The Subprime Crisis, Bond Insurers’ Credit Risk, and the Interest Cost of Municipal Bonds
Author: Gao Liu.
Source: Volume 32, Number 03, Fall 2011 , pp.37-58(22)
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Abstract:
Although municipal bond insurance can lower the risks associated with municipal bonds by providing a financial guarantee, it also transfers insurers’ credit risks to the bonds that they guarantee. The responses of the markets in the recent insurer credit crisis have demonstrated this risk. This article reviews the dramatic changes in the municipal bond insurance market during the recent subprime crisis and examines how the market incorporates the credit risk of bond insurers into the bond borrowing cost. The results show that insurers with a higher credit rating can save issuers more interest costs than can their lower rated competitors. After the insurer credit crisis, benefits associated with municipal bond insurance decreased dramatically. However, insurance policies provided by multiple insurers may generate a significantly larger interest savings after the insurer credit crisis than before, suggesting that using insurers is advantageous. The paper also finds that in the sample reviewed, the bond price associated with bond insurance changed at the announcement of an insurer loss, long before the actual downgrade.Keywords: California municipal bond issues
Affiliations:
1: University of New Mexico.