Financial Perspectives – Spring 2008

Subprime Fallout Touches Muni Market

Major U.S. rating agencies continue to question the strength of some of the nation’s largest bond insurers – and have already downgraded others. Combined, these insurers guarantee approximately $2.5 trillion of securities. Not surprisingly, many municipal bond buyers are nervous about what may happen to their investments. However, their fears may be overblown.

Understanding Risks

To understand the actual risks involved, investors must distinguish between an insurer’s corporate credit rating and the credit quality of the actual bonds it guarantees. The municipal bond market’s worries are largely confined to the first, and reflect insurers’ ability to cover claims resulting from default of the issuers they insure, representing roughly half of the muni market’s outstanding securities. In contrast, the underlying credit quality of investment-grade municipal bond issuers – insured or not – is typically solid. Indeed, municipal bonds historically have had very low default rates of less than half of 1%.

Thus the source of the insurers’ problems is not the municipal bond market itself, but the seemingly inescapable repercussions of the subprime mortgage collapse, as well as the multitude of structured credit market products that flourished during the height of the mortgage-lending frenzy.

To respond to these two very different market sectors, some bond insurers have put forward plans to, essentially, split each insurer into two – one entity that would attempt to insure the troubled structured-product sector and a second that would stand behind the far more solid municipal market. Other options are also being considered, including raising more capital for troubled insurers to enable them to maintain their triple-A ratings. Still more dramatic proposals include restructuring the bond insurance market or calling for a government bailout of some or all bond insurers.

Much of this discussion could be merely rhetoric designed to compel money-center banks to help keep the insurers whole – and thus safeguard the structured products sector to which they are heavily committed. After all, if separated from their municipal-bond moorings, structured product insurers likely could not pay all their claims, pushing down the value of those products – and increasing the banks’ write-downs.

The ‘Cream of the Crop’

Even if the proposals are more serious strategies, the primary focus of both individual investors and regulatory agencies is not related to structured products, but, rather, to the approximately $2.5 trillion in tax-exempt municipal bonds issued by cities, counties, universities and other entities. The triple-A ratings of many of these bonds reflect, at least in part, the insurers that back them. Should the insurers be downgraded, so may the bonds. However, it is important to remember that bond insurers screened their choices carefully, accepting only the cream of the crop. If they did their work properly, then the credit quality of those bonds should remain high, insurance or not.

Nevertheless, reflecting the market’s uncertainty, issuance of municipal bonds declined 38% in January from a year earlier – although other factors, such as the slowing U.S. economy, undoubtedly contributed to the market’s lack of enthusiasm. Still, the strong credit quality that characterizes most municipals continues to bolster the market, and the long-term muni market continues to function relatively smoothly despite bond insurers’ problems.

Nor is all gloomy on the bond insurance front. New, perhaps untraditional, investors have entered the market, while some of the more solid insurers whose triple-A ratings remain intact are stepping in to take market share from their more fragile brethren.

Finally, the banks and bond insurers have ample motivation to preserve the latter’s triple-A ratings. And time is on their side. The risk to an insurer in any given year is limited to just that one year of debt service. In addition, many market watchers believe that the markets have already priced in the insurers’ troubles, minimizing future headaches should more insurer downgrades occur.

Although some increased volatility is likely inescapable, such unpredictability tends to increase both risk on the one hand and opportunities on the other. Of course, whichever hand you choose to play, both patience and prudence are definitely required. Your Raymond James financial advisor can help you weigh the current situation against your personal portfolio, providing direction on which strategies best fit your needs.

introduction to ‘Bond Speak’

• MUNICIPAL BOND ISSUERS: States, cities and counties, or their agencies, that issue bonds to raise funds. Unlike bonds issued by corporate entities, many municipal bonds are at least partially tax-exempt.
• RATING AGENCIES: Organizations that, for a fee paid by the issuer, evaluate and publish their opinion of the relative credit quality of the relevant bonds. The three major municipal bond rating agencies are Fitch Investors Service, moody’s Investors Service and Standard & poor’s.
• CREDIT RATING: A gauge of creditworthiness that, in the financial markets, typically applies to corporate and government debt. Ratings are based on the entity’s financial history as well as current assets and liabilities, and are designed to assess the entity’s ability to repay its debt.
• BOND INSURERS: Entities to which bond issuers pay a premium in return for the guarantee that the insurer will meet the bond’s interest and capital repayment obligations should the issuer be unable to do so.
• STRUCTURED PRODUCTS: Securities created for specific purposes that conventional financial instruments cannot meet. They generally are based on derivatives – financial contracts whose value depends on the value of the underlying security.
• MONEY-CENTER BANKS: A large bank in a major financial center that borrows from and lends to governments, corporations and other banks, rather than individuals and small businesses.

Raymond James & Associates and Raymond James Financial Services are wholly owned subsidiaries of Raymond James Financial, Inc. (NYSE-RJF).

The information contained in this newsletter has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. We may, from time to time, have a position in the securities mentioned and may buy or sell such securities in the course of regular business.

Before making an investment decision, always consult with your financial advisor. Articles in this publication are presented to help broaden your perspective on investment opportunities and the investment process. Whether a particular subject is applicable to your situation or not should be determined by you and your financial advisor based on your financial objectives, time horizon, risk tolerance and current portfolio structure. There is no assurance that the trends mentioned will continue in the future. For additional information about topics in this edition of Financial Perspectives, please contact your financial advisor today. Thank you.