The market no longer believes in the business of insuring municipal bonds.
Ambac has gotten more serious about its months-long threat to file for bankruptcy, today going so far as to miss an interest payment to its creditors and say in a regulatory filing that it’s seeking a “restructuring of its outstanding debt through a prepackaged bankruptcy proceeding.” My colleague Colin Barr has a good breakdown of the company’s financial troubles here.
Ambac’s troubles are more than just the woes of one company. That the bond insurer has been unable to “raise additional capital as an alternative to seeking bankruptcy protection,” as it says in its filing, indicates that investors are ready to let Ambac, and the bond insurance industry, go to seed.
“This is an industry in its death throes,” says Ed Grebeck, the chief executive of debt strategy firm Tempus Advisors, and an adjunct professor at New York University. Grebeck says to look no further than Assured Guaranty (AGO), the only bond insurer left standing. With the flood of muni debt that his hit the market, “you would expect the only guarantor left standing to be printing money, but it has not,” Grebeck says.
Some analysts believe a company like Ambac (ABK) could come back as a plain vanilla bond insurer, having divested its disastrous business of insuring CDOs and asset-backed securities. Certainly the biggest bond insurers are trying to heal their significant wounds. But Grebeck says this ignores the two main reasons that the market is unlikely to believe in the business of insuring municipal bonds.
First, the business model treats credit like insurance, meaning that it looks at historical statistics and tries to look at credit as a series of probabilities. While this can work up to a point, we learned in 2008 that when things fall apart, statistics are all meaningless and credit quality becomes a behavioral phenomenon. Since credit becomes a behavioral issue just when you need coverage the most, it’s unlikely that a muni bond insurer could hold enough capital to cover its defaults and still be a profitable enough insurance company to attract investors.
Second, Grebeck says that bond insurance was predicated on the idea that municipalities would never actually default, but restructure and raise taxes instead. So muni bond insurers collected premiums but never had to pay out, becoming the golden goose of the insurance world. But now it seems we’re entering a whole new world with regards to public finance as localities start to face up to huge underfunded pensions while retirees pile up. “It’s going to be hard for the government to bail out those places that do decide they just can’t pay, as they did with New York, because too many places are strained,” says Grebeck. “The government can’t afford to bail out all of these places, so they won’t help any. The moral hazard would be too great.”