The value of secondary-market insurance for New York City general obligation bonds has skyrocketed in the past two years, as seasoned investors have developed lucrative arbitraging strategies.
At the same time, the major bond insurers are carefully disbursing secondary-market insurance throughout the community, trying to avoid accusations of favoritism while simultaneously propping up the price of this now precious commodity. The buy side, as a result, eagerly awaits notices of capacity and seizes upon every drop.
To some extent, insurers are passively allowing the myth of imminent capacity restraints -- imposed by the rating agencies -- to be perpetuated in the markets because it ensures fatter premiums. Mutual fund portfolio managers said the price for New York City secondary insurance has risen from less than 20 basis points two years ago to more than 60 basis points currently.
This is not to say the restraints are not real. The combined effect of Standard & Poor's Corp., Moody's Investors Service, and Fitch Investors Service places tangible ceilings on how much New York City exposure the insurers can assume. Still, none of the insurers said they had ever reached single-risk limits, and secondary-market buyers know the ability to insure New York City is there.
"They're like OPEC," said Lance Brofman, chief portfolio strategist of the New York Muni Fund. "There's a surplus of oil, but they are doling it out slowly to keep the price up."
Memory of Hoarding
New York City is the second-most insured credit in the entire market, next to Washington, D.C. Every major insurer had the city as one of the top three exposures, with the exception of Municipal Bond Investors Assurance Crop., for which it was fourth. As of June 30, 1991, the industry had backed almost $2.12 billion of gross par insured, according to Moody's Investors Service and company reports.
Yet sheer volume is not the only factor behind insurers' husbanding their capacity. Another reason for slow distribution was a row set off two years ago by one institutional investor's hoarding of Financial Security Assurance Inc.'s secondary-market capacity. This portfolio manager purchased as much as possible, leaving other buyers in the cold, and enhanced a slew of New York debt. When the bonds were resold, the securities fetched far better prices than the purchase price of the insurance.
This same strategy is what market participants long for. Three months ago, AMBAC Indemnity Corp. made $20 million of secondary-market capacity available, but tried to keep it out of any one party's hands. "We spread that around and limited it to $1.5 million for any one firm on the Street," said Robert J. Genader, senior executive vice president at AMBAC.
Yet the market easily stepped around it. Mr. Brofman, holding a large portfolio of unenhanced city GOs prior to AMBAC's capacity notice, scooped up most of the $20 million, sold the bonds at a hefty profit, and catapulted his New York Muni Fund to the number one ranking for 1991's third quarter with an 8.15% total return, according to Lipper Analytical Services Inc.
He explained that mutual funds could not but the insurance directly but must swap -- or sell -- uninsured bonds for insured ones.
"AMBAC said it was $1.5 million per person on a first come, first served basis," Mr. Brofman said. "You can't call up again, but you can get your friend to call for you -- like tickets to a rock concert."
Investment banks and other dealers would have to supply specific Cusip numbers for AMBAC to insure, so Mr. Brofman sold his supply of bonds to the dealer. The dealer then insured them, and Mr. Brofman bought them back for "a dollar more than the price of the insurance," or at a premium of about $1.60 per bond in this instance, he said.
In most cases, dealers were not aware of the available capacity and Mr. Brofman informed them of the strategy, supplied the bonds, and captured the lion's share of the difference.
"I actually was the instigator, in a sense," he said.
The hefty profit comes from the simple fact that insured New York City bonds are worth far more than the cost of insuring them. Uninsured city GOs maturing in October 2019 earlier this week were priced in a retail offering -- less commission -- at 94.388. AMBAC-insured bonds maturing in August 2019 priced on the same basis were quoted at 105.545; call dates on both issues were only six weeks apart in 1999.
After the premium and markup, therefore, Mr. Brofman still raked in almost nine points per bond.
A major attraction for the insurer is that New York City sits comfortably in the "insurable range" of credits -- Baal by Moody's and A-minus by Standard & Poor's.
"We feel it's a good upper medium-grade credit," said Neil Budnick, senior vice president of research and new business development at Municipal Bond investors Assurance Corp., summarizing views from around the industry. "Population is up, a lot of the top 500 companies are in New York, and it has economic diversity."
Confidence in City
"When you compare it to the universe of GOs, is an [improving] city with only one or two industries better than one that may be declining, but has hundreds of top employers? Mr Budnick asked, "No."
Thomas A. Dorsey, senior vice president of underwriting at AMBAC, said New York City is "one of the strongest GO credits around the country" thanks to debt service coverage and covenants. "Real property taxes cover debt service four and half times," Mr. Dorsey said. "They have a lock on those revenues."
Chuck Silberstein, managing director at Financial Security Assurance Inc., said the city's budgetary pressures can create a media phenomenon, but he stressed that he considered the Dinkins administration and the Financial Control Board are capable of managing the situation.
"It's not a very comforting process to watch," Mr. Silberstein said. "But we believe the fundamentals underneath the budget process ultimately provide comfort. Compared with other [East Coast urban areas], New York City is less vulnerable at the core."
The city, meanwhile, wants for more insurance than the industry can provide. The cost savings realized through primary enhancement makes good financial sense and even better political sense. Asked whether New York City would like to see more insurance available for its credit, Michael W. Geffrard, deputy executive director of the city's office of economic development, said, "It's like asking, 'Do you like to breathe?'"
