Deterioration of Monoline Insurance Companies and the Repercussions for Municipal Bonds

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1 Deterioration of Monoline Insurance Companies and the Repercussions for Municipal Bonds Municipal bond prices have been through an extraordinary period of volatility, and much of it has little to do with the integrity of municipal debt. The trouble for municipal bonds does not stem from the issuers of the debt or their underlying credit profiles themselves; it is comes from the insurance companies who have promised to back their debt, otherwise known as monoline insurers. To clarify just how important insurance is to the municipal bond markets, we take a look in this paper at the history of how insurance providers became a crucial component of the capital funding process for municipalities. We also explore how the long-standing business of monoline insurance began to unravel and what the impairment of monolines means for the future of the municipal bond markets. Although the sharp reduction in monoline insurance has permanently changed the municipal bond market, we believe that default rates in municipal bonds should continue to remain historically lower than in corporate bonds. Municipal bonds will be increasingly appraised for their ability to deliver promised cash flows, not by their systemic support from insurance provisions. Under such conditions, it will be increasingly important for municipal bond managers to focus on fundamental credit analysis. IN THIS REPORT Origins of the Monoline Insurance Companies...2 Monolines Decide to Dabble in the Derivatives Markets...4 Downgrading the Monolines...6 How Collateralized Debt Obligations Hammered the Monolines...8 Flaws in Mortgage Default Assumptions Create Toxic CDOs...9 Assessing the Damage to the Monolines...11 Repercussions and Opportunities in Municipal Bonds...14 Case Study: Finding Opportunities in Municipal Bonds...16 The Future of Monolines and Municipal Bonds...18 In this paper, we also demonstrate how investment managers who are able to decipher long-term fundamental values from near-term pricing dislocations are able to capture value opportunities during these periods of heightened volatility. Diligent credit analysis has arguably never been more important in the municipal bond markets than it is now and will be going forward.

2 Origins of the Monoline Insurance Companies Monoline insurers guarantee the principal and interest payments of a debt obligation. If the issuer defaults, the monoline insurer steps in and makes the obligated payments to the debt holders. The term monoline comes from the fact that these firms are regulated to provide only one line of insurance in this case, the financial guarantee business. Thus a monoline insurance company cannot also have life insurance, auto insurance, or property insurance business lines; it is limited to the one business line of insuring financial obligations. The state of New York created this mandate in 1989 when it passed new requirements for bond insurers, which included regulation of capital structure and limits on the types of risks insurers could take on. At the time, New York was home to the majority of these bond insurance companies, so its mandate was viewed as guidance for the entire industry. The bond insurance business had already been around for a few decades before the 1989 regulation created the term monoline, though its use was limited. Before that, bond insurance could be provided by traditional multiline insurance companies, though it typically was not. The first municipal bond insurance company, Ambac Financial Group, Inc., was formed in Two years later, the Municipal Bond Insurance Association (MBIA) was formed as the second municipal bond insurer. These two companies represented the majority of the municipal bond insurance market for several decades and were essential to defining the business as it evolved. In the early days of Ambac and MBIA, investors weren t sure they even needed insurance for municipal bonds. For the first decade in which monoline insurance companies existed, less than 5% of the municipal bond market was insured. Defaults by municipalities were perceived as highly unlikely, and thus the insurance of their bonds didn t seem necessary. These beliefs began to change in 1975, when the city of New York came close to bankruptcy and approached default on its debt obligations. Suddenly municipal debt no longer seemed bulletproof. Then in 1983, the Washington Risks in municipal bonds Public Power Supply became real, and the System (WPPSS, or availability of insurance whoops bonds, as protection became a traders referred to them) highly attractive option. defaulted on $2 billion of revenue bonds. This led to massive losses for investors and negatively affected other municipalities by raising their costs of capital. Risks in municipal bonds became real, and the availability of insurance protection became a highly attractive option. Thus the seeds for a burgeoning financial guarantee business were planted and the business would soon flourish. Monoline insurance companies began to build their prevalence in the municipal bond space throughout the 1990s and into the 2000s. It became increasingly common for a municipality to issue its debt wrapped in the protection of a monoline insurer s guarantee of principal and interest repayment. The benefits of this 2

