Financial Guarantors and the 2007-2009 Credit Crisis Working

Financial guarantors and the 2007-2009 credit crisis Daniel Bergstresser Randolph Cohen Siddharth Shenai Working Paper 11-051 Copyright © 2010 by Daniel Bergstresser, Randolph Cohen, and Siddharth Shenai Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Financial guarantors and the 2007-2009 credit crisis Daniel Bergstresser* Randolph Cohen** Siddharth Shenai*** (First version January 2010, this version November 2010. Comments welcome.) Abstract More than half of the municipal bonds issued between 1995 and 2009 were sold with bond insurance. During the credit crisis the perceived credit quality of the financial guarantors fell, and yields on insured bonds exceeded yields on equivalent uninsured issues. It does not appear that either property and casualty insurers or open-end municipal mutual funds were dumping insured bonds; analysis of holdings data indicates that their propensity to sell bonds was unusually low for the issues insured by troubled insurers. At least on a bond-by-bond basis, the yield inversion phenomenon is also not explained by the rapid liquidation of Tender Option Bond (TOB) programs, which disproportionately held insured issues. Finally, during the recent crisis the insured bonds have become significantly less liquid than uninsured municipal debt. Keywords: Bond insurance, municipal securities, credit crisis. We are grateful for comments from John Chalmers, Otgontsetseg Erhemjamts, Michael Goldstein, Robin Greenwood, Jens Hilscher, Ryan Taliaferro, and from seminar participants at Babson University, Bentley University, Brandeis University, and participants in the HBS research brownbag lunch. We are grateful for research assistance from Mei Zuo and for research support from Harvard Business School. * Corresponding author. Harvard Business School. Tel.: 617-495-6169. E-mail: [email protected] ** Massachusetts Institute of Technology and Vision Capital. *** Harvard Business School, Harvard Law School and Bracebridge Capital. 1 Financial guarantors sell guarantees to pay principal and interest on underlying bonds in the event that the original issuers are unable to pay. These insurance providers, often called ‘bond insurers’ or ‘monoline insurers’, enjoyed a large footprint in municipal finance during the period leading up to the credit crisis. An investor in a bond that has been ‘wrapped’ with financial guaranty insurance will only experience loss in the joint event of default by both the issuer and the insurer. Bond insurance augments the credit quality of the issuer with the credit quality of the insurer. In frictionless markets bond insurance should at a minimum be viewed by investors a weakly positive feature. This relationship should hold regardless of the credit quality of the insurer, although the value of the insurance will reflect both the credit quality of the insurer and the issuer of the underlying instrument. This relationship broke down during the credit crisis of 2007-2009. Yields on insured municipal bonds for the first time began to surpass yields on equivalent underlying (unenhanced) bonds that did not have bond insurance. This paper uses data on actual municipal bond trades to document this dislocation. For bonds whose underlying (unenhanced) credit quality merits the A rating, insured bonds traded at yields that were 2.8 basis points lower than insured bonds with similar underlying credit quality from 2000 to 2007. During 2008 and 2009, the insured bonds traded at yields that were 14 basis points higher than uninsured equivalents. We investigate a number of potential causes for this yield inversion phenomenon. We explore the role of the liquidation of Tender Option Bond (TOB). TOB programs were a market innovation developed to circumvent the tax-induced difficulty of leveraging a portfolio of municipal bonds. In a typical TOB program, a single municipal 2 bond is placed into a trust, which then issues senior and residual receipts. The senior receipts were held by municipal money market funds, and the senior receipts by high- yield mutual funds or other investors looking to leverage positions in municipal debt. We show that the dissolution of TOB programs during the credit crisis has been rapid and widespread. At least on a bond-by-bond basis, the liquidation of these programs does not seem to explain the yield inversion phenomenon. In particular, the yield inversion phenomenon extends across all bonds, including bonds that were never part of any TOB programs. It is possible, however, that the liquidation of TOB programs, by dumping massive dollar amounts of insured debt into the market, affected the overall market price of insurance even for insured bonds that were never part of TOB programs. We also explore the behavior of two other significant holders of municipal debt: open-end long-term mutual funds and property and casualty insurance companies. We test the hypothesis that these institutions have been