The slow rebound of municipal bond insurers
For decades, municipal bond insurers like MBIA, Ambac, FSA and Assured Guaranty were the big kahunas of muniland. They used their AAA balance sheets to stand behind smaller, lower-rated issuers. These small issuers were able to pay a lower yield when they brought their bonds to market after they paid a small insurance premium to the bond insurer for its service. Everyone in the market loved it because at least half of the market was AAA-rated, based on the insurer wrap, making investing and trading very easy for everyone. With insured bonds, you didn’t need to differentiate between a bond rated A or bond rated AA- when trying to figure out a price, because they all carried the AAA wrap.
But the bond insurers all blew up during the financial crisis because they had heard the siren song of Wall Street and in their greed insured a lot of mis-rated mortgage-backed securities (MBS). As their losses on MBS rose and their capital base eroded, the insurers were stripped of their gold-plated AAA ratings and a number of them failed. Only Assured Guaranty and MBIA were left standing, but MBIA is not writing new policies, and Assured Guaranty has been the only insurer still writing insurance for cities and other municipal entities until recently. In July Build America Mutual (BAM), a new firm staffed by former executives of Assured, was formed.
BAM is structured as a “mutual” insurance firm whereby the cities and towns that have insurance policies written on them own the firm. The towns that buy insurance for their bonds pay a fee composed of two parts. One is the actual insurance premium that goes into a pool to cover losses for any policyholder in the mutual. The second part of the fee is a surplus charge, with the charges pooled together to create greater claims-paying ability. Here is how BAM describes it:
Each municipal issuer will become a “member” of BAM by purchasing insurance to lower its cost of borrowing. The cost of the policy will represent both a risk premium and a contribution to BAM’s surplus (a “Member Surplus Contribution”), which fund the growth of BAM’s claims-paying resources.
This is a very good setup and should create like-mindedness among policyholders as they jointly share risks for their debt commitments. There are, of course, the expenses of running the enterprise that policyholders would have to share, such as the cost of management. What is unclear is how much interest policyholders would have to pay for the $500 million in surplus notes that the mutual issued to White Mountain Insurance Group to raise initial capital for the mutual (plus an additional $100 million pledged in collateral trusts). Surplus notes are debt-like instruments issued by mutual insurers to raise equity to start up a mutual firm.
White Mountains Insurance Group, Ltd. (NYSE: WTM) announced today that it has capitalized HG Global Ltd. (“HG Global”) with approximately $600 million to fund Build America Mutual Assurance Company (“BAM”) through surplus notes and to provide reinsurance support for municipal bond insurance risks underwritten by BAM.
The interest for the $600 million will have to be paid by policyholders, so it will be very important for BAM to get as many of them as possible to share this cost. I couldn’t find the interest rate that BAM will pay White Mountain through the conduit entity HG Global, but I can do a rough estimate using what a comparable firm pays for their bonds.
The 10-year bonds of Berkshire Hathaway, which has large insurance operations, are currently being offered at 3.6 percent, according to FINRA TRACE data reported at Yahoo. Using the current Berkshire yield as a rough estimate, BAM will have to pay White Mountain Insurance interest on the $600 million in surplus notes of about $21.4 million per year.
BAM unfortunately didn’t qualify for a AAA rating and instead received a AA rating from Standard & Poor’s. According to data compiled by Thomson Reuters MMD, the spread between 10-year single A bonds and AA bonds is currently running around 57 basis points. So the insurance rates that BAM would offer to A credits have to cost less than 57 basis points to make sense financially. Given the somewhat narrow spread and the estimated interest that BAM will have to pay White Mountain, it will need a lot of policyholders to cover all these expenses.
Thomson Reuters data shows that only about 4 percent of new muni bonds this year were insured, so there is plenty of scope for BAM to write business. The question for insurers and policyholders is: Are they getting an insurance policy that really lowers their bond insurance costs?
Charts from Thomson Reuters MMD.