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Mortgage crisis fallout spreads to 'muni market'

Investors are wary of insurance guarantees for some bonds issued by cities to fund capital projects.

By Ron SchererStaff writer of The Christian Science Monitor / February 8, 2008

In San Francisco Bay: Work proceeds to replace a bridge. The Bay Area Toll Authority has used Ambac to fund various bridge projects.

Alfredo Sosa – staff

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New York

The subprime mortgage crisis continues to ripple well beyond home foreclosures.

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Municipal bonds, securities issued by local governments to fund anything from new sewers to airport improvements, are now caught in the backwash. Though defaults by communities are rare, buyers of their bonds are now wary of investing in any but the best-run and highest-rated communities.

"There has been a disruption the market is not used to," says Bill Stone, chief investment officer of PNC Wealth Management in Philadelphia. "The default rates are so low we can't say it's a crisis, but there is no question there are liquidity issues in the muni market.

The reason for the problem: Many US cities and towns have purchased insurance that boosted their bonds into the best-rated investment category. But some of the insurance companies are the same institutions that also guaranteed the payments on securities backed by subprime loans. Those insurance companies have seen a downgrading of their investment rating, which is used as a surrogate for lesser-rated municipalities that buy the insurance.

Among the effects so far:

•The ability of municipalities to issue new bonds has sharply contracted. According to market participants, the volume of new bonds is down about 80 percent so far this year. Cities from Miami to Chicago have had to postpone bond offerings. But it's too early to tell if such postponements will result in any delays in capital projects.

•Even though the Federal Reserve has lowered short-term interest rates, the problems with the insurers are causing the communities to pay a higher interest rate on their bonds. It's adding one-quarter to nearly half of a percentage point.

•Some of the insurance companies are talking to potential investors to help shore up their capital base. And regulators are involved, trying to facilitate the discussions.

Regulators are concerned because the companies have about $2.4 trillion in debt that they insure. Most of it is plain-vanilla municipal bonds or corporate debt. However, the companies also started insuring collateralized debt obligations (CDOs), which invested in subprime mortgages of varying degrees of safety.

The major insurance companies involved in the business are Ambac Financial Group, MBIA, Financial Guaranty Insurance Co. (FGIC), XL Capital, and Financial Security Assurance.

One priority, most analysts say, is to shore up the capital of Ambac, which has $524 billion of exposure. Last quarter, it reported a $3.26 billion loss to account for the steep slide in value in the CDOs it insured.

On Wednesday, bond insurer MBIA said it planned to sell $750 million in stock to bolster its balance sheet. In January, the company raised $1 billion privately.

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