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Commission Recommends Bond Market Remedies to NLC
by Cathy Spain
For many months, serious disruptions in the municipal bond market have affected the ability of cities and other governments to finance infrastructure and meet other capital financing needs and increased the cost of existing variable debt. NLC, in cooperation with the National Association of Counties (NACo), created a Blue Ribbon Commission on Municipal Credit Enhancement last fall to identify remedies to improve market access and reduce municipal borrowing costs.
Downgrades of the AAA credit ratings of municipal bond insurers were the primary impetus for establishing the commission. Issuers choose to buy bond insurance because the exceptional ratings of bond insurers lower issuers’ borrowing costs. An estimated $2 billion is paid to insurers on an annual basis. If insurers are downgraded, the benefits of their product are lost.
Other market problems noted by the commission were increased interest rates on variable rate debt; uncertainty about the system for rating municipal market issuers due to calls for a new, unified credit rating system; and the requirement for issuers to make unanticipated payments to debt service reserve funds because of downgrades of their surety providers.
A final report recently issued by the commission recommends three actions that NLC and others can take to help stabilize the municipal bond market.
The first is to support federal tax law changes that would increase the demand for municipal debt by providing incentives for banks and other corporations to purchase these bonds. While the focus of the commission’s work was on credit enhancement, it was very concerned about the growing credit and liquidity crisis in the market and the oversupply of bonds that was occurring as institutional buyers of bonds were selling their holdings to obtain needed funds.
Of particular interest is a commission suggestion that NLC and other groups representing local issuers investigate the feasibility of creating a mutual insurance company that would be owned and operated by local governments. The nonprofit company would insure new, fixed rate general obligation bonds of cities, counties, and school districts and revenue bonds sold to finance essential governmental services such as water and sewer facilities.
The commission also urged the groups to seek support from the federal government for the creation of the new mutual company by having it provide capital for the new entity, a federal guarantee for the company or reinsurance.
The 17-member commission consisted of issuer representatives, bond lawyers, underwriters, financial advisors, academics, rating agency and retirement system staff and bond insurance professionals. Bob Inzer, clerk of the court, Leon County, Fla., chaired the commission and Pat Born, chief financial officer, Minneapolis, served as the vice chair.
In coming to its recommendations, the commission discussed financial guarantees provided by state agencies, credit enhancement programs sponsored by state pension funds and banks, how rating agencies rate insurers and the state of the municipal market. Insured bond sales have been 50 percent or more of the municipal bond market. Approximately $200 billion long-term insured municipal bonds are sold annually.
The mutual insurance company recommendation drew considerable interest because of the approach’s familiarity to NLC, NACo, state municipal leagues and state associations of counties. In the 1980s, when liability insurance was unavailable and unaffordable, state leagues and county associations created intergovernmental risk pools to provide much-needed insurance coverage for their members. As a result, they and their national associations are familiar with the insurance business. Additionally, NLC and NACo are affiliated with mutual insurance companies that have been established to provide reinsurance for the statewide risk pools.
A voluntary, national mutual insurance company owned and operated by local governments would have many advantages. It would be mission-driven rather than profit-motivated with the objective of minimizing borrowing costs paid by its members. Any profits would be shared by the participants.
There are many issues to consider in developing such an entity, including ways to capitalize the company. Options identified by the commission were selling debt or equity to state and local governments or their pension funds, a federal contribution, requiring the investment of debt service funds from bonds insured by the program and capital charges (premium) paid by issuers.
Other important issues to consider in forming a new company are:
• whether bond insurance as we have known it needs to be restored
• whether a much greater percentage of issues will be done successfully on a non-insured basis in the future
• whether new commercial entrants will fill the current void in the market
• whether issuers and investors will trust any insurer going forward and especially a new mutual company that is owned and operated by local governments
• the enforceability of assessments on members to provide financial support when the need arises
• how the rating agencies will view such a company
• whether a governance structure can be created that insulates the company from politics in the underwriting process
• how the company will be regulated
• whether experienced talent can be attracted to run the company
A new business model for bond insurance is an innovative idea that NLC will continue to explore. The historic risk involved in municipal credit enhancement has been negligible. The default rate for municipal obligations is nearly 20 times lower than investment grade corporate securities and when there are defaults, the missed payments to bondholders are almost always eventually paid in full for public facility financings, according to a 2007 report by Fitch Ratings.
Details: To see the full commission report, click here. For more information, contact Cathy Spain at spain@nlc.org or (202) 626-3123.
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