Spitzer Warns of Bond Crisis

New York Gov. Eliot Spitzer (D) was expected to warn Congress Thursday (Feb. 14) that states, cities and nonprofit organizations such as hospitals and museums face new financial obstacles unless problems in the bond market are resolved.

The problem is that investors are beginning to abandon municipal bonds – usually considered one of the safest investments on the market after U.S. Treasury bonds. The reason has nothing to do with the bonds themselves, but with how they’re insured.

But the effects, coming in the wake of the subprime mortgage crisis, could raise borrowing costs for state and local governments.

“The problems in this market will affect many average Americans. It will affect the cost of college loans. It will affect museum budgets. It will affect state and local taxes. And that is just one small portion of the municipal bond market,” according to Spitzer’s prepared remarks for a U.S. House subcommittee hearing on the bond insurance industry.

Bond insurers play a key role in helping state and local governments sell bonds. The carriers promise buyers they’ll back the bonds, and even pay interest, if the government defaults on the bond.

That helps buyers feel more comfortable investing in governments or nonprofit organizations they don’t know, while the issuers save money because they don’t have to pay interest rates as high as investors would demand without the coverage.

But in the mid-1990s, municipal-bond insurers branched out. They got into the business of guaranteeing new kinds of securities. Among other things, they started backing up products based on mortgages, car loans, commercial real-estate deals and credit-card debt.

With the collapse of the subprime mortgage sector last fall and its aftershocks in the market, bond rating agencies started questioning whether the municipal-bond insurers deserved the highest distinction, a AAA rating.

It’s precisely that rating that makes insurance for municipal bonds so attractive to buyers.

A lower credit rating for the insurers – or even the threat of one – is making it harder and, therefore, more expensive, for government to finance debt, a common way to raise upfront cash for major building projects and other commitments.

“The result is that governments, already facing reduced income due to the slowing economy, will have higher borrowing costs. That means shifting funds from schools and police to pay interest,” Spitzer said in his prepared testimony.

The credit crunch also means states and municipalities are holding off on construction projects, even though such projects could help the economy, he said.

And it could get worse.

In prepared remarks, Richard Larkin, a former securities rating executive who now works for the investment banking firm Herber J. Sims & Co., told the committee that certain money market accounts are required by law to invest only in the highest-grade products.

Currently, money market funds hold $500 billion in high-quality municipal securities. Larkin said those funds could be forced to unload about $200 billion of investments in state and local debt instruments if the insurers’ ratings are dropped.

“In a market that sees average daily trading volume of only about $11 billion, a selloff of this magnitude would result in a flood of supply, which would reduce the prices of these securities and increase tax-exempt rates. The effects would be felt by both issuers and investors,” he warned.

There are already signs states and local governments are moving away from offering insurance with their bonds.

Of the bonds that are being issued, only 30 percent carry insurance, instead of the normal 50 percent. “One thing that is clear is that investors do not want debt that loses value because of imminent rating downgrades,” Larkin said.

U.S. Rep. Paul Kanjorski, a Pennsylvania Democrat who chairs the subcommittee on capital markets, has suggested that federal regulation – rather than state oversight – of municipal bond insurers could be in order.

But Spitzer, in his prepared testimony, said there was plenty of blame to go around. He noted that the federal Office of the Comptroller of the Currency blocked state efforts to regulate predatory lending in the first place. Federal banking and securities regulators also missed opportunities to stop the crisis, he said.

“The fact that the states need to improve does not lead to the conclusion that federal regulation of insurance is the answer, especially given the performance of other federal regulators on this issue,” he said.