Federal backing could mean more buyers and lower interest rates

The federal government is the only potential guarantor whose backing would significantly lower local borrowing costs. Private bond insurers, and other private parties who might provide assurance to investors in new issues, lack financial strength or have other priorities — for good reason. In 2008 and 2009, less than 12% of bonds issued were insured, compared with almost 50% during the previous 30 years. Institutional investors may like the higher yields of uninsured bonds. Individual investors, who continue to hold 70% to 75% of muni bonds, directly and through funds, have responded favorably to bond insurance. Recently, muni-bond rates have been higher than those on U.S. Treasuries; historically, they have been mostly lower. Federal backing could mean more buyers for new local-bond issues, and lower interest rates. The savings could be meaningful. A rate reduction averaging 0.8% for half of all local-government borrowings in an average year would amount to a benefit to borrowing localities of about $50 billion over a 30-year term. The cost to the Department of the Treasury would be limited, although risks would have to be carefully analyzed and controlled. Opponents of this idea have theorized that “bond insurance” would make it more likely that local borrowers would try to avoid repaying bonds — and that insurance provided by the federal government, rather than a private insurer, would increase that risk. However, the experience of the private bond insurers does not support this theory. Defaults on muni bonds issued for essential governmental purposes, as distinct from those that support private activity with a limited governmental nexus, have remained in the range of less than 0.03% since the Great Depression. Muni-bond insurance was developed in the 1970s. Since then, close to 50% of the bonds issued have been insured. However, default rates for essential-governmental-purpose bonds have not differed significantly between insured and uninsured issues. Muni-bond insurance is not “insurance” in the same sense as life or casualty insurance, even though it is regulated by the same state insurance commissioners. The critical difference between this type of insurance and others is that the insurer has the right to recover from the issuer the amount of any payments it makes to bondholders. The insurer becomes a bond owner, with significant legal rights that historically have been both enforceable, when needed, and an effective deterrent to issuer default. Private bond insurers were single-purpose entities, called “monolines,” created in the 1970s with financial companies as their original shareholders. They prospered, and most went public. The monolines managed risks carefully: They examined issuers and projects for financial viability, charged adequate premiums, and monitored risk exposure. They required that on making payment, the insurer assumed all legal rights and remedies of bondholders. Those remedies worked, or effectively deterred defaults. The monolines' troubles came about not from their core business, but rather from attempting to expand outside of munis and into riskier areas, and because many investments they held were caught in the general financial crisis, including mark-to-market requirements. Warren E. Buffett, who started his own bond insurer in 2008, told shareholders this year that bond insurance “has the look today of a dangerous business — one with similarities, in fact, to the insuring of natural catastrophes.” He said he believes more muni issuers will run into trouble, and that he will ask that insurers “share in the required sacrifices,” even though that was not how the industry's troubles came about. However, even if it were true that insuring muni bonds is too risky for private investors, it is not axiomatic that the same risks would apply, were the federal government — which would be able to make the laws to protect repayment of its advances, and whose losses would come out of all our pockets — the guarantor. As long as the federal government is the only guarantor able to produce meaningful rate reductions for local issuers, it can drive a hard bargain, including legislation to limit the risk to the Department of the Treasury, project selection independent from politics and airtight repayment remedies. Both the current economic situation, and the willingness and power of the administration to deal with it effectively, suggest that a successful guarantee program could be designed. Such a program should include incentives to muni issuers to issue non-guaranteed obligations as soon as it became cost-effective for them. The costs, and tax benefits, of the federal program could be adjusted through pushing through legislation to make sure federal guarantees are used only as needed. Investor reassurance, the real meaning of “muni-bond insurance,” could facilitate the financing of more projects at lower cost to local governments. This could provide meaningful economic stimulus, and can be structured to maintain security for both the individual investor and the federal guarantor. Michael Jozef Israels has been an investment adviser and a lawyer representing municipal-bond issuers. He is the managing member of Brewster Lehman Stewardship LLC, counsel to the New York law firm of Fitzpatrick & Merritt.