Cajoling the insurers to back more city debt, however, is an increasingly difficult task. Mr. Geffrard, who would gladly welcome additional insurers to the playing field, noted that the enhancement market has changed tremendously in the last two years, with many foreign banks retreating from the letter-of-credit market and insurers growing almost too fast.
"Credit enhancers now have to be courted much more assiduously than in the past," he said. "And all issuers are doing that, not just us."
The debt service savings derived from insurance are obvious for the city. In last year's $1.3 billion issue, yields on an AMBAC-insured 2004 maturity were 135 basis points lower than for the uninsured noncallable 2003 maturity. Factoring in the $1.12 million premium, the city realized a present value savings of $2.48 million on the $28.75 million 2004 maturity, according to a spokesman for New York City's comproller.
How Much Capacity Is There?
Market sources suggest that bond insurers withhold capacity for the most optimal market conditions, for when they can reap the highest premiums. "They all say they have capacity," Mr. Brofman said. "They are saving it to sell at the most advantageous times, and the way they [sell] it issubject to negotiation."
But Christopher H. Richman, managing director of public finance at Financial Guaranty Insurance Co., said real princing opportunities are few and far between. Instead of a comparatively stable credit, such as New York City, secondary-market premiums only jump higher in "volatile rating scenarios," where an insurable credit dips moves sharply higher or lower, he said.
"Although everyone is looking for a good premium, there's not an enormous change over a year's time" in most credits, Mr. Richman said. Situations such as those in Suffolk County, N.Y., or Louisiana's GOs, on the other hand, "create real opportunities in terms of pricing," he said.
At the same time, the insurers simply cannot accommodate a voracious borrower ike the Big Apple. Mr. Richman estimated that the entire industry backs only about 5% of the city's outstanding debt, and even at those levels firms must keep an eye on the capacity constraints.
"For New York City paper, most of the major insurers are close to their capacity," he said. "But here you have an issuer that has to depend on its uninsured rating to stay in the market. The city cannot hide under insurance, and that's very attracive to us -- the discipline the market places on New York is substantial."
Mr. Geffrard suggested that because the trend is to apply credit standards more stringently, rather than loosen them, the rating agencies will not open the door for additional capacity. "There probably are some legitimate concerns about concentrations that they have to address to keep the triple-A ratings," he said. "And thos earen't likely to change soon."
The rating agencies must be reckoned with well before the New York State Insurance Commission. Standards set forth by the commission -- allowing a firm to commit up to 75% of its capital to one risk -- are considered far more liberal than those necessary to keep a triple-A. In fact, several insurance executives said getting near the commission's guidelines would be foolhardy.
The Agencies' Contraints
The agencies have different methods of determining when enough is enough.
In Moody's case, no specific limits are set for New York City or the other most frequently insured bonds, such as Washington, D.C., Massachusetts, and New York State. The agency's "shock loss" scenario puts credits into three categories, prioritized according to their perceived public purpose, and assigns risk weightings:
* General obligations and other extremely safe bonds, such as single-family housing or asset-backed deals, where the likelihood of some extraordinary event affecting repayment is small. These are assessed at 25%, or meaning that only one-quarter of the exposure assumed is counted toward the insurer's final capital charge.
* Water and sewer bonds, electric revenue issues, and certain lease deals, which are assessed at 50%.
* And hospitals, multifamily housing bonds that depend on a single property, toll road issues, and corporate obligations, which are assessed at 100%.
The averaging technique appears to allow the assumption of larger single risks, but the end result is a very clear restriction, according to Naomi Richman, vice president and manager of the bond insurance group at Moody's.
"We don't tell them they can or can't do specific deals," Ms. Richman said. "But if they do it, they'll get penalized. They are going to pay a price for it" through increased capital charges."
The gradations at Standard & Poor's are finer -- it delineates six single-risk categories -- but the averaging of the top 10 credits is absent. Dave Penchoff, vice president at the agency, described the methodology as determining "what degree of exposure could a given insurer have to a single issuer, have that issue go into default, and still be able to absorb it."
Standard & Poor's, in addition, gives itself a wider latitude in assessing capital charges within each of its categories. The categories, as with Moody's, begin with GOs and end with "corporate" obligations, but there are more than 20 capital charges ranging from 3% to 45%.
At Fitch, single-risk capacity limits are keyed off of the New York State Insurance Commission's general guidelines, but with a decidedly more conservative bent. Whereas the insurance commission allows an insurer to commit up to 75% of its capital to any single credit (or revenue source) net of reinsurance, Fitch allows the same commitment only to GOs, according to Mark H.S. Cohen, managing director at the rating agency.
"In my opinion, what you are looking for in single-risk is to differentiate risks, or slow-pay versus no-pay," Mr. Cohen said. "GOs will be temporary [defaults], but if a hospital got into trouble, it's more likely to be a no-pay problem."
The Fitch categories and capital charges are:
* General obligations, of which one issuer can account for up to 75% of an insurer's statutory capital, which is policyholders' reserves and contingency reserves.
* Other tax-backed obligations, 64%.
* Utility issues, 64%.
* Certificates of participation and leases, 50%.
* Transportation bonds, 50%.
* Housing credits, 40%.
* Higher education and health-care issues, 35%.
The insurance market situation surrounding New York City is unusual. A high-volume, high-profile issuer in desperate need of lower debt service costs is running up against a fairly small industry with specific constraints preventing it from providing what the city desires. On the buy side, too, the demand cannot be satisfied.