mysak of Bloomberg.com makes an interesting point about municipal bond insurers…
The market is not used to seeing natural disasters produce bond defaults, primarily because natural disasters tend to be very short-term events, with residents returning to their homes or what’s left of them relatively quickly to rebuild. What makes this natural disaster so different is that it may take months before people are allowed to return to their homes.
Then there are the bond insurers. Last week the four major bond insurers announced they had almost $13 billion in exposure to credits that were in Katrina’s path, almost $4 billion in New Orleans alone. There are going to be some interesting days ahead for these insurers, who since they began doing business in 1971 have said they underwrote business to a zero-loss standard. That is, these insurers collected premiums with the expectation that they would never have to pay claims.
They are going to have to pay claims, perhaps lots of them.
If Mysak is correct, it highlights MBIA (MBIA) as a potential problem for the financial markets. MBIA insures municipal bonds so that municipalities and other government agencies can obtain lower interest rates. A Fortune article that detailed the long and short story of MBIA’s stock explained it this way –
At first glance, MBIA’s business is both elegant and simple. The core idea is that a municipality—say, Kansas City—will be willing to pay a small premium to have its bonds insured, because the triple-A rating will lower its interest cost. As long as the premium MBIA charges is less than what the client is saving in interest costs, it can market its product as a way for issuers to save money. MBIA is often paid its premium up front, which it then recognizes as revenue over the life of the insurance. That means that a substantial portion of future year’s earnings are already in the bank. Analysts often cite MBIA’s smooth, predictable earnings as a reason to own the stock.
Bond insurance has proved to be wildly popular—and profitable. MBIA was founded by a group of insurers in 1974, and today about half the municipal bond market is insured; MBIA is the market leader with about 18%.
Aside from numerous off balance sheet entities and regulatory problems, the Fortune article points out that MBIA considers itself a "no-loss" underwriter…it doesn’t actually expect to pay a claim. Again from Fortune…
To outsiders, there is another aspect of the business that is truly through the looking glass. Unlike other insurers, which expect to suffer some level of losses, MBIA prides itself on "no-loss underwriting." In other words, the company never intends to actually have to pay a claim. MBIA says that, with rare exceptions, it insures only debt that is deemed relatively safe, or "investment grade," by the rating agencies, though some issues get downgraded after the initial guarantee. Today the company says that 98% of the debt it guarantees is investment grade. MBIA has had occasional losses, but if they were to become a regular, sizable occurrence, that could threaten its triple-A rating and blow a hole in its business model.
At MBIA’s conference for its investors in March, Gary Dunton presented what he calls "my favorite slide." It shows that over MBIA’s three decades in business, the company has guaranteed more than $1.8 trillion of debt service and suffered only $586 million in losses, or about 0.03%. To many investors, this is all the proof they need that MBIA can come very close to its promise of zero losses.
But now, as Joe Mysak points out, MBIA and other bond insurers are going to have to pay claims. According to Reuters, MBIA insured $2.88 billion in municipal bonds in the hurricane-struck area. MBIA has $6.5 billion in capital, so despite potentially taking a big hit, even if it had to play claims on all the bonds, MBIA would be far from failing.
However, the main problem is that MBIA relies on its own stellar credit rating to insure other municipalities. Again from Fortune…
The key to MBIA is that the credit-rating agencies—such as Standard & Poor’s—give its insurance arm the rare and coveted rating of triple A. That means that MBIA is judged to be one of a handful of the most financially sound companies in America, up there with Exxon Mobil and GE. When MBIA insures, or in industry lingo "wraps," a bond, it gives that bond the attributes—mainly a lower interest rate—of a triple-A-rated bond. In other words, what MBIA sells is its triple-A rating. As CEO Gary Dunton wrote in his 2004 letter to shareholders, "MBIA’s true constant—our North Star, if you will—is our commitment to protecting our triple-A ratings."
If MBIA did indeed have to pay out claims and weaken its balance sheet, the company could be in danger of losing its triple A rating. Remember, this is a company that never expects to have to pay a claim, and according to Fortune, has gone to extreme lengths to hide even minor hits to its balance sheet. It is this triple A rating that is so valuable to MBIA and its ongoing business and I believe this rating could be in jeopardy once the damage assessments come in much higher than expected.
A Reuters story indicates that the rating agencies which gave MBIA its triple A rating have already warned that Katrina could cause cash crunches for the states, cities, towns, schools and agencies that sold municipal debt. Standard & Poors said that it is reviewing $7.8 billion in debt issued by municipalities in Mississippi and Louisiana.
I am far from an insurance expert but it seems to me that when you have businesses that insure something for which they expect no claims, and huge unexpected claims arise, it could lead to problems.
I am picking on MBIA because it has already been targeted by short sellers and it is the largest company that insures municipal bonds. However, several specialty financial firms that sell insurance for municipal bonds could also come under pressure.
According to Reuters, these are the top municipal bond insurance companies in the region and their level of exposure.
|
Symbol |
Name |
Exposure |
Equity |
|
|
|
|
|
|
Private* |
Financial Guaranty Insurance |
$4.15 billion |
$3.8 billion |
|
ABK |
Ambac Financial Group Inc |
$3.8 billion |
$5.3 billion |
|
MBI |
MBIA Inc |
$2.88 billion |
$6.59 billion |
|
Foreign |
Financial Security Assurance |
$2.2 billion |
NA |
|
RDN |
Radian Group |
$485 million |
$3.6 billion |
* 40% owned by PMI Group (PMI)
XL Capital (XL) also has some exposure to the area, but it is limited compared to the size of the firm.
Again, I don’t believe any of municipal insurers will fail as a result of defaults but business could suffer if the rating agencies decide that companies such as MBIA and Financial Guarantee Insurance do not deserve their highly vaunted triple A rating. And that rating and guarantee is essentially what municipalities are paying for when they insure their debt with these companies.
