When a bond issuer wants to assure potential investors that a bond is really and truly safe, they often turn to a bond insurer, also known as a monoline insurer. Bond insurance is very common in the municipal market.
Bond insurance is a fairly recent development on Wall Street. That’s largely because until the 1970s, no one worried much about defaults in the muni market.
But beginning in 1975, things began to change. And the muni market was torn apart by two catastrophes.
First, New York City teetered on the brink of bankruptcy. And after U.S. President Gerald Ford declined to bail out the city, it appeared likely the Big Apple would default on its bond payments.
Then in 1983, Washington Public Power Supply System, a utility in the Pacific Northwest, defaulted on $2 billion of revenue bonds associated with a nuclear reactor. (Market historians will recall that the bonds had the unfortunate nickname of WHOOPS bonds.)
Never again would investors believe that a local government was immune to default.
A number of companies, sensing a need, had already been formed to offer insurance to the muni bond market. Such companies charged bond issuers a fee in exchange for a promise to make the bond payments if the issuer defaulted. The idea was that insured bonds were doubly safe -- munis themselves are generally pretty safe. And the insurance acted as a back up. Furthermore, the credit-rating agencies responded by offering information that made it possible for investors to calculate both risks -- looking at what the bond was rated without insurance, and what it was rated with insurance. (Learn how bond ratings work.)
The first such bond-insurance company, Ambac Financial Group Inc., was formed in 1971. A second firm, MBIA, first appeared in 1983.
For a brief period of time, property and life insurance companies also sold bond insurance. But by 1989, a law in New York limited the sale of financial insurance products to those companies that were dedicated solely to that market – the so-called monoline insurers. That effectively ended the participation of multiline companies in bond insurance nationwide.
Trouble Brews
As the derivatives market began to rise through the 1990s, monoline insurers began to add other financial-insurance products to the mix. And among the items they insured were derivatives that were built upon subprime mortgages.
When the subprime mortgage market collapsed, the monoline industry was hurt badly. In early 2008, credit-rating agency Fitch Ratings downgraded Ambac from AAA to AA. That, in turn, triggered a downgrade of more than 100,000 Ambac-insured bonds worth a half-trillion dollars.
By mid-2008, the monoline market was in such poor shape that the prices of non-insured bonds on the muni market were trading at prices equal to those of insured bonds. In other words, the muni bond market had decided that cost of bond insurance could no longer be justified.