You Can Sue, But You Won’t Win

Now, I’ve never been a great fan of the financial guarantee insurers, or the rating agencies.  Consider my post dealing with then over at RealMoney, Snarls in Insurance Investigation, Part 2.  In it, three-plus years ago, I suggested that Eliot Spitzer should investigate the relations between the rating agencies and the financial guarantors.

Now the City of Los Angeles is bringing a suit against the financial guarantors for forcing them to buy unnecessary municipal bond insurance.  Oh, please.  Did the armies of MBIA and Ambac surround LA City Hall, threatening violence if you didn’t give in to their protection racket?  This suit almost makes the failed efforts of regulators to split the guarantors into separate municipal and non-municipal insurers seem intelligent.

First, the real value of the municipal bond insurance was not for credit enhancement.  Municipal bonds rarely default, and when they do, they often become current again.  It was liquidity insurance.  Now, for a city like Los Angeles, maybe that’s not needed, but most municipalities are small issuers, and there is not enough manpower at bond managers to analyze them all.  The rating agencies fill part of the gap with their ratings.  For most municpalities, they are the only analytical coverage at all.

Now, the municipalities had the choice of issuing insured or uninsured bonds.  Insured bonds could be sold at AAA rates, and bond managers would buy them more easily because they were more liquid.  The question to an issuer boiled down to which is cheaper?  Pay AAA rates plus the guarantee fees and have an easy sale, or, pay at the rates that managers demand for lower-rated municipal bond?  For many munipalities they chose an insured sale because it was cheaper, or not much more expensive.

Any yield premium paid could possibly be attributed to their investment bankers, who did not want the extra work of having to actually sell the bonds.  With the AAA, they would fly out the door with no questions.  A lower-rated bond would cause some bond managers to sit on their hands; even though they could look at the rating from the agencies, they would not trust the rating without further analysis, and that takes time and effort.  (I know from my time as a bond manager, you can’t push your credit staff too hard, or they start making mistakes, because they can’t do quality work.)

The municipalities had another choice as well.  They could have borrowed less money, and raised more taxes, bringning their credit profiles up to AAA.  I know, the rating agencies should have rated municipalities higher, but that’s not who they are suing.  (That said, credit ratings are only moderately related to the yield spreads paid.)

A suit like this would have a better chance if it alleged implicit collusion between the rating agencies and the financial guarantors, and sued them both.  I still don’t think the City of Los Angeles would win such a suit, but the real flaw was not the insurers, but the ratings, including the ratings the financial guarantors themselves, which in my opinion, were always somewhat liberal.  (Hint: with financials, don’t just look at the rating, but look at the implied rating from the spreads on their debt.  The rating agencies holding company debt always traded at wider yields than their stated ratings would imply.)

Now, with the added fun in the space since Moody’s moved Assured Guaranty and FSA to negative watch, something I did not expect, this leaves Berky as the last man standing in the space.  But one seller does not a market make.  What this means, if Moody’s follows through, and S&P follows suit, is that muni bond insurance is likely dead for some time.  Who loses?  Small municipalities primarily.  They will face higher debt issuance costs.  Even large issuers have found the new issue market less than inviting recently.

In closing, could this come at a worse time for municipalities?  Revenue bases are eroding even as demands for services rise.  (Housing price will be a drag here for a few more years.)  They can’t print money or issue debt at whim to solve the problem, so they have to make painful cuts.  I will add this, even more painful cuts will come over the next 10-20 years as the pensions/ retiree healthcare crisis descends on the municipalities.  Not a fun time for anyone… and I’m sure there will be more lawsuits over the whole shebang, most of them bogus.