Bond insurance and regulatory arbitrage
Readers familiar with the Macquarie Group are likely to have several reactions to the news that Macquarie is considering entering the US municipal bond insurance market. First, if Macquarie is interested, there is almost certainly money to be made. Second, much of the gain is likely to be at the expense of the governments concerned, and will involve some combination of regulatory arbitrage and financial engineering. Finally, given its high-risk business model ( Babcock & Brown, the other leading exemplar of this model is trying to stave off the banks as you read this) isn’t it a bit odd for Macquarie to be guaranteeing the debt of low-risk entities like local governments?
[update: Pressure on ratings agencies to treat public and corporate bonds on the same basis is having an effect]
All of these reactions are correct, and they reflect the fact that the municipal bond insurance market is the spurious creation of regulatory reliance on for-profit rating agencies like Moody’s and S&P. Lots of investor are required, under a range of regulations, to invest only in AAA-rated assets, and these ratings are handed out by Moody’s and S&P. Since the agencies benefit from giving high ratings to corporate bonds (they are paid to rate them) they systematically give these bonds higher ratings than government debt, even though the default risk on the latter class is far lower. So, a local government that is almost certain to pay up may be rated A, while a private corporation with a comparable balance sheet would be rated AAA.
Markets are aware of this, so the interest rate on government bonds tends to be lower than for similarly rated (but higher risk) corporate bonds. But the market isn’t perfect and the problems are exacerbated by regulations like those mentioned above which give the ratings agencies opinions the force of law.
This opens up the regulatory arbitrage opportunity. It’s easy for a private corporation like Macquarie to set up a AAA business, without putting in an awful lot of equity. This business can be used to guarantee the debt of sub-AAA rated municipalities who can then borrow at the AAA rate paying the insurer a premium. Since the municipalities are
never hardly ever going to default (except in a general crisis that would probably bring down the insurer anyway) it’s money for jam.
The only remaining question is why this money is sitting on the table. The answer is that the previous incumbents, firms like MBIA and Ambac, got too greedy and diversified into insuring securities based on mortgages. Of course, these were highly rated by S&P and Moody’s but the ratings were issued under the lax standards applied to the private sector, and they’ve now started defaulting on a large scale. Long after it was obviously necessary, Ambac and MBIA have lost their AAA ratings, and gone into “run-off” mode (that is, they continue to collect premiums and pay out claims, but don’t write any new policies).
The only way to fix this problem in the end is to abandon any official reliance on private ratings agencies. If individual investors find the opinions of these agencies useful, they can follow them, just as they can choose to follow or not, the recommendations of stockbrokers on equity investments. But requirements to hold only AAA-rated or only investment-grade securities should be junked (pun intended). If regulators need to ensure that investment portfolios are safe, they should do the work themselves.