Why does municipal bond insurance exist? After all, default rates are incredibly low, on the order of 0.1%, much lower than on corporate issues. Not surprisingly, this low-default insurance business has been highly profitable, at least until recently, for incumbents.
Now, however, we have Warren Buffett wanting a piece of the (broken) action. Should he get it? A provocative piece in the upcoming issue of Portfolio argues nyet. Not so much to Warren, as to the whole idea of muni-bond insurance. It is, in Jesse Eisinger’s word, a "scam".
So why do the governments buy bond insurance in the first place? Mainly to get the higher credit rating, which lowers the interest rate and reassures investors. The rub, though, is that they should have received lower rates anyway. The municipalities’ credit ratings are too low. If rating agencies properly assessed them according to investors’ true risk of loss, muni bonds would have lower interest rates without the expense of insurance.
We know this because Moody’s has been conducting an epic research project over the past decade to figure it out. The result is a secret decoder ring, provided by Moody’s, into which an investor can plug a muni-bond rating. Out pops what the corporate rating would be. According to Moody’s table, almost every muni bond would get a higher rating. About two-thirds would probably be triple-A if they were rated with the same criteria used to rate corporate bonds.
The obvious conclusion is that Moody’s, as the most influential of the credit-rating agencies, should simply start lifting its ratings on municipalities. But Moody’s doesn’t have any plans to do that. Why it won’t is one of the great mysteries of the muni-bond world. Is it merely a historical artifact? Are the rating agencies plagued by memories of government debacles like the Orange County, California, derivatives blowup or the strike-riddled and garbage-strewn streets of New York during the 1970s budget crisis? According to Moody’s, investors and issuers like the system the way it is. But that’s not credible. Why would issuers want to pay more than they should? More likely, the system remains unchanged because bond insurance is good for everyone in the market—except for municipalities, that is, but they have no choice except to go along with it.