Bond Insurer Downgrades Carry Far-Flung Ramifications

Bond insurers guarantee the timely repayment of a bond's principal and interest if the issuer defaults. Historically, most of their business has been to insure municipal bonds, which are generally safe, low-default securities issued by states, cities and municipalities in order to finance various projects, such as building a highway or school.

However, the past subprime mortgage boom seemed too attractive to pass up and some of the country's largest bond insurers started backing mortgage securities. That shift, of course, has left many insurers in hot water. Ratings agencies like Standard & Poor's, Moody's and Fitch Ratings have grown concerned about these insurers' financial strength — and even the threat of insolvency — if they're forced to cover the rising wave of defaults in the months ahead, prompting them to downgrade some insurers and put others on "ratings watch negative," a sign that they could very well follow suit.

In mid-January, Fitch Ratings and Standard & Poor's lowered the triple-A rating of Financial Guaranty Insurance Co., or FGIC, and Ambac Financial (ABK), two of the country's largest insurers, to double-A. Last week, Moody's issued its first downgrade as well, slashing the rating of Security Capital Assurance (SCA) to A3, from triple-A. Fitch Ratings, meanwhile, has announced a change in the modeling assumptions it uses in rating bond insurers, to reflect the expectations of a sharp increase in losses because of subprime exposure. It has also placed insurers MBIA (MBI) and CIFG Holding on "ratings watch negative," a sign that a downgrade is very likely.

These downgrades have far-reaching ramifications. In the bond insurance business, a triple-A rating means everything. When a bond issuer, say a state-run hospital in West Virginia looking to finance the construction of a new wing, purchases insurance, its bonds automatically receive the rating of the bond insurance company. So if that issuer isn't able to get triple-A rating on its own, a bond insurer's triple-A rating will allow it to borrow at cheaper rates, explains Scott Berry, senior mutual fund analyst with investment research firm Morningstar. (Municipal bond rates are typically lower than those of taxable bonds, but their net returns are higher once tax exemptions are factored in.)

That's bad news for those who own municipal bonds, since a bond's value automatically decreases when it gets downgraded. At the same time, its perceived level of risk increases, and in the world of investing, higher risk usually equates to higher returns. However, while investing in municipal bond funds may seem like an attractive proposition for individuals seeking high yields, some large institutional investors, like money-market-fund managers, are not celebrating.