Bond Insurers Research Articles

The Price of Safety: The Evolution of Municipal Bond Insurance Value

Economic theory predicts that bond insurance lowers issuers’ financing costs by resolving asymmetric information and mitigating credit risk. With comprehensive data over the last 36 years, we find increasingly diminished empirical support for these models. The value of insurance in resolving asymmetric information beyond that resolved by credit ratings and other observable bond characteristics is economically minimal. The average gross value of insurance ranges from 4 to 14 bps when bond insurers offer Aaa-rated coverage. However, this gross value becomes insignificant after 2008 when Aaa-rated insurance no longer exists. Evidence suggests that the lack of insurance benefit in the postcrisis period is attributable to the deteriorated creditworthiness of insurance companies. Examining noninterest saving explanations for the continued use of insurance in the no-Aaa insurance market, we find evidence that issuers purchase insurance out of habit (with insurance value most diminished for habitual purchasers with low governance quality) and for the convenience it affords in default, but no evidence that insurance improves secondary market liquidity. This paper was accepted by Gustavo Manso, finance. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4813 .

Regulating Financial Guarantors: Abstraction Bias As a Cause of Excessive Risk-taking

To improve financial regulation, scholars have engaged in extensive research over the past decade to try to understand why systemically important financial institutions engage in excessive risk-taking. None of that research fully explains, however, the unusually excessive risk-taking by financial guarantors such as bond insurers, protection sellers under credit-default-swap (CDS) derivatives, credit enhancers in securitization transactions, and even issuers of standby letters of credit. With tens of trillions of dollars of financial guarantees outstanding, the potential for failure is massive. This Article argues that financial guarantor risk-taking is influenced by a fundamental anomaly in perceiving risk. Financial guarantors commit to pay out capital only if certain future contingencies occur, in contrast to banks and other financial institutions that pay out capital—for example, by making a loan—at the outset of a project. As a result, financial guarantors are subject to a previously unrecognized cognitive bias, which the author calls “abstraction bias,” that causes them to underestimate the risk on their guarantees. The Article provides empirical evidence that supports the existence of abstraction bias and its influence on financial guarantors. The Article also examines how an understanding of abstraction bias can improve the regulation of financial guarantor risk-taking.

Modeling Municipal Yields With (and Without) Bond Insurance

We develop an intensity-based model of municipal yields, making simultaneous use of the credit default swap premiums of the insurers and both insured and uninsured municipal bond transactions. We estimate the model individually for 61 municipal issuers by exploiting the dramatic decline in credit quality of the bond insurers from July 2007 to June 2008, and decompose the municipal yield spread based on the estimated parameters. The decomposition reveals a dominant role of the liquidity component as well as interactions between liquidity and default similar to those modeled by Chen et al. [Chen H, Cui R, He Z, Milbradt K (2018) Quantifying liquidity and default risks of corporate bonds over the business cycle. Rev. Financial Stud. 31(3):852–897.] for corporate bonds. Toward the end of the sample period, our model also reproduces the “yield inversion” phenomenon documented in the literature. This paper was accepted by Neng Wang, finance.

Bond Insurance and Public Sector Employment

This article explores how financing frictions that originated from the demise of municipal bond insurers affected public sector employment outcomes during the 2008-9 financial crisis. I construct a new data set that combines local governments' characteristics, reliance on bond insurance, bond issuance, and employment. Leading up to the crisis, bond insurance was a major source of cheap funding for local governments, especially for those that were small and opaque. Furthermore, insurance relationships were sticky, implying high switching costs. During the 2008-9 financial crisis, issuers that had prior relationships with less healthy insurers issued less debt and experienced lower employment growth. Consistent with financing frictions arising from asymmetric information, smaller and more opaque governments were most affected. Between 2007Q2 and 2009Q2, this friction caused 4% lower full-time employment growth and 15% lower part-time employment growth at affected local governments.

