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Municipal bond insurers look to benefit from Detroit bankruptcy

12.08.2013 08:13

The Financial Times  Last updated:August 11, 2013 10:58 pm

Municipal bond insurers look to benefit from Detroit bankruptcy

By Stephen Foley and Henny Sender in New York

Bond insurers exposed to billions of dollars of Detroit debt expect to emerge as long-term winners from the largest municipal bankruptcy in US history.

Executives at MBIA and Assured Guaranty have relaunched their municipal bond insurance businesses, arguing that losses in Detroit will be small and that the risks highlighted by the city’s fall from grace could drive more bond investors to demand payment protection.

Insurers cover losses if a local government borrower defaults, something that had appeared a safe and sleepy business until Detroit.

The Motor City’s decision to treat its general obligation bonds as unsecured even though the bonds were backed by the full faith and credit of the city sent shock waves through the municipal bond world.

Those shock waves hit the bond insurers with special force. Ambac Financial, which had provided insurance on some of the bonds, issued a statement warning that the city’s “ability to access cost-effective financing in the future will be needlessly imperilled”.

On a conference call with analysts last week, Jay Brown, chief executive of MBIA, said that he saw a “silver lining” in the reaction to Detroit’s bankruptcy.

”Muni bond defaults have historically resulted in a greater appreciation of the value of bond insurance,” he said. “So we will continue to remind the market that there will be no losses of principal and interest payments to . . . insured bondholders.”

Before the financial crisis, more than half of the $3.7tn of US municipal bonds bought were wrapped with insurance from Assured, FGIC, MBIA and Berkshire Hathaway Berkshire among others, a business model based on a kind of arbitrage.

By providing insurance, a bond that was rated at a less than optimal level became a much more highly rated piece of debt, enabling a city to borrow more cheaply. The city was happy to pay the insurer with the money saved while the insurer pocketed the fee, confident that the city would always raise taxes rather than default.

However, the insurance companies lost their gold-plated credit ratings after making a disastrous move into insuring mortgage-related derivatives.

Now the proportion of municipal bonds wrapped with insurance has fallen below 5 per cent, forcing investors to pay more attention to municipalities’ credit quality.

According to Lipper data, about $4.2bn has flowed out of US municipal bond funds since Detroit filed for bankruptcy on July 18.

Last month, Assured launched a new double A rated subsidiary, Municipal Assurance Corp, to write new muni business, and MBIA hopes to start writing new business if it can persuade rating agencies that its subsidiary deserves a higher rating than its current triple B status. Neither is expected to regain their triple A rating, limiting business opportunities to lower-rated municipalities.

Rising interest rates mean that bond insurance could become more valuable to issuers, and fear over a wave of muni defaults – although overblown – could drive investors to demand an insurance wrapper, too, said Mark Palmer, an analyst at BTIG.

Detroit’s woes are “an advertisement for the bond insurance space”, he said. “Any losses that the insurers face in Detroit might turn out to be a small price to pay for a revival of their industry.”

MBIA and Assured are among several insurers at the centre of the fight to restructure Detroit’s $18bn of liabilities. MBIA has insured $2.3bn of debt secured against income from Detroit’s water and sewerage system, plus $100m of general obligation bonds that the city’s emergency financial manager claims are unsecured.

Assured has insured $1.8bn of water and sewerage debt and $321m of bonds regarded as more risky. It attributed an $87m provision against losses in its most recent quarterly results mainly to Detroit.

Both companies say they do not expect losses on the secured debt.

The cost of borrowing for other Michigan issuers has increased. On August 8, Saginaw county delayed a bond issue because it was reluctant to pay the higher cost investors demanded, as had a second county, Genesee, earlier this month.

“The municipal bond market is finally beginning to discriminate,” says Ken Buckfire, president of investment bank Miller Buckfire in New York. “That’s because investors realise that local governments are finding it increasingly difficult to pay for promised pension fund and healthcare benefits.”

The proportion of bonds issued with insurance in the second quarter was 3.9 per cent, according to Assured, up from 2.6 per cent in the first quarter.

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