This Could Be the End of Bond Insurance

Even though bond insurers Ambac (NYSE: ABK  ) and MBIA (NYSE: MBI  ) lost nearly all of their credibility over insuring structured finance vehicles -- including mortgage-backed debt linked to the declining housing market -- one section of their businesses remained on solid footing: insuring municipal bonds.

In the past few months, as Ambac and MBIA scrambled to recover over rumors they weren't liquid enough to meet soaring default worries on insured collateralized debt obligations (CDOs), it was always the municipal bond insurance division that investors knew would be there to pick up the slack.

When banks such as UBS (NYSE: UBS  ) and Citigroup (NYSE: C  ) rallied around plans to keep bond insurers alive, the idea was to let profits from the municipal bond division shore up losses on CDO products.

And when Warren Buffett offered to take the municipal bond portion off bond insurers' hands, nearly everyone scoffed, knowing full well that such a plan would lead to their quick demise.

In any case, it's nearly impossible to imagine bond insurers living to see another day without the ability to milk cash from insuring municipal bonds.

That, however, could soon be the case.

And I thought car insurance was a rip-off
Bond insurance on municipal debt costs taxpayers billions of dollars, yet the default rate on such bonds is minuscule at best. According to bond giant PIMCO, from 1970 to 2005, the average investment-grade municipal bond defaulted a mere 0.07% of the time -- about as close to zero as you can get.

That leads to quite a predicament. If defaults on municipal bonds are essentially not an issue, why are taxpayers coughing up billions of dollars in bond insurance to protect investors from such an event? That's a question many people, including legislators on Capitol Hill, would like to know.

At the center of the storm is why rating agencies use a different method to rate municipal bonds versus corporate bonds. Rating agencies have typically used a more demanding system to rate municipal bonds than they use to rate debt issued by corporations, so it's more difficult for municipalities to achieve the grand poohbah of ratings, the coveted AAA.

The new plan to demolish insurers
Last week, however, rating agency Moody's (NYSE: MCO  ) announced that it will begin rating municipal bonds using the same method it employs to assess corporate bonds. Under such circumstances, there's a good chance that many more municipal bond issuances will be win an AAA score, which would essentially cancel out the need for insurance.

That isn't welcome news to Ambac and MBIA, who desperately need to keep the municipal business humming if there's any chance of keeping their doors open. For the past several months, investors have thrown around bankruptcy talk, most of which happened following analysis that assumed the municipal division would remain healthy. Take that away, and the one remaining pillar holding up the shaky building that is the bond insurers would quickly fall away.

In perhaps a more telling sign of how quickly the market for municipal bond insurance has turned, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) -- known for its uncanny ability to remove itself from the risk to which others fall victim -- has acknowledged municipal bond insurance's bleak future just months after setting up a new subsidiary to enter the municipal insurance market. Ajit Jain, one of Buffett's right-hand men who also serves as the head of Berkshire's new municipal bond insurance division, recently remarked that if the rating agencies began scoring municipals on the same scale with corporate bonds, "there will be little need for a financial guaranty insurance marketplace as we know it."

Options are running out
Responding to the developments, Ambac shares now trade at around $5 a share (versus 52-week highs approaching $100), even after the recent plan to raise $1.5 billion in capital that investors hope will allow it to remain AAA-creditworthy itself.

Over the past several months, we've seen a slew of credit turbulence that surrounded a lack of liquidity; Ambac and MBIA certainly fell victim to those concerns. But even if those issues get ironed out, making municipal bond insurance obsolete is an entirely new beast to deal with -- one that bond insurers, now completely strapped for cash, don't have the flexibility to work around.

After fighting tooth and nail over credit concerns, the new rating rules may shutter the light at the end of the tunnel for bond insurers. Alas, Bill Ackman may have been on to something.

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