The Price of Safety: The Evolution of Insurance Value in Municipal Markets

Economic theory predicts that bond insurance lowers issuers’ financing costs by resolving asymmetric information and mitigating credit risk. With comprehensive data over the last 36 years, we find increasingly diminished empirical support for these models. The value of insurance in resolving asymmetric information beyond that resolved by credit ratings and other observable characteristics is economically minimal. The average gross value of insurance ranges 4 to 14 bps when bond insurers offer Aaa-rated coverage, with the value of insurance increasing in market competition. However, this gross value becomes insignificant after 2008 when Aaa-rated insurance no longer exists due to widespread downgrades and bankruptcies of bond insurers. Evidence suggests that the lack of insurance benefit in the post-crisis period is likely attributable to the deteriorated creditworthiness of insurance companies. Examining non-interest saving explanations for the continued use of insurance in the post-Aaa insurance market, we find evidence that issuers purchase insurance out of habit (especially those with low governance quality) and for the convenience it affords in a default event, but no evidence that insurance improves secondary market liquidity.

Public Disservice: the Negative Impact of Credit Ratings on US Municipal Bond Issuers

Credit rating agencies implemented a "dual ratings system" under which US municipal bond issuers are assessed more harshly that other types of issuers. This system created an artificial demand for bond insurance because the so-called monoline bond insurers were rated more leniently than the governments they insured. Using the Ambac Bond Insurance Cases, Superior Court of California Case Number CJC-08-004555, as a reference point, this paper discusses the origins of the dual ratings system and its costs to state and local government borrowers. Although the bond insurance business was a casualty of the 2007-2008 financial crisis, I find that the dual ratings system remains and that insurance is re-emerging - to the detriment of government bond issuers and their stakeholders.

The Influence of Accounting Information Disclosed under GASB Statement No. 34 on Municipal Bond Insurance Premiums and Credit Ratings

This paper examines the impact of accounting information on first the cost of municipal bond insurance and secondly on the credit rating awarded on municipal debt, using data disclosed under Statement No. 34 of the Governmental Accounting Standards Board (GASB 34) for insured general obligation debt issued by Texas cities. It finds that both governmental fund and government‐wide financial information is related to the cost of municipal bond insurance and the credit rating on municipal debt. The paper also shows that the utilization of accounting information by bond insurers is not identical to its use by a bond rating agency.

Understanding the Role of Pension Obligation Bonds

Taxable pension obligation bonds (POBs) emerged in 1993 and have been issued extensively by a number of state and local governments. POBs are almost always general obligation bonds (GOBs or GO bonds). They convert “soft” unfunded pension liabilities on the pension plans balance sheet into “hard” bond debt on the governmental employer’s balance sheet. California has been one of the big issuers of POBs. Due to a court decision requiring voter approval, the State of California has not issued POBs as have some states. However, a judicially created loophole allows county, municipal and other local governments to issue such pension bonds without voter approval and without regard to state constitutional debt limits. Many have done so. Bond issues are usually insured by one of a handful of Wall Street bond insurers. There have been a number of Chapter 9 municipal bankruptcies in California including that of the City of Stockton. The combination of POBs, bond insurers and Chapter 9 proceedings can result in an outcome that allows a government to transfer a large amount of unfunded pension debt to a bond insurer. That’s what happened in Stockton. There may be others.

Municipal Bond Liquidity Before and After the Financial Crisis

I examine how liquidity risk affects municipal bond pricing. Liquidity has become a central concern to municipal bond investors, issuers, and regulators since the recent collapse of the monoline municipal bond insurers. The results show that liquidity risk had a minimal effect on yield spreads in the period prior to the insurance collapse, but since that collapse 10-20% of a typical municipal yield spread is due to liquidity risk. These findings have implications for our understanding of the determinants of municipal yield spreads, and for contemporary public policy debates about how to improve the efficiency of the public capital markets.