3 arrangement favored both the issuer and the buyer. Issuing municipalities recognized the added value of the insurance it made their deals cheaper and easier to sell in the marketplace. Buyers of the debt also appreciated the insurance; municipal debt already had high creditworthiness, but with the added AAA-rated insurance protection, municipal bonds seemed nearly as good as U.S. Treasury debt. The market for insured municipal debt began to grow to the point where it became a significant portion of the municipal bond market. By 2002, more than 40% of municipal debt was insured by a monoline, and in 2007 at the start of the credit crunch, nearly 50% of municipal bonds were backed by a monoline ten times more than the 5% of municipal bonds that were insured during the 1970s. Such a breadth of influence in the municipal bond space made the monoline insurance business an intrinsic part of the market paradigm. Insured municipal bonds were viewed as AAA-rated quality with essentially no need to even measure their underlying credit profiles, because all monolines were AAA-rated companies and none had ever failed to make a payment. Therefore, payments to investors were guaranteed, regardless of whether or not the municipality could make them. In short, confidence was high in monoline-backed municipal bonds. As a result, many investors did little due diligence on the credit quality or the insurance that backed the bonds. What could possibly go wrong? 3

4 Monolines Decide to Dabble in the Derivatives Markets Up until 2007, no monoline insurer had ever been downgraded or failed to make a payment. The companies steadily received premiums to guarantee financial obligations and rarely had to pay out claims. It was an exceedingly stable business model: receive a consistent supply of insurance premiums in return for backing debt obligations that typically had very little default risk to begin with. However, the modest origins of the business may be where trouble began for many of the monolines. They became convinced of the stability of their business, even as they began to insure debt obligations that they had never guaranteed before. Many of these financial instruments were new to the industry and to insurers, which meant changing habits that were 30 years in the making. Just within the last five years, credit markets have begun to change quickly as new financial innovations were There were new instruments to hedge against credit risk, essentially replacing some traditional forms of debt insurance, the monoline s bread and butter. introduced by investment banks and hedge funds. There were new instruments to hedge against credit risk, essentially replacing some traditional forms of debt insurance, the monoline s bread and butter. Derivatives were allowing the capital markets to provide insurance to other investors, bypassing the need for insurance companies. In particular, the credit default swap (CDS) was gaining significant market share. CDS is essentially an insurance contract against the default of a referenced bond. The buyer of the CDS pays a premium at a fixed rate while the seller is contracted to make the investor whole in the event of a default by the referenced bond. CDSs became widely used after the corporate bond downgrades and defaults of 2002 and Each year, the CDS market reached unfathomable new levels of volume, growing from less than $5 trillion in 2003 to more than $14 trillion in It grew to $29 trillion by the end of 2006 and $45 trillion by the end of 2007, according to the International 4

