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Municipal bonds have traditionally been extremely safe investments with very low default rates and attractive tax exempt features for most investors. Municipal bond insurance has allowed state and local governments to obtain higher credit ratings, thereby generating significant interest savings over the life of the bonds. The municipal bond insurance market has been through major changes in the past year and could be in for even more change going forward.

In late 2007, the monoline insurers specializing in tax-exempt bond insurance ran into significant trouble as a result of inadequate premium rates and acceptance of riskier business. Stronger players such as Berkshire Hathaway (NYSE:BRK.A) have entered this line of business over the past year. Warren Buffett’s latest letter to shareholders (.pdf) provides a concise account of the recent history in tax-exempt bond insurance. In recent weeks, there have been proposals for the Federal Government to step in and provide such insurance directly to municipalities. This has the potential to create significant moral hazard problems and could result in a large bailout of state and local governments in the years to come.

“It Would Cost the Federal Government Zero”

The Wall Street Journal ran a very insightful editorial on April 17 regarding plans put forward by Rep. Barney Frank who is the House Financial Services Committee Chairman. Rep. Frank has been a proponent of the concept of having the Federal Government provide an FDIC-like insurance program for issuers of municipal bonds. Rep. Frank has also been pressuring the rating agencies to lower the standards used for evaluating the creditworthiness of state and local governments.

As the WSJ Editorial page reported, Rep. Frank considers the premiums charged by the firms that have stepped into the municipal bond insurance market to be too high and believes that the Federal government could step in and fill this function at lower cost to municipalities. Given historically low default rates on municipal bonds, Rep. Frank believes that the plan would cost the taxpayers nothing. From the WSJ Editorial:

The payment history of municipal bonds seems to support Mr. Frank. But then the triple-A ratings assigned to many mortgage-backed securities were also based on backward-looking models that failed to anticipate today’s housing bust. The muni-bond performance record is also mostly the history of uninsured bonds. But the very existence of insurance can change the behavior of the policyholder or beneficiary — watch Barbara Stanwyck and Fred MacMurray in the 1944 classic “Double Indemnity.” If a state or locality knows someone else will make bondholders whole, they are far more likely to default than an uninsured issuer would be.

The key point is that Rep. Frank and others are not considering the moral hazard issue when assuming that taxpayers would not be on the hook for defaults. Analyzing the behavior of municipalities and bond holders as it relates to uninsured bonds does not necessarily predict the behavior of the same set of actors when it comes to insured bonds.

Insurance Creates Moral Hazard

The fact that any type of insurance can create moral hazard issues is well understood. The fact that a third party will be liable for mishaps can influence the behavior of individuals and companies. Moral hazard refers to the chances of an economic actor responding differently to risks when he is insulated from the risk in question versus being fully exposed to the risk. Whether one is referring to auto insurance, homeowners insurance, or even medical insurance, behavior patterns will change in response to incentives. This is no less true for municipal bond insurance, whether provided by the Federal Government or private companies.

Last month, I wrote about state and local governments struggling with long term pension obligations and the implications this might have when it comes to the safety of municipal bonds. In the earlier article, I included a quote from Warren Buffett’s latest shareholder letter that I think is equally relevant on the current topic:

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Clearly, the risk of widespread bond insurance increases the probability of default because stakeholders consider the presence or absence of insurance when they make decisions that can impact default patterns.

Concentrated Benefits and Dispersed Costs

If the Federal Government attempts to enter the municipal bond insurance market due to a belief that private companies such as Berkshire Hathaway that are currently filling this need are charging premiums that are too high, it stands to reason that the government will eventually crowd out private insurers, or at least those private insurers that exercise underwriting discipline. With the underwriting discipline demonstrated by Berkshire’s insurance subsidiaries, I have confidence that adequate premium rates are being charged to compensate for the risk in the municipal bond insurance business, but the explicit goal of the government will be to offer insurance at premium rates that private firms would not accept, thereby driving Berkshire and other private firms out of the market eventually.

Imagine that a scenario similar to New York in 1975 occurs at some point in the future and a default on bonds would merely result in the Federal Government having to step in. Would bondholders, unions, and government officials have the incentive to make painful cuts in budgets in order to remain solvent when the easy way out would be to default and leave the United States taxpayer holding the bag? The benefits of the default would be concentrated while the costs would be spread out over a large group of taxpayers. This is not a recipe for making tough choices.

There is no way to know what the ultimate cost to the Federal Government would be, but it is safe to say that it will not be “zero” and will not be pleasant.