February 21 2008: 1:29 PM EST
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Common sense fix for muni bonds

If muni bonds got the ratings they deserve, we wouldn't need to bail out the bond insurers. We wouldn't need bond insurers at all.

By Jon Birger, senior writer

NEW YORK (Fortune) -- What the municipal bond market needs most is not an injection of capital into the bond insurance companies. What it needs is an injection of common sense into its credit rating system.

The simple truth is that the overwhelming majority of tax-exempt bonds issued by states and cities deserve a triple-A credit rating without any bond insurance, given their historically minuscule default rates.

The only way Fitch, Moody's and Standard & Poor's can justify denying them a triple-A is by applying a completely different ratings standard to munis than they do to other kinds of debt. Consequently, the bond market winds up with crazy situations in which, for example, State of California bonds are rated triple-A when the state sells taxable bonds to foreign investors but single-A when California sells tax-exempt (but otherwise identical) bonds to muni investors in the United States

What does this disconnect have to do with the current bond insurance debacle? Plenty. After all, the bond insurance industry wouldn't even exist without it.

In recent weeks, banks and regulators have been bandying about costly plans to bail out Ambac (ABK) and MBIA (MBIA) and in doing so preserve the triple-A credit rating that these bond insurers imprint on every bond they insure. By selling states and cities insurance that turns triple-B and single-A bond issues into triple-A's, bond insurers help governments reduce their borrowing costs and help themselves to some of the yield that would have otherwise gone to investors.

Due to missteps in the mortgage market, Ambac is reportedly looking to raise some $2 billion from banks and other investors in order to prop up its balance sheet. Financial Guaranty Insurance Co., another bond insurer, is considering a plan to spin off its muni insurance business in order to raise capital for its non-muni insurance business.

The stakes are enormous because insured bonds now comprise half the $2 trillion muni market. A downgrade of Ambac and MBIA would spark a massive muni sell-off and force the banks, insurance companies, brokerage houses and investment firms with big muni positions to take substantial writedowns. Coming on the heels of the mortgage implosion, such writedowns could be devastating.

And that's just for munis. The bond insurers are also on the hook for some $500 billion in securities in the mortgage- and asset-backed markets - markets that they aggressively (some might say blindly) entered once growth opportunities in munis became scarce. Giving muni bonds the rating they deserve would free up capital to back those less-secure bonds.

Rather than a bailout, a better solution to the bond insurance imbroglio would be for regulators and investors to pressure Fitch, Moody's and Standard & Poor's to rate tax-exempt municipal bonds more equitably by putting them on the same scale as taxable bonds. Doing so would reveal the underlying safety of munis and thus blunt the market impact of an Ambac or MBIA downgrade. (Most muni issues would then have a double-A or triple-A rating whether or not they were insured.)

Rationalizing the rating system would also reduce the short-term financial pressure on bond insurers (though, long term, it would blow up their raison d'tre) as the capital needed to insure a double-A or triple-A bond is substantially less than that to insurer a single-A. "It is potentially a silver bullet for the market," muni market analyst Matt Fabian, managing director with Concord, Mass.-based Municipal Market Advisors, says of a ratings makeover.

Fabian is a long-time critic of the rating agencies and with good reason. Fitch, Moody's and S&P all acknowledge that the historical default rate among plain-vanilla munis (a category which includes general obligation bonds and water-and-sewer bonds but excludes riskier hospital bonds and industrial development bonds) is puny. According to an S&P study, the historical default rate on plain-vanilla munis rated triple-B - the lowest rung of investment grade - is 0.09%.

A Moody's report puts the historical default rate on all triple-B munis at 0.059%. That's an astonishingly low number when you consider that the triple-B default rate on munis is 11 times lower than the 0.675% default rate on corporate bonds rated triple-A by Moody's.

So why then do the rating agencies maintain separate rating scales for munis? Fabian contends the rating agencies are simply serving their own interests. If everything were rated double-A or triple-A, there would be little need for bond insurance. And no bond insurance would mean the rating agencies wouldn't be able to charge for two ratings per bond issue an insured rating in addition to the underlying rating instead of just one.

I'm not quite as cynical as Fabian. Moody's managing director Gail Sussman makes a reasonable argument that most institutional investors like the current rating scale because it helps them identify credit quality differences that would be obscured if everything were rated double- or triple-A. Personally, I don't think those gradations are meaningful, but Sussman is right in asserting that many investors like to see them.

Still, there has to be a way to put municipal ratings on par with corporate ratings without losing the nuance investors have, rightly or wrongly, come to expect. Perhaps Moody's could add an Aa4 and Aa5 to its stable of double-A ratings. Whatever the solution, the system needs to be fixed.

Municipal bonds have always been substantially better credit risks than the bond insurance companies insuring them. That made no sense a year ago, and with the credit markets hanging in the balance, it makes even less sense today. To top of page

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