Municipal bond insurance got its start as a way to protect investors if their bond issuer defaulted. But as the industry matured, bond insurers tried to generate new revenue by underwriting sometimes exotic structured finance products.

Early History–It’s a Long Walk to Alaska

The location dramatized an important benefit of this new type of insurance; after all, how many investors have ever visited Juneau? More importantly, how many would want to travel so far to perform due diligence on municipal hospital facilities? (To learn more, see “Due Diligence In 10 Easy Steps.” )

Once Ambac attached its insurance guarantee to the bonds, long expeditions became less necessary. The insurance was purchased by the bond issuer (Greater Juneau) when the bonds were issued, and it continued as long as any bonds in the issue remained outstanding. If any insured bonds should ever default on principal or interest payments, Ambac guaranteed to make up any defaulted or late payments to the investor. In effect, the high credit rating of Ambac (which was “AA” from S&P in 1971) trumped the credit rating of the bond issuer. Once investors became satisfied that Ambac was a high-quality insurance company, they didn’t have to worry as much about the due diligence on municipal bonds issued in Juneau, Laredo or Anytown, U.S.A.

The invention of municipal bond insurance revolutionized the public debt markets over the next 36 years. In 1974, another new insurance company entered the market, the Municipal Bond Insurance Association (nyse: MBI), and gained the highest possible rating, “AAA .” In 1979, Ambac also achieved this rating. By 1988, 25% of all newly issued municipals carried insurance. In 1994, bond insurance helped to avert panic in the municipal market, when Orange County, California, declared bankruptcy. (For more on the corporate debt rating system, see “What Is A Corporate Credit Rating?” )

The U.S. municipal bond market grew steadily over several decades to about $2.6 trillion in value as of year-end 2007, according to the Securities Industry and Financial Markets Association (SIFMA). The market is subdivided into two types of bonds: General obligation (GO) bonds are backed by the issuer’s full credit and taxing ability, and are commonly issued by states, counties and municipalities.

Revenue bonds are backed by specific revenue streams from license fees, tolls, rents or special purpose tax assessments.

GO bonds are generally considered to be of higher quality, because the bond issuer has taxing power and can increase taxes to repay bonds, if necessary. For example, most states in the U.S. command either “AAA” or “AA” ratings, which indicates very high quality, even without bond insurance. The issuers of revenue bonds, however, tend to be smaller and lack discretionary taxing power, so their ratings are more varied and often lower. About two-thirds of all new municipal bonds issued are revenue bonds, according to the SIFMA. (To learn about investing in muni bonds, see “The Basics Of Municipal Bonds ” and “ Avoiding Tricky Tax Issues On Municipal Bonds .”)

Building Investor Confidence

By paying a premium to a municipal bond insurer at the time a bond is issued, GO and revenue bond issuers have been able to “enhance” the issue’s credit quality to the highest “AAA” level. This increases investor demand for the bonds in both the initial underwriting process and secondary trading market.

Historically, the leading bond insurers have pursued two other strategies that helped to increase investors’ confidence in their guarantees.

–Narrow focus –While many insurance companies pursue a variety of business lines (e.g. life, auto, health and homeowner’s insurance), companies like Ambac and MBIA “stuck to the knitting.” For this reason, these companies are often called monolines. The narrow focus helped them avoid exposure to huge losses that have hurt other insurers, such as the vast property damage caused by Hurricane Katrina.

–Zero-loss standard– The monolines have always emphasized that they conduct rigorous credit analysis of every bond issuer to maintain a “zero-loss” underwriting standard. In other words, they claimed to have confirmed that the insurance would not be necessary except in very extreme cases.

For a quarter of a century, the narrow focus and zero-loss standard worked for the monolines according to plan. For example, during the first half of 2007, $231 billion in long-term municipal bonds were issued in the U.S. according to the SIFMA. Within this issuance, roughly 48% of the nominal dollar volume had credit enhancement. About 90% of the enhancements were through monoline insurance, as opposed to other methods such as bank letters of credit or standby purchase agreements.

Meanwhile, default rates on municipal bonds were very low, averaging just 0.63% on a cumulative basis for all bonds issued between 1987 and 1994, according to a long-term study by Fitch Ratings.

In this environment, the municipal bond insurance industry flourished. MBIA and Ambac grew their annual revenues to $2.7 billion and $1.8 billion, respectively, and they were joined in the field by others including FGIC, XL Capital Assurance and ACA Capital Holdings .

In a search for increased profit, the monolines began to diversify their book of business into the lucrative world of residential mortgage-backed securities (RMBS) and other structured finance products. The RMBS products included both high-quality “prime” mortgages and lower-quality subprime mortgages. In the structured credit product line, monolines guaranteed the principal and interest on exotic CDOs (collateralized debt obligations ) that sliced and diced different cash flows of RMBS, all of which were heavily leveraged to a continuation of the U.S. housing boom that persisted from 2002 until 2006.

Then in 2006, the housing boom went bust. The RMBS and CDO guarantees of the monolines became costly liabilities, and the credibility of their zero-loss standard went out the window, perhaps forever. (To learn more, see “Why Housing Market Bubbles Pop.” )

In late 2007 and early 2008, the tide began to turn against the monolines in three ways:

–Standard & Poor’s downgraded the credit rating of ACA Capital Holdings by 12 levels, to “CCC” (highest risk). This downgrade came after ACA reported a $1 billion loss.

–Fitch Ratings reduced the prized “AAA” rating of Ambac to “AA,” while also putting the company on “negative watch,” indicating the potential for further downgrades.

–MBIA was forced to scramble for additional capital to shore up its losses, which were reported as $1.9 billion for 2007 amid heavy balance sheet write-downs. (To read about other subprime casualties, see “The Rise And Demise Of New Century Financial” and “Dissecting The Bear Stearns Hedge Fund Collapse.” )

Although the monolines did maintain their narrow focus on insuring credit risks, their foray into RMBS and CDOs proved costly to their stature as strong guarantors. The question then remains: What should municipal bond investors know, and do, about this type of insurance going forward?

–Insurance is only as good as the rating and credit underwriting policies of the monolines that stand behind it. It’s important for investors to evaluate not only the quality of the underlying bond, but also that of the insurer.

–It may take some time for the monolines to shake out the mess from the worst housing market in decades.

–Perhaps most importantly, diversification can be just as valuable in municipal investing as in other areas. That means spreading risk among different issuers and regions of the country. A number of tax-exempt mutual funds offer diversified portfolios of municipal bonds, and one significant event of 2007 was the proliferation of exchange-traded funds (ETFs) that specialize in municipals.

Consider insurance as just another feature attached to a municipal bond–not an excuse to preclude further due diligence. The bond insurers gambled their reputations on exotic new products–but you don’t have to do the same with your nest egg.

This article is from Investopedia.com , the Web’ s largest site dedicated to financial education. Click here for more educational articles from Investopedia.