Municipal bond insurers guarantee the payment of interest and principal to investors if the city, county or state that issued the bond defaults.
Just like any insurance policy, the issuer pays a premium to the insurer for the guarantee. In return, investors are willing to accept a lower interest rate from the issuer because there is no risk of default.
But municipal bond insurance is only as good as the company that wrote it.
Although there are four major municipal bond insurers in the United States, only two, MBIA Inc. and Assured Guaranty Ltd. (NYSE: AGO), trade as stand-alone entities. Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) includes a municipal bond insurer among its portfolio of businesses, but this is a small part of Berkshire’s total business.
It is virtually impossible to make any sort of generalizations about municipal bond insurance except that each risk must be examined in detail.
For example, the city of Detroit is scheduled to be taken over by a state-appointed financial manager as of March 27. Investors could not be blamed for thinking that this would likely lead to an increase in defaults on city debt and be bad news for municipal bond insurers.
According to MKM Partners analyst Harry Fong, MBIA has $2.5 billion in exposure to Detroit, of which about $100 million is general-obligation debt, while most of the rest is backed by water and sewer revenues. As for Assured Guaranty, Fong says it has about $2.8 billion in exposure to Detroit, of which $355 million is general-obligation debt, $1.85 billion is backed by water and sewer revenues and $600 million is exposed to the Detroit school district.
“Water and sewer revenue bonds would almost certainly be unaffected in the event of a bankruptcy, as the city cannot divert revenues from the utilities for general purposes,” Fong writes. Fong says that the new financial manager “will have the power to sell municipal assets, restructure services, restructure labor contracts and reorder the city’s finances.”
So the municipal bond insurers’ actual exposure to bankruptcy risk in Detroit is much smaller than their total exposure to the city.
If Detroit were to declare bankruptcy, it would not be good news for the insurers but it would not be a disaster, either.