Mortgage crisis fallout spreads to 'muni market'

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

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

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

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.

Part of the problem is that investors still don't know the extent of the losses in the subprime mortgage mess. Financial institutions continue to write down loans. On Tuesday, for example, Fitch Ratings said it was reworking its computer models on losses in the CDO market.

"Fitch believes that a sharp increase in expected losses would be especially problematic for the ratings of financial guarantors," Fitch said in a statement.

Without good information, "the market is pricing in pretty bad scenarios," says Mr. Stone. "The worst case is if the structured debt defaults and the insurance companies don't have the ability to pay."

Municipal bond funds are trying to appease investors who have been withdrawing funds and moving into Treasury securities. "There is a mini-panic out there," says Bob MacIntosh, who runs a municipal bond portfolio at Eaton Vance in Boston. "I have never seen anything like it in my 25 years in the business."

Investors are conjuring up defaults everywhere, Mr. MacIntosh says. But, he says, "All issuers are paying their debt service."

The lack of appetite for the bonds is especially acute for short-term muni securities, which have about a one-week maturity. They would normally be purchased by tax-exempt money-market funds.

Some of the blocks of bonds are insured by Ambac or FGIC. The money-market funds are returning those investments to the underwriters, such as Merrill Lynch and Citigroup, which are subsequently losing money on the deal. "If the auction fails or there is a high interest rate, the banks are losing money on their position," says John Mousseau, who heads Cumberland Advisors' tax-exempt fixed-income area.

Some investors are considering getting into the business. Warren Buffett has said Berkshire Hathaway, his investment vehicle, will enter. Vulture investor Wilbur Ross has also said he's looking at the business. And a consortium of eight banks, including Citigroup, has indicated it is looking at beefing up Ambac's capital.

Stone says the flight to safety is causing his analysts to look at the underlying rating of the bond, not just the rating of the insurance company. For some issuers, this shift has been beneficial. For example, the state of Wisconsin sold $127 million in water and sewage bonds last Thursday. It carried no insurance, even though the bond was rated AA+, not quite the highest rating. "It was sold at a record-low interest rate," says Frank Hoadley, the capital finance director for Wisconsin. "As far as I know, there are willing investors out there."

However, some communities have had to adapt. Miami-Dade County, after shelving a $540 million bond refinancing in November for construction at Miami International Airport, went to a $411 million offering in December. Miami officials did not return calls for comment.

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