5 Swaps and Derivatives Association (ISDA). It was estimated to be around $55 trillion at the halfway point of During this time, the old stable game of collecting premiums on municipal bond insurance was being left in the dust. Yes, municipal bond insurance was still profitable, and it was still a viable business (nearly 50% of municipal bonds were insured in 2007), but it was hard not to notice all the profits being made in the derivatives markets. Additionally, demand for collateralized debt obligations (CDOs) was soaring. A CDO packages several types of debt obligations together and then sells tranches of varying credit quality to investors. In 2004, $157 billion of CDO issuance went to market; in 2005, $272 billion; in 2006, $552 billion; and in 2007, $503 billion, according to the Securities Industry and Financial Markets Association (SIFMA). The size of the CDO market was estimated to be around $2.5 trillion at the end of 2007, and investors were increasingly asking for insurance on these deals. The premiums paid to insure CDOs were larger than those in the comparatively thin profit-margin business of municipal bond insurance. Many of the deals had high credit ratings and were claimed to be highly diversified against risk. For the monolines, the lure of the market was too great to ignore. Besides, the higher credit profiles were systemically assessed by the ratings agencies and securities firms to be of investment grade. Monolines had been in the stable business of bond insurance for a while, but things were changing around them. Financial innovation was creating a tremendous amount of new financial obligations on which to potentially earn premiums such as CDO insurance. Meanwhile, the CDS business was generating a seemingly endless supply of premiums in an environment of tightening credit spreads and historically low levels of default. Chart 1 Estimated Annual CDO Issuance, U.S. Dollars ($ Billions) Year Source: Securities Industry and Financial Markets Association (SIFMA) as of July 25,

6 Downgrading the Monolines Prior to 2008, seven AAA-rated monoline insurers collectively accounted for nearly the entire municipal bond insurance business. The monolines had to maintain their AAA ratings to secure business; investors were looking for nothing less than AAA-rated guarantees on the debt they were buying. What good was an AA-rated insurance provider for an AArated municipal bond? It added nothing to the deal. On top of that, municipal bonds were already on a higher credit quality scale than the corporate ratings scale, meaning that an A-rated municipal bond had less likelihood of default than an A-rated corporate bond, or an A-rated insurance company for that matter. Municipals had better overall credit profiles and were put on a customized ratings scale with a downward bias to give some context across the different deals. For a monoline, this all meant that losing its AAA-rating would effectively shut down its municipal bond insurance business no one would pay for its guarantee. In 2008, that worst-case scenario began to unfold. Ambac and MBIA had been around since the early 1970s and had largely built the entire municipal bond insurance business. They had each been rated AAA for more than 35 years. MBIA was the largest monoline of all seven and Ambac was the Suddenly the monolines second largest. But none had some huge claims of that mattered now. to pay to cover losses on Suddenly the monolines mortgage derivatives. had some huge claims to pay to cover losses on mortgage derivatives. On January 18, 2008, Fitch Ratings downgraded Ambac to AA. Three months later, on April 4, Fitch downgraded MBIA to AA. Standard & Poor s eventually followed suit on MBIA, downgrading the company to AA on June 6 just weeks before Moody s took the company even further down to A2 on June 19. 6

7 In similar fashion to MBIA, Ambac s rating was cut by Standard & Poor s and Moody s in June to AA and Aa3, respectively. Both of these companies had fallen into similar positions of negative excess capital due to unprecedented claims obligations, but they were both adequately raising enough capital to operate, mainly through their core business of providing continuing insurance to municipal bonds. They weren t paying excessive claims on municipal bonds those securities were doing just fine. It was their portfolios of structured finance CDOs (SF CDOs) in residential mortgages (RMBS) that was dragging them down. In addition to the extraordinary losses that Ambac and MBIA were paying out in CDO losses, neither of the companies could take on new business. Without the AAA-rated integrity, both companies had lost franchise value; their insurance meant nothing to municipal bond buyers. But three other monolines were in even worse shape. Security Capital Assurance Ltd. (SCA), which is the parent company of XL Capital Assurance; CIFG Guaranty (CIFG); and Financial Guarantee Insurance Company (FGIC) were each dropped below investment grade by Fitch and Moody s. These three companies not only had negative excess capital and forfeited franchise value, they were testing insolvency. The difference between each of these five companies came down to how much SF CDO insurance they sold and how loaded those deals were with subprime RMBS. 7

