MarketWatch is reporting California enters frayed muni market, protection-free.

California’s upcoming $1.75 billion issue will join a growing number of municipal bond deals notable for what’s missing — bond insurance. Financial troubles at MBIA (MBI), Ambac Financial (ABK), and other companies that provide this insurance have, in many cases, made the bond insurance irrelevant or even a handicap.

California, for instance, has not paid for bond insurance on its last two big deals — a $3.3 billion economic recovery bond, sold in February, and a $1 billion general obligation bond, issued in November. The state doesn’t plan to pay for insurance on its upcoming general obligation bonds either, which are available to retail investors Monday and Tuesday and are set for institutional sales and pricing Wednesday.
That’s a change from the past. California spent $102 million insuring general obligation bonds between 2003 and 2007.

“The value of bond insurance is not what it was a half-year ago,” said Tom Dresslar, a spokesman for the California state treasurer’s office. He said the state continues to do the math on whether to buy bond insurance, comparing the interest rates it would pay on insured bonds with those on uninsured issues.

It has recently found the benefits of insurance are not worth the payout.
“It would be a waste of taxpayer money to buy insurance on our bonds,” Dresslar said.

What is odd, traders and analysts say, is that the bonds lacking insurance are trading at the same prices or even higher than comparable ones carrying insurance.

Take some recent moves in Massachusetts general obligation bonds traded on the TheMuniCenter trading platform. Both carry an interest rate of 5.25% and are due in 2019. But on Thursday, the one with the lower credit rating (Aa2/AA) and no insurance was trading at a higher price — $109.445 — than the Massachusetts bond with a higher credit rating (Aaa/AAA) and insurance. The better rated, insured bond traded at $108.735.

“The bidders have chosen, to some extent, to penalize the insured bonds, when a year ago the exact opposite would have been the case,” said James Colby, senior municipal strategist at Van Eck Global, a $5.5 billion asset management firm that manages three municipal-bond exchange-traded funds.

Insurance penalized?

“Insurance penalized” makes for a good story but that’s not what is really happening. The reality is James Colby missed the boat. The better rated bond was only rated better because Moody’s, Fitch, and the S&P; continue to pretend that the guarantee of Abmac and MBIA is worth something.

What’s really happening is the market does not believe that AAA ratings can be inherited (at least from the current sad collection of monolines) and neither do I.

By implication, the ratings of Moody’s, Fitch, and the S&P; are worthless as well. Here are three reasons why:

Why Buy Insurance?

You can pin an “AAA” label on a donkey or you can put lipstick on a pig. Both are a waste of time and money. And that is exactly what the market has decided.

Instead of trading at levels artificially assigned by Moody’s, Fitch, and the S&P;, the market is making an attempt to assign a more legitimate default estimate on municipal bonds. As long as that is happening, and with the realization that Ambac’s and MBIA’s guarantees are worthless, it is foolish to pay for insurance.

A Look At “Unfair” Muni Ratings

Recent events have California calling for reform of “unfair” muni ratings.

California is spearheading efforts by municipal bond issuers to reform “unfair” ratings that cost taxpayers billions of dollars, a spokesman for the state Treasurer Bill Lockyer said on Monday.

The state, the largest municipal bond issuer in the United States with about $43.7 billion of general obligation debt outstanding, is drafting a letter to three major rating agencies urging them to change how municipal bonds are rated, spokesman Tom Dresslar said.

“The current system is not fair. It makes no sense and it harms taxpayers to the tune of billions of dollars,” Dresslar said.

“The Agencies’ own studies have shown that corporate issuers with higher ratings default at a much greater rate than municipal issuers. Taxpayers wind up paying through the nose for this dual standard. So we think it’s time to end that system,” he added.

Many municipal bond issuers have lower ratings than their corporate counterparts despite a lower default rate because rating agencies have historically evaluated the risk in the $2.6 trillion municipal bond market more conservatively.

Lower ratings mean issuers had to pay more to borrow money in the $2.6 trillion municipal bond market, costs that are borne by taxpayers.

Dresslar said once the letter is finished, California will circulate it among other issuers to gather signatures and urge rating agencies to develop a new system that better serves taxpayers, investors and the market.

Dresslar needs to get a grip on reality. One cannot compare munis to corporates, and that is exactly what Fitch said: Huxley Somerville, a spokesman for Fitch Ratings, said the rating agency was “pretty explicit” that its ratings were meant to compare muni issuers to each other, given the hugeness of the municipal market, and not to corporate credits.

Dresslar also needs to keep in mind that taxpayers and municipalities prefer fantasyland over accuracy, while investors prefer the latter. Dresslar does not want “fair” he wants low rates, probably based on historical trends. But historical trends failed in subprime, Alt-A, and even super-prime so historical trends are a bad measure of what’s going to happen, especially at economic turns.

Sadly, Moody’s, Fitch, and the S&P; continually fail to do their job. Moody’s has even expressly stated so in blunt terms: “Moody’s has no obligation to perform, and does not perform, due diligence.

Truer words were never spoken (See Fitch Discloses Its Fatally Flawed Rating Model for the origin of the quote). In light of the above, it should be clear the big three serve no legitimate economic purpose at all.

Mike “Mish” Shedlock
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