Muni Defaults No Threat

¹²Assured's Frederico: Defaults No Threat
But, Hard Times Ahead For New Insurers

By Patrick Mcgee | 13 September 2010

Assured Guaranty's chief executive officer said while the outlook for new municipal bond insurers isn't good, the industry's alleged problems with existing portfolios are overblown and unsupported by recent data. Dominic Frederico said the threat of defaults in the muni market is unlikely to become another crisis for existing bond insurers because the majority of problematic credits are uninsured. In other cases, such as Harrisburg, Pa., and Jefferson County, Ala., revenue issues are being obscured by political considerations.

Assured Guaranty is the only municipal bond insurer to weather the financial crisis with double-A ratings or higher, and it is the only guarantor to write new policies this year. The lack of competition has led to higher costs for financial guarantees. That, and post-crash skepticism about the value of the product in general, have diminished the market's enthusiasm for bond insurance, as illustrated by the smaller share of new issues being guaranteed.

Assured has wrapped $18.5 billion in the primary market so far this calendar year, or 7% of the $266.6 billion issued, according to Thomson Reuters. In 2009, $35.4 billion, or 8.7%, of all deals were insured— the lowest volume since 1990. "We're like an only child— we don't have anybody to play with, but all the toys are all ours," Frederico said at the Keefe, Bruyette & Woods insurance conference last week.

Frederico has repeatedly said the viability of bond insurance would be enhanced if new insurers were able to access the market. But he acknowledges that it will be difficult for them to attain strong ratings from at least two of the three major rating agencies. "The landscape for entrants in the new market is incredibly hilly," Frederico said. "It's hard for us to envision that you're going to have a whole lot of new entrants."

One problem for potential participants is raising capital, he said. Bond insurance contracts tend to be long term, so without an existing portfolio it can be difficult to generate earnings in a short period. BondFactor Co. and the Municipal Infrastructure and Assurance Corp.— two startups that hoped to begin writing insurance policies in the last year— were forced to postpone plans several months ago. Neither has been publicly rated.

A possible solution to help the industry move forward could be for state insurance regulators to step in and facilitate the sale or auction of existing insured bond portfolios held by below-investment grade companies, Frederico said. Ambac Assurance Corp., a former leader in the industry, saw its ratings fall from gilt-edged before the financial crisis to junk due to its exposure to risky mortgage-backed securities. Wisconsin-based Ambac maintained a $213 billion portfolio of insured munis at the end of the second quarter.

But Ambac's regulator, the Wisconsin insurance commissioner, says auctioning its muni portfolio wouldn't be in the best interests of all policyholders. Meanwhile, Frederico took aim at muni market pessimists who believe a wave of defaults could be the next calamity for the bond insurers who were hard hit by the residential mortgage-backed securities debacle. Some of the commentary originates with billionaire investor Warren Buffett, who in early 2009 expressed caution about relying on "history-based models" for determining public finance defaults. He said a similar reliance helped lead to the "stupefying losses in mortgage-related securities."

Buffett more recently warned in June of "a terrible problem" ahead for municipal and state finance. Frederico, reminding the conference that his company has guaranteed more than $400 billion of municipal bonds, said he takes such comments seriously but simply cannot find evidence to back them up. "We keep hearing about this impending crisis and about how people are just going to stiff the bond insurers," he said, but added that there's no evidence of that "if you really break down the numbers."

There have been 60 defaults in U.S. public finance this year through Aug. 2, totaling $2 billion. That's less than 0.1% of the $2.8 trillion outstanding, according to Assured data. The majority of those— ?47 issues totaling $1.8 billion— were either below investment grade or unrated.

By contrast, more than 99% of Assured's public finance portfolio was, by internal ratings, investment grade as of June 30, including 38% rated double-A and 49% rated single-A.? "We've got a strong portfolio, highly exposed to the tax-backed and GO areas," Frederico said. He noted that the largest number of muni defaults to date have been in special assessment and recreational revenue credits. He described those areas as "unsuitable for insurance" and said Assured only rates credits it assesses as investment grade.

Assured's underwriting standards have helped it incur less than $100 million of losses in its public finance portfolio between Sept. 30, 2007, and June 30, 2010, according to the company's financial presentation. Most recently, it helped to cover a $2.1 million claim on behalf of Pennsylvania's Harrisburg Authority for its incinerator debt payments because the facility did not generate sufficient revenue. But Frederico said the problems in Harrisburg— which is currently seeking bank loans to avoid defaulting on general obligation debt due Wednesday— are political, not financial.

"Two years ago they knew they were going to have this balloon payment that was going to become due this year for $68 million," Frederico said. "At the time the mayor suggested that they sell the incinerator and lease the parking garages. Both of them would have easily generated enough value not only to pay off the $68 million value but to pay off entirely the debt obligation."

Echoing a Moody's Investors Service report on Tuesday that blamed "political gridlock between the Harrisburg mayor and the City Council," Frederico said the struggle "has nothing to do with their ability to address their financial responsibility". Analysts at Bank of America Merrill Lynch similarly wrote Friday that it's unclear if Harrisburg is actually operating under financial distress "or whether public officials are acting arbitrarily in opting to miss the GO bond payment". In the event that Harrisburg files for Chapter 9 bankruptcy, Frederico suggested bond insurers could potentially recoup any losses through the courts because Pennsylvania's capital city will have a tough time proving it is insolvent.

"At the end of the day, we're going to get a substantial recovery because this is not a revenue issue," he said. "This is purely an ability to manage your own expenditures, your own balance sheet, and this whole issue of willingness, not ability". The Harrisburg situation, in other words, isn't an appropriate case study for predicting a looming crisis in public finance. "We can always judge ability to pay," Frederico said. "Where the problem of today is— because of the kind of political scenario that we live in— is this willingness issue."