8 How Collateralized Debt Obligations Hammered the Monolines The credit crisis that began with the collapse of two Bear Stearns hedge funds in the summer of 2007 owes much to the massive amount of mortgage-backed securities (MBS) that were created with subprime mortgages. These assets were loaded into many different security structures, such as CDOs and structured investment vehicles (SIVs). Part of the problem was the breadth of bad deals being made, but an even greater part of the crisis was the systemic proliferation of leverage on these assets. Thus, when the bad deals, such as subprime mortgages, failed to produce the expected level of cash flows, losses were amplified throughout the overlevered financial system. The problem was an overconfidence in overly optimistic default assumptions that were supplied by the deal makers and endorsed by the ratings agencies. The whole system was levered up on some overly rosy assumptions that poor-credit homeowners and no-documentation mortgage borrowers would continue to make their payments. As the credit crises unfolded, monoline insurance companies suddenly became increasingly liable for losses in a variety of financial obligations, including direct exposure to RMBS and CDS contacts. But it was predominantly their As the credit crises exposure to SF CDOs unfolded, monoline that determined just insurance companies how much trouble suddenly became they got themselves increasingly liable for into. It was the rapid losses in a variety of deterioration in SF financial obligations. CDO asset values that pushed their business models over the brink and into negative excess capital reserves; in other words, they didn t have enough cash to cover potential losses. The actual number of mortgage defaults went well beyond what the models projected, and the monolines that participated more heavily in the SF CDO guarantee business were the ones that got burned the most. 8

9 Flaws in Mortgage Default Assumptions Create Toxic CDOs The problem was a lack of transparency in structured deals. The first layer of opaqueness started with securitizing mortgages this process creates distance from the originator of the mortgage. Mortgages are pooled together with other mortgages and then packaged into an MBS and sold to investors. Investment managers can drill into the MBS to see the actual deals, but it s difficult to thoroughly look into all of the actual mortgages it could even require having to track down the original paperwork at the broker that created the contract. But it gets even more challenging. These MBS can be packaged together into other securities such as CDOs. The distance from the original mortgage grows. An investor would have to drill through the CDO, into each of the MBS deals, and then through to the underlying mortgage itself an exercise that is difficult and time-consuming, even for the most diligent investors. On top of that, CDOs themselves can be pooled together to create something called a CDO squared, a CDO that holds CDOs that hold MBS that hold mortgages. At this stage, it s essentially impossible to drill into the original mortgages. So to account for this difficulty, the pools themselves carry profile statistics, such as prepayment rate, default rate, seasoning, credit enhancement, overcollateralization, and several other characteristics. These assumptions can have ranges to allow for different scenarios, but they need to be fairly accurate to properly value the asset. Herein lies the issue: many of the assumptions were based Herein lies the issue: on faulty estimates many of the assumptions about the health of the were based on faulty housing market and the estimates about the health underlying credit profiles. of the housing market and the underlying credit During the housing profiles. boom, which was actually a credit bubble in disguise, mortgages were made of increasingly suspect underlying quality. There was no incentive for the mortgage brokers to originate good mortgages; they sold them to the street and assumed none of the default risk for themselves. Brokers profited sheerly from the volume of the deals being made, not the quality. The brokers that limited themselves only to qualified borrowers were missing out on the game, while those that were expanding into subprime and alt-a markets were making money (alt-a borrowers are typically between prime and subprime borrowers). Teaser-rate deals were created because it was more important to get the contract than to get one that would keep paying. Adjustable-rate mortgages grew, as did negative amortization and interest-only contracts. Loans were given at 100% loan to value (LTV) compared with the traditional 80% LTV threshold, and borrowers didn t even have to document income or assets in many cases. In short, by little more than signing your name, you could likely get a mortgage, and that mortgage was then quickly passed to Wall Street to be packaged into a series of complex 9

