Muni Debt: Bridges To Nowhere?

So far in February, though, this tooth-fairy scenario has been rudely interrupted by the harsh reality that startling dangers remain in the wings, just waiting their turn, and are likely to emerge vividly enough over the next month or two to spook investors and send stocks below their January lows and beyond. Bulls didn’t really think they were going to escape bears so easily, did they?

The culprit this time is probably going to come hurtling in from a corner of the finance world least expected to give anyone grief: the formerly sleepy world of municipal finance, or the conduit through which cities and states pay for civic infrastructure. It may be hard to believe that your local roads, bridges and sewers could have a connection to the crisis that has rocked world financial markets in the past eight months, but this could be one of the worst threats yet.

Here’s the problem: Citizens have for decades empowered their towns, states, school districts and regional mass-transit agencies, among others, to issue debt to pay for all the niceties of modern transportation, education and public health that we take for granted. These long-term obligations, which you may know as municipal bonds, or munis, are backed by civic agencies’ taxation powers. The agencies nick local homeowners and other consumers for a few cents here and there on sales taxes, property taxes and use taxes, and it adds up to enough cash flow to pay off the debts.

For the most part, this is a lovely setup, and there have been ridiculously few defaults on the debts over the decades. But because virtually all local governments are treated like country bumpkins by Wall Street, they aren’t accorded the top-quality ratings, known as AAA or AA, that would allow their debts to be sold to safety-seeking money market funds, private investors or overseas pension funds.

As a result, local governments for years have bought a type of guaranty known as a wrap from companies called monoline insurers. These insurance companies essentially agree to wrap their own AA or AAA ratings around the municipalities’ lower ratings, allowing the bonds to be sold easily in the global marketplace. The monoline insurers thus have had one of the greatest free lunches of all time: They’ve collected billions in premiums from muni issuers yet rarely, if ever, paid a claim.

Because the monoline business was so profitable, the biggest insurers decided a few years back to spread their wings a little and branch out into the business of guaranteeing some riskier credits. Egged on by ratings agencies that wanted them to diversify away from the poky world of munis, executives at Ambac Financial Group (ABK, news, msgs), MBIA (MBI, news, msgs) and PMI Group (PMI, news, msgs) threw common sense out the window and persuaded their boards and shareholders that they could guarantee a new type of highly leveraged debt we have come to know as the evil villains in the past year’s credit psychodrama: collateralized debt obligations, or CDOs.

CDOs, you may recall, are those bundles of high-yield securities backed by subprime home mortgages, subprime auto loans, credit cards and the like that have dripped acid all over the world financial system in the past year. As many mortgage holders have stopped making payments on loans amid rampant home foreclosures across the United States, the securities underlying the CDOs have been downgraded left and right by the ratings agencies — in many cases from AAA all the way down to junk-bond status in a single swat.

As you can imagine, these downgrades make the CDOs too risky for pension funds to hold, but they are illiquid and hard to sell. Holders have therefore obsessed over whether the monolines would make good on their insurance policies in the event of default and have concluded they are so frightfully undercapitalized that payoffs are unlikely. So the insurers have found themselves under the microscope of ratings agencies, which have been threatening for the past couple of months to downgrade their high ratings. Because high ratings are all they have to sell, Ambac and MBI shares have plunged 84% and 79%, respectively, since early October as their business prospects have collapsed and their solvency has deteriorated.

Now this is where it starts to get ugly for cities and states — which means you and me.

In many cases, munis are sold as part of “tender option bond,” or “put bond,” derivatives. In these programs, which became very popular among hedge funds in this decade because their low risk profiles permitted a lot of leveraging, a bond could be tendered back to the issuer if any of a variety of troublesome events triggered, ranging in severity from a default to a ratings downgrade. The programs required the issuer to buy the bonds back at par, or face value.