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.

24 thoughts on “Bond insurance and regulatory arbitrage

  1. PrQ,
    I would agree with your main point. It is a point I have made several times in discussions on the Basel II Accord. Giving the ratings agencies quasi-regulatory status is really just lazy regulation.
    The problem, of course, is how you replace the system? Do you create another bureaucracy whose job it is to decide what possible investments get the tick of approval? This seems to be implicit in your last sentence. It is an option I would strongly oppose on cost grounds – as well as many others. The chances that a regulator would be able to understand and rate securities better than S&P and Moody’s I see as remote, at best.
    Otherwise, do you rely on possibly incompetant, corrupt or perhaps just unlucky administrators to do the work while flying blind? Mandate a maximum return to limit risk taking?
    Where do you go?

  2. “Since the municipalities are never going to default”

    Orange County defaulted on its bonds in 1994.

    Never say never.

    Fixed now. BTW, Vallejo in CA just defaulted so that’s two in fifteen years. I’ll leave it to readers to estimate the annual default risk

  3. “Vallejo in CA just defaulted so that’s two in fifteen years. I’ll leave it to readers to estimate the annual default risk.”

    It’s probably not a good idea to estimate default risk purely from historial rates when defaults are low frequency but high impact.

  4. Why can’t we create some form of derivative that prices the probability of default via normal market means. Essentially you could bet for or against a particular entity defaulting on it’s debts in the next year, decade, century, whatever. Others could bet against you and the subsequent market would offer a risk based price. The price signal could then give an indication of the market assessment of risk rather than a rating agency assessment of risk. The regulators could use the market as the guide rather than the rating agencies.

  5. p.s. I bet you $10 buck the Australian federal government doesn’t default on it’s debts between now and christman. 🙂

  6. Municipal bond defaults aren’t particularly high impact. The crash of B&B (if it happens) will be bigger than Orange County, and far bigger than Vallejo, and this is just the example from today’s news.

  7. AR I don’t have a well-developed alternative, but I think it’s clear that the model of relying on ratings agencies is broken beyond repair. In the short run, the appropriate response is to rely on proven conservative strategies, then develop more reliable models of certifying innovations.

  8. When this was discussed earlier, I think the nearest I could come up with to a market-based system was a market-maker system where the underwriter was required to maintain liquidity in the bonds they issued and they were required to hold prime liquid assets representing say 20-30% of the value of the underwritten securities.

    I remember reading several years ago in The Economist a proposal for tradeable “event-linked” put options.

    The idea being that the issuer would pay investors a small premium (or a small regular dividend)to hold put options which they could use to raise additional capital in event of certain specified events occurring.

    (For a bond insurer, these options might be triggered if, say, total losses on their insured bonds exceeded 10% of their capital base or if their capital as a percentage of the total business written exceeded a certain figure.)

    In theory, such options might make the system more secure but we’ve seen again and again in the last twenty years or so that markets can be badly wrong about the soundness of financial firms such as Barings or Enron.

  9. Given that Basel II is based on rating agencies editorials and the editorials have proved as reliable as editorials longer than three letters I would have thought one conclusion followed naturally, Basel II will not survive. If Macquarie can make a few bucks in it’s dieing days good luck to them.

  10. charles,
    Basel II only relies on the ratings for the smaller institutions – those not following the internal ratings based methodologies. In Australia, practically none of the smaller institutions will be lending to rated companies (imagine BHP going to a credit union for a loan). In the US and Europe this is more common.
    The problem with that is that the insurer – or the option issuer or the underwriter (in practice the same thing) – then needs to be rated in some way.

  11. Andrew as I said, these are the best ideas I can come up with but that doesn’t necessarily mean they’re particularly good.

  12. Okay I’ve refined the structure of my bet a little. I’ll give you $1000 if the Australian federal government defaults on it’s debts within twelve months from today, however if they don’t default you have to give me $5. Any takers? Or to put it another way how low does the price of this bet have to be before I have some takers (i.e. is $5 cents too high a price). And how would that price change if we were talking about BHP or Westpac. Surely the market price of a $1000 payout could be used as a risk rating reference with a lower price representing a less risky enterprise.

  13. Andrew, this is a summary of the state of play in Australia.

    Click to access Final-Basel-II-RIS.pdf

    As I understand it moving forward Basel II is the structure APRA will use to judge the financial status of all ADIs and insurance companies.

    All the bank balance sheets I have bothered to read recently detail there capital adequacy using the Basel II framework and it is the Basel II framework that have forced several overseas banks to seek further capital as too much of there capital slipped into a lower grade.

    I think Basel II is very important both here and in any country that has agreed to adopt the recommendations and that within Basel II ratings matter. The problem is the rating aren’t worth a pinch of the proverbial.

    The humor, (if my understanding is correct) USA pushed for the framework to be based on rating agencies.