10 investment vehicles. The problem was that the pools came with default assumptions provided by the deal makers, which were largely assumed to be fairly accurate. The default assumptions were also accepted by the ratings agencies they had no reason to challenge them, but probably should have. By not performing thorough due diligence on the risk assumptions, the ratings agencies were complicit in overrating the CDO deals. As a result, investors and the monoline insurers thought they were holding much better quality investments than they actually were. Financial innovation had resulted in exceedingly CDRs are based on the complex securities. To premise that mortgages value these investments, are issued to qualified an investor in a CDO buyers. In fact, the that held subprime whole system was based MBS would look at the on this assumption. constant default rate (CDR) assumptions on the deal to alleviate the need to drill into the actual mortages themselves. The CDRs were adjusted higher for subprime mortgages but couldn t possibly account for the actual level of bad deals being made because by their very nature, CDRs are based on the premise that mortgages are issued to qualified buyers. In fact, the whole system was based on this assumption. The Bond Market Association created the standard default assumption (SDA) rate back in the earlier days of the MBS industry. Both the SDA and CDR model assumptions rely on mortgages being made under fair terms to qualified borrowers. They both assume that the subprime borrower has good income and adequate assets and that the mortgage payments are reasonable and can be made. In many cases, none of these assumptions were actually true. So the CDRs for qualified buyers were overlayed to thousands of mortgages that were actually made under unqualified circumstances to unqualified borrowers. They were bad mortgages, and the default rates were going to be far greater than their models were predicting. Not everyone got into the CDO game, though the profits were certainly enticing. Many investors were not comfortable accepting the CDR or SDA assumptions of the underlying debt The diversification obligations, and their caution is supposed to proved to be prescient. One protect investors if other important factor of a losses occur in one CDO deal is the correlation area of the debt factor of its underlying holdings. assets. The diversification is supposed to protect investors if losses occur in one area of the debt holdings lower correlation is better, measured on a scale from zero to one. By late 2006, it seemed increasingly apparent that the housing boom was running out of steam and that the run-up may have been achieved with some suspect extensions of credit. By midsummer 2007, investors began looking for the exits on these deals, but there were fewer and fewer buyers. Liquidity dried up quickly, and thus the credit crunch began. And in a credit crisis, security correlations go quickly to one perfect correlation and soon everything is at risk. At this point, two of the major CDO safety switches (CDR and correlation assumptions) were way out of range, statistically showing scenarios that were the equivalent of a 1000-year storm even the senior tranches (composed of higher credit quality) weren t safe as credit enhancements were eroding quickly. By the second quarter of 2008, it was estimated that $200 billion worth of CDOs had defaulted globally. And now the monolines were about to get the bill. 10

11 Assessing the Damage to the Monolines Of the seven AAA-rated monolines in 2007, only two had maintained their AAA-ratings as of October 2008: Financial Security Assurance, Inc. (FSA) and Assured Guaranty Ltd. (AGL). Both of these companies limited their exposure to the SF CDO business and to subprime RMBS. While their competitors moved into insuring CDOs and issuing CDSs, these companies seemed cautiously skeptical of the bubbling credit paradigm and minimized participation in these business lines. However, these companies were not immune from losses, and each had some direct exposure to RMBS. The key difference from the other five monolines is that these two companies maintained adequate excess capital and appeared to be able to manage losses associated with current claims. FSA and AGL were also rewarded with increased market share as they represented the only surviving AAA-rated monolines. FSA has taken the majority of new business, and, as an added reward for surviving, the company takes in premiums that are three times what they were a year ago. Fitch Ratings projected the claims-paying resources that each of the seven monolines requires to maintain their AAA-rating. The graph below shows adjusted claims-paying resources (ACPR) versus target claims-paying resources (TCPR). The target is how much in claims-paying resources each monoline would have to maintain to keep its AAA-rating; that is, to be able to adequately cover all of its projected claims liabilities. Note that the capital shortfalls for the bottom three monolines that are rated below investment grade (CIFG, FGIC, and SCA) are much higher percentages of each company s capital resources. Chart 2 Monoline Insurers' Claims Paying Resources, July 2008 U.S. Dollars ($ Billion) $18 $12 $6 $0 Adjusted Claims-Paying Resources (ACPR) Target Claims-Paying Resources (TCPR) Excess/Shortfall -$6 FSA Assured MBIA Ambac CIFG FGIC SCA Insurer Source: Fitch Ratings Services as of July 17,

