It is no longer news to municipal bond investors that the once-pristine bond insurers have found themselves in perilous straits since straying from their core business of insuring municipal bonds.
As the insurers’ bad news was unfolding, we felt compelled to reassure our clients that municipal bonds rarely default, and that bond insurance has seldom been necessary to ensure timely payment of principal and interest (see: “Don’t Lose Sleep Over Bond Insurers’ Woes“). We noted that most municipal bonds never really needed to be insured in the first place.
Although the financial media had been silent on this subject prior to the unveiling of the insurers’ missteps, it has, predictably, now jumped on the bandwagon. While we agree with the sentiment that the overwhelming majority of munis are extremely secure on their own merit, we take issue with those pundits who suggest that bond insurance is a complete waste of time and money.
The usually insightful syndicated columnist, Jane Bryant Quinn, told municipal bond investors, without reservation, in a recent piece that “you’ve been wasting your money by buying insured municipal bonds.” And in regard to bond insurance, she emphatically said, “you don’t need it, and never did.”
Toward the end of the column, she does, however, acknowledge that “occasionally municipal bonds default” and alludes to “bankruptcy talk” in Jefferson County, Alabama. She provides little detail, other than mentioning that some of the debt is insured by FGIC and XL Capital Assurance, which have suffered downgrades by all of the rating agencies.
Not so fast
We think Jefferson County’s predicament bears further analysis.
The county’s headaches stem from the financing of its sewer authority, once considered among the most enlightened issuers in municipal finance.
Investment bankers convinced the authority that they could better control their interest costs by utilizing sophisticated strategies involving “interest rate swaps” and issuing “auction rate securities” (floaters). Eventually, these auction rate securities accounted for almost half the county’s overall debt. As the auctions for these securities routinely began to fail, the interest cost on this floating rate debt soared out of control, far exceeding the revenue produced by the authority. The massive increase in interest cost resulted in a shortfall of approximately $2.5 million per week, an amount clearly unsupportable by sewer system cash flow.
Ms. Quinn casually mentions that “rescue negotiations” are underway, but again provides no detail, possibly because it is the very insurance companies she deems worthless that are offering the most promising plans for avoiding bankruptcy.
FSA proposes the issuance of $1.6 billion in new debt to advance-refund outstanding school bonds, as well as a portion of the sewer system debt. This would essentially extend the maturity of the remaining school bonds, freeing up the existing one-cent sales tax, which could then be used to support the sewer bonds. Another key aspect of the FSA plan would convert the remaining auction rate securities to variable rate demand notes, whose interest rates are more easily controlled.
Another proposal offered by insurers FGIC and XL Capital would expand sewer charges to non-sewer system customers within the county to generate additional funds for debt service.
Regardless of how the situation is finally resolved, FGIC and XLCA have vowed to stand behind their commitments. In a joint press release, they stated: “If called upon, FGIC and XLCA will stand behind our unconditional, absolute, and irrevocable obligation to pay interest and principal, as scheduled, on the insured Jefferson County bonds as provided under the terms of our financial guaranty insurance policies.”
Worthless to whom?
Bondholders can find comfort in the fact that these much- maligned insurers are bringing needed municipal finance expertise to the table. More important, it appears investors will continue to receive their bond interest payments without interruption.
Clearly, we cannot condone the irresponsible manner in which the bond insurers have managed their own financial houses, but to suggest that the concept of bond insurance provides no value to the investor is without merit.
We haven’t conducted a formal poll, but it’s our guess the Jefferson County Sewer bondholders do not consider buying insured bonds a “waste of money.”