One way to solve the problem is to back bonds with the full faith and credit of the government parents entity issuing them. Another is to obtain municipal bond insurance.
Remember credit default swaps (i.e. guarantees of someone else's investment security, often mortgage funds)? Municipal bond insurance is conceptually similar. The municipal bond insurance company promises it will pay if the issuing municipality defaults.
The trouble with municipal bond insurance, as in the credit default swap market, is counterparty risk. A guarantee is only is good as the person making it, and municipal bond insurance companies aren't particularly creditworthy at the moment, as a result of the financial crisis. In August:
Ambac, one of the largest bond insurers, was downgraded further into “junk” territory in July, and of the ten municipal bond insurers, only three maintain a financial strength rating of AA or higher. . . .
Since there is no economic value from bond insurance unless it results in at least an A rating for the bond, many of the insurers rated below BBB are now in “runoff” mode. In runoff, the insurers do not underwrite new business (as is the case with Ambac) and simply collect money on insurance premiums already written. Over several years, the insurer hopes that premiums will be enough to offset potential losses on all claims and then attempt to reestablish the business or simply return any excess proceeds to equity and/or bond holders.
An insurer is still liable to pay claims (i.e., a default or missed interest payment) even if in runoff, since they maintain some claims paying ability. Given the potential mountain of claims against the existing capital base (particularly from those subject to sub-prime mortgage exposure), it is uncertain whether these insurers will be able to meet future claims. A bond insurer is required to make up any missed interest payments, but principal repayment, in the case of default, is not made until maturity or until bankruptcy is resolved, whichever comes first.
Municipal bond insurers National/MBIA, Radian, CIFG and Syncora/XLCA, FGIC and ACA also weren't looking good in the August report. Only Berkshire (BHAC), Assured Guarantee (AGO), and Financial Security Assurance (FSA) were still safely in the A range for their own credit ratings. S&P gave a negative outlook to all three, while Moody's flagged AGO and FSA with a "Credit Watch Negative" rating, which isn't at all reassuring given the tendency of credit reporting agencies to be lagging rather than leading indicators of a company's growing credit distress.
The percentage of municipal bonds that are insured at all has fallen from 18% to 11% over the last year. Municipal bond insurance is essentially worthless when the underlying issuing municipality is more creditworthy than the insurer.
On the upside, municipal bonds are safer than they appear. Most are rated a notch or two below the level they would belong in if they were private corporations, based on the default rates of classes of municipal bonds. And, the House is considering a bill to create a mid-sized public sector municipal bond insurance fund to fill the gap created by the collapse of most of the firms in the industry.
Still, since bonds can always be issued with higher credit ratings and returns, it isn't obvious that the middle man of municipal bond insurance is necessary at all. About 89% of municipal bonds are issued without it. "Roughly 90% of insured bonds carry an underlying rating of A or better," so their bond ratings often don't take a hit when their mortgage insurer gets in trouble and those municipalities could issue bonds even without insurance. Only about 1% of all municipal bond issuers actually need municipal bond insurance to have access to the bond markets at reasonable interest rates, and some of those issues could turn to full faith and credit backed bonds instead to improve the credit rating of their bonds.
In short, perhaps municipal bond insurance, like subprime mortgages, is a financial product that almost never actually makes mutual economic sense for all parties involved. So, perhaps the industry deserves to die or to be reduced to a tiny niche market.