12 Thus, only FSA and AGL had enough capital resources to maintain their AAA-rating as of July In the meantime, new competitors have entered the space to fill the gap. True to Warren Buffett s instincts for finding value in stressed financial conditions, Berkshire Hathaway Assurance (BHA) has entered the market as a potential AAA-rated competitor. The company s initial deals have been to provide reinsurance on bonds backed by downgraded monolines. According to Fitch Ratings, the other five monolines (Ambac, MBIA, CIFG, FGIC, and SCA) insure approximately $114 billion of SF CDOs. Fitch estimates that the companies will lose $15 to $21 billion on that exposure, with the companies that are more exposed to subprime RMBS fairing the worst. Clearly not all SF CDOs are created equally, thus each company has different vulnerabilities to SF CDO defaults. Chart 3 shows each of the five downgraded monolines exposure to SF CDOs. MBIA and Ambac had the largest portfolios but not necessarily the highest concentration of bad debt. SCA, FGIC, and CIFG have much higher concentrations of projected losses in SF CDOs as a percentage of total exposure. SCA, FGIC, and CIFG were in much tougher shape. CIFG was projected to have losses of approximately 27% on its SF CDO exposure, FGIC 26%, and SCA 21%. All three of these companies suspended the origination of new business and were seeking ways to preserve and/or infuse new capital. However, without substantial improvement to their financial conditions, their viability as ongoing insurance providers in the municipal bond space is highly questionable. Municipal bonds backed by these insurers have experienced tremendous volatility as investors try to figure out the value of the underlying credits with potentially worthless Chart 3 Downgraded Monolines' Exposure to Structured Finance CDOs, July 2008 $35 $30 Structured Finance CDO Exposure Median Expected CDO Losses U.S. Dollars ($ Billion) $25 $20 $15 $10 $5 $0 MBIA Ambac SCA FGIC CIFG Insurer Source: Fitch Ratings Services as of July 17,

13 insurance. At times during 2008, municipal bonds backed by these monolines traded at levels worse than if they had no insurance at all. That is an indication That is an indication of just how toxic the of just how toxic the junk-rated monoline junk-rated monoline insurance became the insurance became the bonds they backed bonds they backed were were priced worse priced worse than if they than if they had no had no insurance at all. insurance at all. insurers. In 2007, nearly 50% of all municipal bonds were insured. In 2008, only 21% of new bonds have been wrapped in monoline guarantees. The market for municipal insurance is in significant decline while municipal bond prices experience heightened volatility and the prospects of a future without insurance. What does this say for investors? If anything, it shows that there is no substitution for due diligence, whether or not a bond is wrapped in insurance. The other two challenged monolines, Ambac and MBIA, may continue to exist but are not out of the woods yet. They are not able to generate new municipal insurance due to their credit impairment and loss of reputation. However, they each maintain high levels of excess capital and the capacity to cover the staggering losses that they face. The municipal bond insurance business has dropped off significantly in 2008 with the absence of these 13

14 Repercussions and Opportunities in Municipal Bonds During the monoline crisis of 2008, municipal bond markets produced some extraordinary valuations. Suddenly, underlying credit profiles of municipal bonds were important again. Bonds that carried the AAA ratings of their insurance coverage were being downgraded to their However, with the fundamental creditworthiness. adversity came Consequently, their values some tremendous were in decline as their opportunities risk profiles increased. to find value, as Additionally, bonds that market trepidation were insured by the most led to significant challenged monolines price dislocations were strongly out of from fundamental favor, as headline risk and asset values. heightened levels of uncertainty washed over the markets. However, with the adversity came some tremendous opportunities to find value, as market trepidation led to significant price dislocations from fundamental asset values. Chart 4 shows the level of insured bond yields over AAA-rated general obligation municipal bonds. The deterioration in the credit profiles of the monolines led to a significant widening in those spreads to compensate for the added risk. This even occurred in FSA, which retained its AAA rating. Chart 4 Yield Spread of Insured Bonds vs. AAA-Rated G.O. Municipals, Spreads (% of Yield) FSA FGIC MBIA Year Source: Barclays Capital 14