  14. Seems like a bunch of frogs hopping about in the frypan trying to work out which one’s the safest. Unfortunately central banker frog who inadvertently stepped on the induction cooktop’s touch control before hopping in, doesn’t seem to be of much help either.

  15. JQ says “Since the agencies benefit from giving high ratings to corporate bonds (they are paid to rate them)”

    John, your assertion that ratings agencies give more favourable ratings to firms that pay for them is misguided. Not all corporate bond ratings are paid for and there’s no evidence corporate bonds are rated differently when the rating is paid for. It is true that rating agencies give higher ratings on average to corporations that pay for them. However, once you adjust for private information there’s no evidence that rating agencies are influenced by fee revenue. Firms with favourable private information seek (ie, pay for) ratings in order to signal this information to the market place while, for obvious reasons, lower quality ones don’t. See study below.

    Click to access yingjingan-113004-solicited_rating.pdf

    BTW, if lowering your rating was as simple as paying for it, why don’t the municipalities just do this? Surely this would be cheaper than buying insurance.

  16. Spiros (2), for your convenience the ratings agency Moody’s has already done this calculation and the news is that municipal bonds have a strikingly lower default rate than corporate bonds of a similar rating. See exhibit 4 and 5 of page 8 of the link below. For example on a five year cumulative basis a single A municipal bond has an historical default rate of 0.0053% and a single A corporate bond has a 0.4681% default rate. As a very crude approximation this means a single A corporate bond would need to yield about 0.08% per annum more than a single A municipal bond for an investor to break even on average.

    Click to access content.ashx

    BTW, since we’re throwing anecdotes and statistics around, in the past 15 years the ratings agency Standard and Poors has recorded 1,148 bond defaults and Moody’s has recorded 8 municipal bond defaults in the same period.

  17. JQ says “it’s money for jam�.

    Here’s my back of the envelope analysis on what that jam tastes like: produce credit default indexes for a portfolio of municipal bonds and a portfolio of investment grade corporate bonds. If you use the historical Moody’s five year cumulative default realisations weighted by the credit weightings in each portfolio you get an expected loss from default on the municipal bond portfolio of 0.01% and an expected loss from default on the investment grade bond portfolio of 1.28%. As at 13 June 2008, the spread on the municipal index is about 0.45% and the spread on the investment grade credit index is about 1.10%. So if we make the naïve assumption that the historical averages are realised and that all defaults occur the instant before the end of the fifth year the expected municipal bond portfolio excess return is 2.24% at the end of the period and the expected investment grade credit portfolio excess return is 4.22%. So it would appear that there’s even more jam in corporate bonds than municipal bonds. I haven’t been able to get data on the volatility of the returns so the difference may be purely compensation for the additional beta of the investment grade portfolio over the municipal bond portfolio. The apparent anomaly could also be a function of current bond spreads being a little wider than usual at the moment.

    So what does the jam taste like? Well, the municipal bond jam is sweet but it’s spread a bit more thinly than the investment grade jam. The investment grade jam is occasionally sour but on average it’s still sweet and it’s spread more thickly. I guess it depends how on much variation you can tolerate in your jam.

  18. As far as US Municipal bonds in particular are concerned you have to wonder whether a self-insurance scheme for municipalities at either the state or Federal level might not be more efficient and more transparent.

  19. “So, a local government that is almost certain to pay up”

    But, apparently not always on time.

    The US “Municipal Bond” market is not as simple as it looks.

    “Municipal bonds can be issued on behalf of corporations or by municipal entities which might have higher overall default rates because of their exposure to corporate risks such as bankruptcy.”

    “Following the 1873 Depression, when more than 24 percent of the outstanding municipal debt was in default, the greatest number of defaults occurred in the South, the fastest-growing region at the time. Factors that caused defaults included fluctuating regional land values, commodity booms and busts, cost overruns and financial mismanagement, unrealistic projections of the future, and private-purpose borrowing.”

    The problem is you do not know when history is going to repeat 1873, but you know it will.

  20. Have a listen to the croaking of the central banker frogs now,22606,23845834-5006368,00.html
    Bloody priceless aren’t they? Makes you wonder how they didn’t anticipate all that inflationary expectations before they got expected now doesn’t it? Do they really think anyone with their funny money now is going to lend it out at negative real returns for long? In the meantime (ie until such time as real returns are forthcoming and reflect true marketplace risk) they’re effectively turning it into commodity money or commodity streams as fast as they can. Have a guess what 2 outcomes will ensue, precisely as they’re doing that?

  21. ===
    Bankruptcy filings by cities have been very rare. The largest municipal default over the past 15 years was Orange County, California, and bondholders who didn’t sell into the panic had a 100% recovery rate and no missed coupon payments.(1) Also, the city of Desert Hot Springs, California filed for bankruptcy in 2001 and did not default on its debt.

    1. Source: Moody’s Investor Service, “The U.S. Municipal Bond Rating Scale: Mapping to the Global Rating Scale and Assigning Global Scale Ratings to Municipal Obligations,” March 2007.

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