Bond Insurers

Bond Insurers

The Liquidity Crisis: The 2007–2009 Market Impacts on Municipal Securities

This article surveys developments in the municipal debt market for their practical and conceptual implications for public financial managers and scholars. It provides an overview of the market crisis of 2007–9, focusing on what fiscal stress reveals about debt costs, the incidence of risk, and management methods. The first part focuses on the systemic factors—highly leveraged subprime mortgage instruments and collateralized debt obligations—that affected credit availability, interest costs, and the changing risk profiles of the debt instruments. The second part emphasizes the new institutional architecture of the borrowing environment: the collapse of the market for variable‐rated securities, the withdrawal from the market of traditional bond insurers, the diminished availability of credit enhancement instruments from banks, the demise of the standby bond purchase agreement, and the introduction of Build America Bonds. The article presents an agenda for practitioners and scholars as they face a borrowing future that differs markedly from that of the past.

Municipal Bond Insurance Premium, Credit Rating, and Underlying Credit Risk

This article explores the question of whether bond insurers are able to sufficiently evaluate the credit risk of insured bonds, the answer to which would determine the future of municipal bond insurance. A sample of insured municipal bonds is investigated to determine whether bond insurance premia can predict the future credit rating transition, the proxy for bond credit risk. The results show that municipal bond insurance premia, conditional on bond credit ratings and other explanatory variables, have explanatory power over credit rating downgrades but not over upgrades. As such, bond insurance premia convey extra information about the underlying credit risk of a bond issue than the original credit rating reveals. This research also provides evidence that the rating agencies might not be doing as a good job as they could potentially do.

Model Uncertainty and Insurance of Structured Bonds

In this paper, we present a stylised credit risk model for structured bonds. Through this, we explain how the presence of primary bond insurers such as Ambac and MBIA, who were highly active in bond markets prior to the recent financial crisis, contributed towards transforming the emergence of model uncertainty within a segment of opaque structured products with little data on historical performance or borrower characteristics into a marketwide problem. It is no surprise that these products, with little information to facilitate accurate credit risk modelling, were susceptible to model uncertainty. The contagion of this model uncertainty, however, arises specifically due to (i) the presence of rating-constrained investors who cannot hold the asset unless its credit rating is sufficiently high, and (ii) the insurer's lack of willingness to defend his rating by raising additional capital against his exposure to potentially toxic bonds. We find that the credit rating agency's attitude towards model uncertainty -- as represented by the α-maxmin preference (Ghirardato, Maccheroni and Marinacci, 2004) -- is of primary importance, as its strict capital requirement in the face of model uncertainty could trigger an insurer downgrade. This results in a systemic price discount of all insured bonds, and its adverse effect on the overall investor welfare is most acute when the proportion of rating-constrained investors is high. We also outline how the capital requirement may be optimally redesigned to meet the conflicting needs of different groups of market participants.

Municipal Bond Insurance Premium, Credit Rating and Underlying Credit Risk

This article explores the question of whether bond insurers are able to sufficiently evaluate the credit risk of insured bonds, the answer to which would determine the future of municipal bond insurance. A sample of insured municipal bonds is investigated to determine whether bond insurance premia can predict the future credit rating transition, the proxy for bond credit risk. The results show that municipal bond insurance premia, conditional on bond credit ratings and other explanatory variables, have explanatory power over credit rating downgrades but not over upgrades. As such, bond insurance premia convey extra information about the underlying credit risk of a bond issue than the original credit rating reveals. This research also provides evidence that the rating agencies might not be doing as a good job as they could potentially do.

The Determinants of Bond Insurance Premium

This paper provides an empirical test of the demand side of Thakor’s (1982) theory of bond insurance signaling, namely that the insurance premium charged by municipal bond insurers provides a signal to the market that reduces asymmetric information in the market. We test the theory for a sample of bonds that covers before, during and immediately after the 2007-08 financial crisis. We find empirical evidence consistent with the theory that the bond insurance premium provides a signal to the market regarding the intrinsic, underlying credit risk of debt.

The contagion effect of default risk insurer downgrades: The impact on insured municipal bonds

Municipal bonds are often insured by insurance companies that promise to pay investors in the event of default on the part of the issuer. However, just as the financial strength of the insurer can provide assurance to investors, questions about insurer stability may heighten investor concerns. This paper considers three major downgrades to large municipal bond insurers and the effects of each downgrade on a large sample of municipal bonds. Results reveal the effects to be widespread: not only are risk premiums on bonds insured by the downgraded insurer affected, but so are those on bonds insured by other insurance companies.