15 In addition to the value found in individual bonds during the monoline crisis, the municipal bond market as a whole hit extraordinary levels of relative value compared to U.S. Treasuries. Considering as how nearly 50% of the municipal bond market was rated AAA through monoline guarantees, the abrupt disappearance of those assurances shook the municipal bond market to its core. Investors questioned whether this asset class was in fact nearly as risk-free as the U.S. Treasury market a belief that had taken hold over several decades of low defaults and high creditworthiness. Municipal bond-to-treasury ratios have historically averaged in the 80% to 90% range. However, in mid-march 2008, yields on municipal bonds hit all-time highs compared to U.S. Treasuries, with ratios topping out over 120%. This was the result of extreme distress in the credit markets, which prompted the Fed to aggressively drop interest rates by 200 basis points in less than two months. The U.S. Treasury market staunchly followed the Fed s lead, as investors rallied Treasuries and fled other asset classes. At the same time, the monoline crisis was growing. As investors were fleeing to U.S. Treasuries, municipal bonds were beginning to fall from grace. Were they still AAA-rated debt? Or was the rug being pulled out from under them with the deterioration of the monoline insurers? As a result, yield ratios on municipal bonds to U.S. Treasuries persisted well above their normal levels for much of Chart 5 Yield Ratio of Municipal Bonds to U.S. Treasuries, Ratio (%) Year Source: Barclays Capital 15

16 Case Study: Finding Opportunities in Municipal Bonds The dislocations in the municipal bond market did not go unnoticed by some careful investment managers. Some with active management styles that rely on fundamental credit research were in a unique position to capture value from the market volatility. The Municipal Fixed Income team at Wells Capital Management (WellsCap) noticed some attractive dislocations in pricing during the monoline crisis. Bonds backed by weakened insurers traded at price levels similar to comparable bonds that did not have insurance, meaning that the insurance was being sold for free. On one hand, this was bad news for owners of municipal bonds that were losing value to a market that had become overly distrustful of the monoline effect. But just as existing holdings were in decline, new opportunities to add value were presenting themselves. Portfolio managers Lyle Fitterer, Robert Miller, and Wendy Casseta at WellsCap identified many bonds with attractive fundamental values, trading at uncharacteristic levels of comparability. For example, their credit analysis team noticed in March 2008 that Louisiana State Property Insurance revenue bonds were trading at 141 over the Municipal Market Data scale (MMD), a widely used metric for pricing comparable municipal bonds. A higher rating equates to a higher yield and a cheaper price. The Louisiana revenue bonds were insured by Ambac and rated BBB. Ambac had already been downgraded by Fitch in January, and concerns over its SF CDO portfolio and exposure to CDO-squared deals were creating significant headline risk for the monoline. At the same time, noninsured BBB-rated revenue bonds were trading at 100 over MMD, far more expensive than the Louisiana bond s 141 rating and 5.71% yield. This meant that having the name Ambac on the bond was worse than having no name at all; if Ambac failed, it wouldn t mean that the bonds failed, it would just mean that the bonds had no insurance. Investors were essentially being paid to take the insurance. 16

