Connie Lee Insurance Co. plans to use ratings from McCarthy, Crisanti and Maffei Inc., a virtual unknown in the municipal market, when it enters the new issue insurance business later this year.

The selection was revealed in a confidential prospectus for the firm's upcoming $65 million equity offering. It surprised market participants, who expected Connie Lee to choose either Standard & Poor's Corp. or Moody's Investors Service.

Critics contend the plan could be designed to permit Connie Lee to compete head-to-head with the primary insurers, a scenario Congress had tried to avoid when it created the insurer in 1986.

Connie Lee's mission, according to its enabling legislation, is to insure and reinsure educational facilities bonds for institutions whose credit rating would not allow them to qualify for traditional insurance.

For that reason, Congress mandated only educational institutions rated "below the third-highest rating category by a nationally recognized statistical rating organization" could qualify for the Connie Lee program. The restriction's intent was to keep Connie Lee, whose federal parentage may be seen to confer implicit federal backing, from competing directly with private bond insurers for higher-rated issues.

But that is exactly what some critics say could happen through the use of McCarthy Crisanti, which was recently purchased by Duff & Phelps/MCM.

One source close to the situation said there is no reason to choose McCarthy Crisanti other than an expectation the firm would offer triple-B ratings for credits that might do better with other rating agencies.

A spokeswoman for Connie Lee declined comment, citing securities laws related to the private stock offering.

Phil Maffei, executive vice president at Duff & Phelps, said he could not comment on the firm's relationship with Connie Lee because of confidentiality concerns.

But Mr. Maffei said he believes his firm was chosen over the major rating agencies because it "makes an effort to turn around ratings quicker."

Asked how Duff & Phelps might compare to Standard & Poor's or Moody's rating an identical issue, Mr. Maffei said "it's tough to say" Duff & Phelps would come out lower. Currently, the firm focuses mainly on corporate issues.

When the Connie Lee legislation was drafted in 1986, bond insurers were alarmed the new firm would get an unfair competitive advantage from its relationship to the government. About 75% of Connie Lee's outstanding stock is owned by the Student Loan Marketing Association; the remaining 25% is owned by the federal government through the U.S. Department of Education.

Robert Godfrey, executive vice president at Municipal Bond Investors Assurance Corp., helped forge the eventual compromise between Sallie Mae and the insurers that set out the rating guidelines to qualify for Connie Lee coverage. The identification of the rating agencies as "nationally recognized" was intentionally left vague because specifying firms would have amounted to awarding a franchise.

"Initially, the feeling was that it would always be Moody's and Standard & Poor's, but the document had to say a nationally recognized statistical rating organization," he said. "What would not be within the spirit is abusing the rating agency relationship" to insure higher quality credits, Mr. Godfrey added.

Any move to deflate ratings, Mr. Godfrey and others said, would eventually collapse because the market would discount the agency's credibility. Congress would also get wise to the circumvention of its intent.

"They are going to have to show that they helped out needy institutions," he said. "Showing a portfolio of relatively solid credits won't play well ... on Capitol Hill."

Primary insurers hurt by the competition also could express their dissatisfaction by not renewing reinsurance treaties with Connie Lee, sources say.

MBIA has the most leverage in this respect. With the business assumed from its purchase of Bond Investors Guaranty, MBIA accounted for nearly 90% of Connie Lee's reinsurance in 1989, according to Standard & Poor's. Financial Security Assurance Inc. also uses Connie Lee reinsurance.

Connie Lee's implicit federal backing could present two major competitive problems for the bond insurers: The market may perceive a Connie Lee-insured credit to be stronger than the industry's, and issuers could select what they deem to be a safer insurer.

Robert Froelich, vice president of research at Van Kampen Merritt Advisory Corp., said Connie Lee is likely to have a competitive pricing edge, particularly if its guarantee ends up trading higher than the insurers.

"If this comes about, it could change the way the whole industry is structured." Mr. Froelich said. "It makes it a very, very different playing field. It's going to be tough to compete with them.

"The driving force is going to be when the smaller institutions that haven't been active in the market start addressing their needs," he added. "They'll have to analyze who they are going to go with. It'll be a no-brainer for these people; they don't know the rest of the insurance industry."

A spokesman at Financial Guaranty Insurance Co. said any move to compete for higher quality bonds would contradict the social goals Connie Lee was set up to achieve. "It remains to be seen whether [Connie Lee's] rumored intentions are consistent with the original congressional mandate to assist tax-exempt, higher education facilities," he said. "In FGIC's view, it is unlikely that Congress ever intended to create a quasi-public insurer to directly compete with private enterprise."

Mr. Godfrey said the competitive advantages were exactly what the original compromise legislation sought to nullify. "That's why they have to live within their mandate. You've got an ample private-sector market and a strong [municipal] debt market, anyway," he said. "We shouldn't be using taxpayer money to guarantee it."

Connie Lee has maintained that, despite its federal parentage, it is a private insurer. The firm has obtained an AAA claims-paying rating from Standard & Poor's and must comply with the attendant capital requirements, unlike government-sponsored enterprises which rely almost solely on implicit federal backing. And a 1988 Internal Revenue Service ruling found that Connie Lee is not explicitly backed by the federal government.

Richard Smith, managing director at Standard & Poor's, said the selection of McCarthy Crisanti is not precluded by Connie Lee's founding legislation. "The legislation never said it had to be the same party that's providing the claims-paying rating," Mr. Smith said. Whether Connie Lee can then get an intentionally lower rating from another organization is "up for interpretation," he said.

According to the equity prospectus, Connie Lee's long-term objective is "to become the leading insurer and reinsurer in the higher education market sector." The firm currently reinsures teaching hospitals as well as educational institutions.

In 1990, the two sectors together accounted for $10.36 billion of municipal issuance, or 8.1% of the $127.97 billion sold last year, up from $9.35 billion in 1989, or 7.4% of that year's new, long-term issues, according to Securities Data Co./Bond Buyer. The data do not include bonds for primary and secondary educational institutions and student loans.

From the buyer's point of view, a greater degree of price competition in the new-issue market would only weaken the industry, according to Peter J.D. Gordon, president of Peter J.D. Gordon Inc. and former director of municipals at T. Rowe Price.

"We already have more than sufficient price competition for insured bonds," Mr. Gordon said. "It seems difficult that the market would readily accept a new participant."

Mr. Gordon said he would avoid issues rated by a new municipal agency. "I would have reservations about a less-recognized evaluator rating municipal bonds. Their marketability is not likely to improve significantly, and these issues wouldn't gain increased liquidity."

He said a Connie Lee bond would not have a significant trading advantage, even with the "indirect federal guarantee." If the competition were to end up head-to-head, he added, "the insurers aren't going to be happy because it will further erode their spreads."

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