For decades municipal bond insurers prospered: they collected handsome fees for providing coverage that guaranteed to pay principal and interest if municipal issurers failed to pay on a due date. This insurance underwriting job was easy because municipal defaults are rare. Between 1940 and 1990, for instance, only three-tenths of one percent of municipal issuers failed to pay off their bonded debt – only 1,200 out of 400,000 tax-exempt bond deals.
The growth of the bond insurance business closely paralleled the increase in individual investors, as opposed to institutions, in the marketplace. Individuals, the dominant buyers of municipal bonds, do not want to hear about a risk when talking about what is often their retirement money. Retail investors are usually risk averse, and often will sacrifice a few basis points in yield in exchange for the added security of bond insurance.
In recent years, however, the management of bond insurance companies endangered their very profitable and risk averse business by insuring esoteric bond issues that very few people fully understood. Also, to increase the yield in their investment portfolios they used capital to purchase these complex securities.
When the sub-prime mortgage market collapsed last year these insurers (i.e., MBIA, Ambac, FGIC) were caught between a rock and a hard place. Their capital drastically declined because they had to write down many securities backed by worthless sub-prime mortgages held in their investment portfolios, and their pay outs on the defaulted debt significantly increased. As a result of this predicament, the major rating agencies threatened to drop the triple A rating of the insurers. (Two weeks ago Fitch rating service downgraded Ambac to a double A rating.)
Hoping to be proclaimed the saviors of Wall Street, New York’s governor, Eliot Spitzer, and his insurance commissioner have been trying to steamroll the major banks and insurance companies into embracing their controversial bail-out proposal that calls for:
- the endangered insurers to split their companies into two new entities, one that contains the safer insured municipal policies and one that holds the vulnerable guarantees;
- the banks to infuse the bond insurers with the cash/lines of credit needed to maintain their triple A ratings. (The Spitzer administration argues that the losses bank investment portfolios will take if insurance ratings are downgraded will be far greater than the amount of money they invest to shore up the ailing insurance companies.)
Sadly, on Friday, February 22, 2008, Ambac Financial Group agreed to a version of this plan.
The Spitzer solution is not only ridiculous, but is a sterling example of arrogant and overreaching government activism. No doubt, Ambac policyholders will sue to block the plan and their shareholders will not vote to approve it. Neither will agree to decrease the insurance risk pool. They will not permit Ambac to abrogate contracts.
Governor Spitzer must learn that he does not have dictatorial powers; that he cannot impose his misguided policies by threats and browbeating. Ambac policyholders and shareholders must teach Spitzer that he is not above the rules, that he cannot abuse power, that he cannot violate the sanctity of a contract and that he is not the smartest man in the room.