Treasury guarantees carry more risks than benefits

The real and potential risks of federalizing municipal-bond insurance far outweigh any potential benefits. While many smaller issuers are paying higher rates than during the leverage-fueled parties of 2005 and 2006, the muni market is open to all issuers. Even Guam, a well-below-investment-grade issuer, was recently able to float a large loan that received substantially more bids than there were bonds available. In fact, most tax-exempt yields have fallen since the start of the year.

Unfortunately, many issuers didn’t understand why yields were so low three and four years ago and didn’t understand why they spiked so much higher in 2008. Worse, they don’t understand why things have steadily improved. As a result, some states and their representatives are demanding ever more federal assistance, even though such short-term “help” could compromise their autonomy and increase risks in the future.

Let me explain why federalization of muni-bond insurance is such a dangerous idea.

First, if the federal government were to insure muni bonds, it would be creating a new fixed-income asset class — bonds issued by states and local governmental bodies carrying a guarantee that the federal government would make investors whole should the issuer default. Given its own needs, the Department of the Treasury can ill afford the price competition such a new asset class would create. Moreover, the U.S. balance sheet can ill afford the massive addition of risk that such guarantees would entail.

Federalization also would mean that a group of federal bureaucrats, probably in the Department of the Treasury, would be making economic decisions based on political factors. Which municipalities would receive guarantees? Which projects would get the federal nod? Don’t think that even the best and the brightest would be immune from playing politics when it comes to allocating guarantees. All these decisions will be made at the expense of state autonomy and local decision-making.

Second, if the Treasury Department were to begin insuring muni bonds, its likely dominant market role would silence the professional buy-side and rating agency credit analysts who are at least partially responsible for keeping municipal default rates low.

In the absence of real credit risk, investors would be willing to buy any and all federally insured muni bonds — and bankers would be willing to sell them. Local governments would thus be almost completely reliant on the guidance of a single group of federal bureaucrats and their own judgment to avoid over-leveraging themselves. That is a risky proposition at best.

Third, the current interest-rate environment for muni bonds is not necessarily a bad thing. Higher rates signal investor concerns or structural problems with bond offerings. Weaker issuers will likely borrow less or look to strengthen or merge their operations to reduce costs. Treasury guarantees would quash this nascent market discipline.

Finally, and perhaps most importantly, Treasury guarantees would imply a resounding lack of federal confidence in the municipal sector. Investors could take the hint and begin to flee non-guaranteed muni securities, driving issuers’ interest costs sharply higher. And because the entrance of a federal guarantor would quickly end the business prospects for private insurers, there would be no easy way for the Treasury Department to extract itself if political will turned against the continued underwriting of muni risks.

A federal program to aid private bond insurers is a bad idea as well, because it is extremely tough for the insurers to maintain their current credit ratings while trying to rebuild market trust. These are not the kind of companies I’d like to bet on with my tax dollars. Luckily, the bond-insurance-oriented bill proposed last month by Rep. Barney Frank, D-Mass., met a notably chilly market response and appears to face long odds.

To be sure, credit conditions for muni issuers are worsening and are likely to lag any economic rebound by at least a year. And although California is very unlikely to default on its bonds, the state government seems determined to turn difficult decisions into excruciating ones. As a result, we’re likely to see an increase in municipal defaults, although mostly among risky-sector credits, and almost surely there will be a rise in municipal bankruptcy filings, particularly in California and Texas.

But keep in mind that even in the Great Depression, buy-and-hold muni-bond investors ultimately lost just one-half of 1% of their portfolios to defaults. This is a solid statistic to convey to investors, and it should end pleas for a federal insurance program, which could be larger and more invasive than anything seen in the 1930s.

Matt Fabian is a managing director at Municipal Market Advisors, an independent research and consulting firm in Concord, Mass., that provides advice on the municipal-bond market to institutional and retail investors, dealers and underwriters, issuers and regulators.

Related Topics: Investment Company Institute (ICI)