Congress Examines Municipal Bond Ratings, Bond Insurance Industry

By | March 13, 2008

The fast-spreading U.S. mortgage crisis prompted lawmakers Wednesday to explore problems with municipal bonds, painting a bleak outlook for bond insurers that one official said imposes a “secret Wall Street tax” on state and local taxpayers.

Connecticut Attorney General Richard Blumenthal is investigating how credit rating agencies grade the risk of municipal bonds and said the existing system is “quite possibly illegal.” He joined other state officials in calling for changes at a House committee hearing.

Billions of dollars could be saved by city and state governments if credit raters adopted a unified rating system for municipal and corporate bonds and abandoned the present dual system, said California State Treasurer Bill Lockyer.

Signaling that rating system changes may be coming, an executive for Moody’s Investors Service, Laura Levenstein, said the credit rating agency is preparing to give corporate ratings to municipal bonds when issuers ask, beginning in May.

Levenstein, a senior managing director at Moody’s, declined to answer questions from Reuters after the hearing held by the House Financial Services Committee.

If municipal and corporate ratings were put on the same footing, the need for bond insurers — which now prop up municipal bond ratings — would be sharply diminished, said Ajit Jain, head of the new bond insurance unit of Berkshire Hathaway, the diversified business group controlled by billionaire investor Warren Buffett.

“I remain very concerned about the long-term viability of this business in general and for us in particular,” Jain said.

Buffett’s company stepped into the bond insurance market recently at the invitation of New York insurance regulators who have been trying to stabilize an industry hit hard by its exposure to the unfolding debacle in subprime mortgage debt.

The bond insurers’ problems have disrupted the market for municipal bonds, making it more expensive for state and local governments to issue bonds and borrow money to finance vital projects such as roads, parks and schools.

“There is no question that the recent dislocations in the municipal bond markets have created unanticipated hardships for municipal issuers and in some cases dramatically increased their borrowing costs,” said Erik Sirri, a senior Securities and Exchange Commission official at the hearing.

The bond insurance industry — led by firms such as MBIA Inc and Ambac Financial Group Inc — guarantees repayment of municipal bonds. It got into trouble in recent years by guaranteeing riskier mortgage-backed securities. When the mortgage-backed market tanked last year, the bond insurers’ triple-A credit ratings were jeopardized.

Standard & Poor’s, a major credit rater, cut its rating on bond insurer CIFG Guaranty to “A-plus” from “AAA” on Wednesday. Moody’s cuts CIFG’s rating last week.

Credit rating downgrades and the threat of downgrades of bond insurers have set regulators scrambling to shore up the industry and raised broader questions about how it operates.

The rating system creates demand for bond insurance by pushing municipal issuers to buy it to lift their ratings to the level of higher-graded corporate debt, despite a record of lower defaults among municipal issuers.

State officials said the dual rating system that holds municipalities to a higher standard than corporate issuers increases borrowing costs of taxpayers. Some investment funds can only hold bonds rated above a certain level.

Committee Chairman Barney Frank, a Massachusetts Democrat, floated another idea to stabilize bond insurers by suggesting the government offer municipal bond reinsurance.

Blumenthal has been probing credit rating agencies. The ratings market is dominated by S&P, a unit of McGraw-Hill Cos’ ; Moody’s; and Fitch Ratings, a unit of Fimalac SA .

He said the credit raters’ dual-grading approach to the municipals market has “no legitimate business reason” except to prop up the bond insurance industry.

(Additional reporting by Dena Aubin and Dan Wilchins in New York, Patrick Rucker and David Lawder in Washington; Editing by Leslie Adler)

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