Economic Capital for Bond Insurers

This article presents an approach to computing economic capital and to pricing bond insurance portfolios. Because bond insurers face losses that are highly correlated and dependent on the business cycles, we enhance the Merton structural approach by incorporating business cycles using a Markov switching model. The authors use several risk measures from the insurance literature and explore their impact on calculation of a bond insurer9s economic capital. They show how the insurer9s characteristics and insured bond portfolio affect its economic capital and analyze the marginal impact of adding a new bond insurance contract to an existing portfolio. Such analysis is useful when setting the premium for a new insurance contract. Overall, the premium will be highly dependent on the measure used to compute capital at risk.

Challenges related to financial guarantee insurance

Traditionally, bond insurers have provided guarantees of payments on municipal bonds, where defaults have been very limited. But since the late 1990s they have become increasingly involved as guarantors of elements of various structured financial products: in particular, the credit enhancements provided by these entities have played an important role in making securities based on sub-prime loans attractive to a wide range of investors. It is this trend change in their activity that has become the focal point in concerns about the health of these entities that have grown during the financial turbulence. The note identifies three policy issues that arise in the context of the current challenges facing these entities and it draws some preliminary findings. First, while concerns regarding the potential financial stability implications of further downgrades and/or failures of some of these companies have ebbed somewhat from their peaks in early 2008, the situation still bears monitoring. Second, current developments raise questions regarding the role of financial guarantors in specific financial market segments. In this context, there appears to be a public interest in the continued availability of guarantees on payments on municipal bonds. Private solutions seem to be forthcoming. Third, transparency of the financial guarantee insurance sector is limited. In this context, the performance of credit rating agencies in providing guidance for investors regarding the quality of the guarantees provided by financial guarantors appears to have been uneven.

The Subprime Problem

Today9s sub-prime mortgage situation has its roots in the failure of market-based restraints on the riskiness of loans that lenders could make. Before securitization, sub-prime mortgage lenders retained the loans that they originated and, therefore, cared deeply about credit quality. Following the rise of securitization, bond insurers constrained subprime lenders from making unreasonably risky loans through their pricing decisions and through limits on their appetites for risk. Later, sophisticated investors from the mainstream MBS area started taking credit exposure to sub-prime mortgage ABS by purchasing subordinate tranches from uninsured deals. Like the bond insurers, they were experts in mortgage credit risk and that expertise was reflected in their risk appetite and pricing behavior. However, starting in 2004, CDOs and CDO investors became the dominant class of agents pricing credit risk on sub-prime mortgage loans. The departure of the bond insurers and the traditional subordinate investors left a void, because the CDO managers were less discriminating and selective in allowing high-risk loans to be included in securitizations. In the absence of restraints, lenders started originating unreasonably risky loans in late 2005 and continued to do so into 2007. Delinquencies and foreclosures might never have risen to troubling levels had policymakers instituted rational constraints for the sub-prime mortgage sector. All things being equal, the less the government meddles in the lives of individuals the better. However, when market forces fail to produce acceptable results, government intervention may be necessary and appropriate. <b>TOPICS:</b>MBS and residential mortgage loans, CLOs, CDOs, and other structured credit

Finance, Imperialism, and the Hegemony of the Dollar

The July-August 2007 crisis in subprime mortgage markets precipitated the collapse of the market for asset-backed securities, forcing huge write-downs of more than $45 billion on the balance sheets of major banks. In the aftershock, interbank lending dried up. Bond insurers and money market funds were beset by a loss of confidence as the credit squeeze spread. The plunge in stock markets in January 2008 suggests that the repercussions of the collapse of the subprime mortgage market are still working their way through financial markets. With over 170,000 jobs lost and the expected spate of foreclosures, many observers believe that the credit crunch has pushed the economy towards a recession.This article can also be found at the Monthly Review website, where most recent articles are published in full.Click here to purchase a PDF version of this article at the Monthly Review website.