Although not unexpected, the announcement by Ambac that it filed for Chapter 11 bankruptcy was yet another somber reminder of the demise of a once-proud industry.
Ambac was the first of the companies that made up the industry known as “monoline insurers,” aptly named because their sole business was insuring the debt of municipal bond issuers.
The monoline era began in the 1970s and blossomed over the next three decades, employing a unique strategy that seemed to benefit all market participants. Bond insurance enabled issuers to borrow at a lower rate, made investors feel more secure and produced solid profits for the insurers because municipal bonds rarely defaulted.
By 2005, bond insurers guaranteed almost 60% of all new issuance.
Greed reared its ugly head
Unsatisfied with the profits produced by its moderate-risk business model, the bond insurers became captivated with the seemingly insatiable housing demand and the cash flow produced by mortgage securitization.
When subprime mortgages began to default, Ambac and other insurers were forced to accept responsibility for the payments. As muni investors know, this was followed by a dramatic drop in the insurers’ credit ratings, making issuers and investors less inclined to pay for insurance. The inability to write new business and the prospects of looming liabilities did not paint a pretty picture on the insurers’ financial statements.
Today, the percentage of new insured bonds has plummeted to less than 8%.
What’s next?
The Ambac announcement, however, may not be all bad. It could even prove to be a silver lining for holders of Ambac insured municipal bonds.
Regulators in Wisconsin, the state where the company is registered, seized part of the business last March, and forced it to suspend payments on policies linked to sour mortgages. The stated purpose of the regulators was to protect the municipal bond guarantees from the fallout of the ill-fated mortgage business. This restructuring has been challenged by the policyholders of the mortgage bonds and is slated to come before a court by year end.
Last one standing
Currently, the lone remaining active municipal bond insurer is Assured Guaranty (AGM), which boasts high-profile billionaire Wilbur Ross as its major investor. Though it lost its “AAA” rating in October, it still enjoys an “AA+” rating with a “stable outlook.” To its credit, AGM was able to sidestep most of the mortgage bond wreckage.
S&P attributed its AGM downgrade to a “lack of demand for bond insurance, which could limit the potential for the re-emergence of a strong and vital bond insurance sector.”
Ironically, while most bond insurers have been disgraced, downgraded and discredited, we have found their knowledge of municipal finance and due diligence practices to be a valuable tool in bolstering our own research efforts.
Contrary to their practices in the mortgage market, the former “AAA”-rated bond insurers rarely provided insurance to municipal issuers with risky underlying credits. In other words, most of the municipal bonds they insured didn’t really need it.
As we have previously mentioned, in the current economic climate, it has never been more important for investors to scrutinize the bonds they purchase. As it turns out, because of the past vetting practices of the once formidable bond insurers, formerly “AAA”-rated bonds with good underlying credit are a good place to start.