Although it looks like MBIA is now out of the woods, rival bond insurer Ambac’s fate is still murky. Reports indicate that the ratings agencies are now considering the rescue plan worked out by banks and state insurance regulators. The plan may be revealed as early as this week, and will probably involve splitting Ambac in two to segregate the municipal bond insurance business from the less healthy business of insuring riskier credit products.
Last week Holman Jenkins pointed out that segregation is unfair to customers who bought insurance on CDOs because it would “retroactively award municipal clients privileged status at the expense of other clients with equal claim on the insurers.” Bill Ackman, who has been shorting the bond insurers for years, raised a similar point. Indeed, Jenkins expects that the policy holders left with guarantees from the suddenly even more precarious side of the business will launch lawsuits to prevent the break-up.
There’s also a much stranger objection to the segregation plan, one stemming from an objection to the very existence of municipal bond insurance. We first heard about it in Portfolio, of all places. In the latest issue Jesse Eisinger argues that municipal bond insurance is a scam, and it’s victims are municipal governments. This will no doubt come as a surprise to state regulators and treasuries who have been on knife’s edge fearing that the collapse of the bond insurers would make raising money costlier or, in some cases, perhaps impossible. If the governments are the victims here, why exactly are they working to keep the victimization going?
According to Eisinger, the racket begins with the ratings agencies. At the heart of his argument is that claim that they issue ratings for muni bonds that are consistently too low. This forces municipalities to buy bond insurance, which raises their ratings and lowers their interest costs. In short, the ratings agencies and the bond insurers are in cahoots.
Yesterday we pointed out that this would require us to believe that the bond market consistently misprices munis, overestimating the muni risks due to the bum ratings. Of course, such consistent mispricing is implausible. If munis with poor ratings had yields higher than risk warranted, the market would quickly correct this. Witness what happened to the auction-rate securities market when some bonds on reasonably safe securities were paying coupons as high as 20%. Demand for these shot up, and the excess yield was quickly eliminated. The fact that the agencies use different scales for corporate and muni ratings might create some noise, but the signal of excess returns would be heard loud and clear.
What’s more, munis tend to have lower yields than similarly rated corporate bonds precisely because investors know that they are rated on a different scale. Investors are not confused by the ratings. The perception, for instance, that 'A' rated corporate bonds have greater associated risk than 'A' rated municipal bonds is widespread and has the added advantage of being accurate. Fitch and Moody’s are very clear that they rate muni bonds relative to other munis, and that munis have much lower default rates than similarly rated corporate bonds.
To put it differently, if Eisinger was correct, the bond insurance racket is even more extensive than he suspects. It not only involves ratings agencies and insurers. It includes bond investors, who must be deliberately avoiding the excess returns that would be available if bond issuers were really overpaying because they get lower ratings than they deserve. One thing we know for sure is that investors are not confused by the ratings—the perception, for instance, that 'A' rated corporate bonds have greater associated risk than 'A' rated municipal bonds is widespread and has the added advantage of being accurate.
Today both Felix Salmon, who writes the Market Movers blog for Portfolio.com, and Jesse Eisinger have responded. Felix insists that the difference in yields between corporate bonds and munis is only a product of their tax-advantages, and not at all a result of risk assessment. He doesn’t give any evidence for this beyond his own certainty that this is the way things are. The academic literature on the subject is decidedly mixed. Some studies have found that yield spreads can be explained by risk differences; some find they cannot. The bond traders we speak to insist that credit risk—as well as other risks—do indeed play a strong role in muni pricing.
Eisinger’s response makes clear that he regards muni bonds as essentially free of default risk. But this is just incorrect. Out of the three-hundred and seventy-five and half billion dollars worth of muni bonds issued between 1977 and 1998, bonds worth $24.9 billion defaulted, according to an influential 1999 study by Fitch. That means around 6.6% of muni debt defaulted, which is hardly trivial. Of course, the actual “default rate” is lower if you count by the number of issuances defaulting rather than the dollar volume and that number is inflated because it includes a lot of private activity bonds, basically corporate bonds that enjoy tax-free status because they have municipal sponsors. But even if we just include investment grade munis, there’s still something like a 0.5% historical default rate. On average, muni bondholders recover 68% of the par value of their defaulted bonds—which is better than the average for corporate bonds but, again, not trivial. And things have been even worse during especially bad economic times. During the 1873 Depression more than 24 percent of the outstanding municipal debt defaulted.
Eisinger is extremely impressed with the power municipalities have to raise taxes to pay off their loans, and seems distressed that investors and rating agencies don’t share this view. But there are lots of reasons investors may lack confidence in municipalities. Local governments often aren’t subject to very rigorous financial disclosure rules, investors may distrust the political and they may lack the financial acumen to anticipate future financial crises.
Like so much else that is misunderstood in financial markets, the issue really comes down to pricing. To turn a phrase on its head, people who think they know the value of everything, very often don’t know the price of anything.