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.