The Trouble with Bond Insurers

Recently, it has emerged that bond insurers might also be adversely affected by the subprime meltdown. In a recent article called “Time to think the unthinkable about bond insurers” on Bloomberg, it was noted that

… the stocks of the two biggest bond insurers, MBIA Inc. and Ambac Financial Group Inc., plummeted as investors worried that the two firms’ exposure to failing mortgages might cost them their AAA credit ratings.

What happens next? Let’s say that things continue to deteriorate, as Gimme Credit so tactfully put it. At some point, the rating companies would say to the insurers, “You have to put aside more money to continue being rated AAA.” If they couldn’t raise that capital, by selling more stock or bonds, the rating companies would cut those ratings.

From the Past

And then? Well, that doesn’t mean that the city or municipality that issued the bond won’t fulfill its obligation. The amazing thing about the insurers, after all, was that they covered credits that wouldn’t default — they underwrote business to a so-called zero-loss standard.

The bonds’ prices would decline, yes, but probably not by very much. The bonds themselves would no longer carry an AAA rating, but the new rating of their insurer, as well as their own ratings, of course. Since most municipal bonds are held to maturity, their owners would likely never even notice.

I have no idea what the rating on one of the major bond insurers would be cut to. It looks like an AAA-rated municipal bond insurer has only been trashed once before.

So, a credit downgrade on the currently AAA-rated insurers certainly look possible.

But why am I concerned about this? Because I owned some municipal reset bonrds that are insured by AMBAC, MBIA etc. If the insurers are downgraded, it is possible that some investors would redeem the muni resets, causing the yield to reset higher. The big question is of course whether this can adequately compensate for the perceived additional risk.

As I wrote in my muni resets posts, I can easily get out of the resets in a matter of less than a week (I owned 7-day resets) if I had to without any loss or transaction fees. Perhaps it is now time to look into this option.

PS. By the way, I just checked on the yields. My municipal reset bonds (average yield 3.33%) are currently earning 23 basis points (0.23%) more in after-tax returns compared to the next nearest alternative, FSPXX, yield 3.10%.

[1] Related discussion on Bogleheads.

1 Comment

  1. Pingback: indexfundfan @ indextown » Blog Archive » AMBAC downgraded

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