dumping insured debt into the market during the credit crisis, potentially in an effort to ‘window dress’ their portfolios. We use fund and insurer holdings data to test this hypothesis, and find that the opposite is true: open-end mutual funds and insurers have actually been more likely to sell the uninsured bonds than the insured bonds during the crisis. We also show that during the credit crisis insured municipal debt has become significantly less liquid than uninsured bonds. We use observed bond transaction sequences, as in Green et al (2007), to identify likely matched buy-sell transactions for specific bonds. This approach allows us to identify round-trip transactions costs for insured and uninsured bonds. Our results suggest that prior to 2007, the costs of trading insured and uninsured municipal bonds were approximately the same, and that these costs 3 fell from an average gross markup of as much as 200 basis points to under 100 basis points by the beginning of 2007. With the credit crisis, however, estimated gross markups across the board have risen back to their earlier levels, and estimated markups on insured debt have been as much as 30 basis points higher than for uninsured bonds.5 As an example of the phenomenon we describe in this paper, consider a comparison of two New York City bonds, one insured by Ambac, the other uninsured. The two bonds are otherwise identical, except for their coupon amounts. Both are Series E bonds issued 8/17/2005 and maturing 8/1/2015. Both bonds are General Obligation bonds, and are non-callable. The insured bond has a 4 percent coupon, and the uninsured bond has a 5 percent coupon. Figure 1 displays the yields of the two bonds. The yields are provided by Bloomberg, based on dealer polls. The bonds trade but are not highly liquid: together the bonds have 445 trades observed in the MSRB database, with approximately ¾ of the trading activity in the insured bonds. The solid red line shows the yield on the insured bond, while the dashed blue line shows the yield on the uninsured bond. During 2005 the uninsured bond consistently yielded about 20 basis points higher, as would be expected because of the insurance wrap. In November 2007 the spread climbed back above 20 basis points, and continued a jagged climb, peaking at 84 basis points on March 7, 2008. During 2008 the spread became very volatile. At midyear the spread was consistently around 40 basis points, but fell steadily from there. On August 1, 2008, the spread went negative for the first time, passing 40 basis points before the end of August and reaching -63 basis points in 5 An earlier version of this paper used transactions counts as a measure of liquidity, and found that insured debt traded more frequently than uninsured debt prior to the credit crisis and equally- or less- frequently since the credit crisis. Although no measure of liquidity is perfect, we feel that using the Green et al (2007) approach to estimate actual round-trip transactions costs is preferred to raw transaction counts. 4 September. In the Fall of 2008 the spread went slightly positive, but was once more negative by the end of the year, and it has remained negative ever since. In February 2010 – the we wrote the first draft of this paper – the difference was around –15 basis points. Between that draft and the current draft (October 2010) of the paper, the yield inversion phenomenon has become even more pronounced, hovering in the neighborhood of – 40 basis points.6 These apparent dislocations have been a remarkably persistent feature of the credit crisis. Indeed, so far they appear to be something closer to a new equilibrium feature of municipal credit markets than a transient phenomenon, at least while the currently outstanding insured municipal bonds remain outstanding. The persistence of these patterns reflects a number of factors. In particular, municipal bonds are exceptionally difficult to sell short and indeed there is essentially no borrowing market for tax-free municipal bonds. There are millions of individual municipal bonds, many of which only have a small number of holders. At the termination of the short position, an arbitrageur who had shorted an individual municipal bond could find himself unable to obtain, and perhaps unable to even locate, an identical bond. In addition, a short-seller of a municipal bond would face an extra tax hurdle, related to the tax exemption enjoyed by most municipal debt. While a municipality can pay tax-exempt interest to an investor, if that investor lends shares to a short-seller, the short-seller does not inherit the ability to pay tax-exempt interest to the bond owner who has made his bonds available for borrowing. Thus, in order to compensate the lender for the after-tax value of the coupons foregone on the municipal debt, the arbitrageur will 6 The different coupons and prices of the two bonds causes a difference in their durations.

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