State and Local Financial Instruments

State and Local Financial Instruments

Policy Changes and Management

Studies in Fiscal Federalism and State–local Finance series

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

The ability of a nation to finance its basic infrastructure is essential to its economic well-being in the 21st century. This book covers the municipal securities market in the United States from the perspective of its primary capital financing role in a fiscal federalist system, where subnational governments are responsible for financing the nation’s essential physical infrastructure.

Chapter 12: Enhancing municipal credit

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

Subjects: economics and finance, public finance, politics and public policy, public administration and management, public policy

Extract

Often issuers (and sometimes underwriters in competitive bid sales) purchase private, third-party credit enhancement or participate in credit ‘pooling’ programs for their bonds. Individual investors may also purchase separately credit enhancement (usually bond insurance) from private firms to protect their investments. In private credit enhancement contracts, a bond becomes ‘wrapped’ by the financial guarantee of a bond insurance firm or a bank. When this happens, the issuers are said to ‘lease’ the creditworthiness of the credit guarantor or liquidity support provider. Current evidence suggests that credit enhancements lower issuer borrowing costs, provide additional repayment security, and send an important signal to financial markets, all of which improve liquidity and pricing in secondary market trades. This chapter primarily discusses bond insurance – the most widespread form of private third-party credit enhancement for municipal bonds. Though the bond insurance industry is a much smaller version of the industry that existed prior to the meltdown during the Great Recession, it still remains the only feasible credit enhancement option for most credit classes. Alternative credit enhancement mechanisms such as state sponsored credit pools or bank letters of credit are generally reserved for only the strongest credit quality issuers or shorter-term obligations. We provide a discussion of current empirical evidence on the role of bond insurance in the municipal market, the bond industry regulatory framework and risk exposures, and the uses of bond insurance.

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