17 After drilling into the fundamental credit profile of the Louisiana bonds, the WellsCap portfolio managers bought the bonds for their clients funds at the 141-over-MMD level. The bonds subsequently outperformed the municipal bond market, returning more than 700 basis points of price appreciation in the first two months that WellsCap owned them. Five months later, the team traded out of the bonds at 100 over MMD, capturing significant price appreciation after investors realized that the dislocation of pricing was overblown and the fundamental values of the credit were realized in the market. In April, the team found CIFG-insured bonds issued by the Xenia Rural Water District of Iowa. The revenue bonds were rated BBB and trading at 125 over MMD while comparables were trading at 100 over MMD. Once again, buyers of the distressed monoline s insured bonds were paid to take the insurance. The markets didn t want bonds with the CIFG name on them. Technical pricing patterns and headline risk were outstripping fundamental analysis, which was the perfect environment for a value-style, research-driven investment team. WellsCap added the Xenia revenue bonds at 125 over MMD in late April. In late August, the team garnered value from them by capturing a price appreciation to 100 over MMD. On June 6, 2008, the WellsCap team added Denver Colorado Airport revenue bonds at an option-adjusted spread (OAS) level of 190 over MMD. The bonds were insured by MBIA, which was downgraded by Standard & Poor s on the same day, June 6. Headline risk for MBIA was heavy that day, as the world s largest monoline had been knocked from its AAA pedestal by a major ratings agency. In reality, the Denver Colorado Airport bonds were rated A and fairly solid credits, but the MBIA headline risk pushed them out of favor. Since then, the Denver Colorado Airport revenue bonds significantly outperformed and were priced at an OAS of 90 over MMD as of October Again, fundamental credit research allowed WellsCap to capitalize on these dislocations and to profit from an otherwise difficult period for the municipal bond market. 17

18 The Future of Monolines and Municipal Bonds The global credit crisis in September and October 2008 sent municipal bond yield ratios back to the historic peaks seen in the first quarter of Markets returned to an environment of heightened risk aversion that presented potential new opportunities for investors who were able to decipher long-term fundamental values from near-term price dislocations. Diligent credit analysis has never been more important Diligent credit analysis has in the municipal never been more important bond markets than in the municipal bond it is now and will be markets than it is now and going forward. will be going forward. The disappearance of monoline financial guarantees has significantly and permanently altered the landscape. While some monolines, such as FSA and AGL, may continue to provide insurance, the role of monolines in the municipal bond markets will likely be significantly reduced. Thus, the risk-pricing paradigm for municipal bonds will be different. A year ago, 50% of new issuances were rated AAA solely because of the insurance provision. Going forward, municipalities will, in many cases, have to rely solely on their own creditworthiness to attain a AAA rating. This is potentially good news for investors seeking higher levels of tax-free yield more variation in credit qualities equals more opportunities for higher yields from lowerquality issuances. However, it also necessitates a more rigorous analysis of credit quality in the municipal bond markets. Adding to the changing landscape, Moody s Investor Services has announced intentions to adjust its credit rating scale for municipal bonds to a parity with corporate bonds and other fixed-income securities on a global ratings scale. Municipal bonds have historically had a much lower default rate and have been on a different ratings scale to evaluate their risks. According to Standard & Poor s, no AAA-rated or AA-rated municipal bond has defaulted in more than 20 years. Monoline insurance provisions certainly played a role in this. By comparison, AAA-rated and AA-rated corporate bonds have defaulted, and at rates higher than BBB-rated municipal debt. The global ratings scale will bring the comparisons between municipal bonds and corporates closer in line. As a result, we believe that default rates in municipal bonds should continue to remain lower than corporate bonds and that municipal bonds will be increasingly appraised for their inherent ability to deliver promised cash flows, and not by their insurance provisions. Portfolio management teams that have deeper credit research resources should be strongly positioned to Portfolio management add value in the nearterm environment of credit research resources teams that have deeper heightened volatility and should be strongly price dislocations as well positioned to add value. as in the long-term shift to a market devoid of insurance guarantees. With the uncertainty in municipal bond markets comes the potential for opportunity. Fundamental investors who can drill into the underlying credit profiles may be best prepared for the new municipal bond paradigm. 18

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