Private Guarantees for Municipal Bonds: Evidence from the Aftermarket**

This paper considers the market for private guarantees for municipal debt. It reviews the empirical evidence on the effects of insurance upon the pricing of new is.sues. It also presents the first empirical evidence available on the effects of bond insurance in the aftermarket for tax exempt securities. Aftermarket trades in identical securities in insured and uninsured forms are used to estimate the effect of insurance upon the true yield of the bonds and the sale price of those bonds. The effect of bond insurance upon yields and during 1987-89 is estimated to be substantial—14 to 28 basis points in terms of yield, or 1.9 to 3.9 percent in terms of the quoted prices for municipal securities with 30-year maturities. D the past decade there has been an astonishing increase in the incidence of guarantees for the securities issued by state and local governments. A wide and diverse variety of public programs provide some form of credit enhancement for local issues. These programs include state bond banks, revolving loan funds ("credit pools"), debt service guarantees, and a range of explicit assurances, Direct state guarantees include programs providing full collateralization (Texas), full-faitb-and-credit backing by the state, state-administered insurance programs (Minnesota), more complex pledges of future tax revenues, and sometimes pledges to divert unrelated state funds to bondholders under certain conditions.' But the most important addition to the complex patchwork of guarantees has come from the private sector. The provision of guarantees by private profit-making firms for the debt issued by public agencies has been transformed from a niche in tbe fi*Univer8ity of California, Berkeley, CA 94720. nancial services industry to a major component of that industry. This paper presents new evidence on the pricing of private guarantees. In Section 1 we describe briefly the operation of the industry and the recent history of its expansion.^ Section 2 considers the microeconomics of bond guarantees and surveys existing econometric evidence on the pricing of insurance in the market for newly-issued debt. This section also presents the first empirical evidence available on the pricing of bond insurance in the resale market (or "aftermarket") for municipal bonds. This empirical analysis is based upon a unique body of micro data on bond trades during the period 19871989. Tbe data consist of observations on the trades of bonds which are "identical twins"; in each case the underlying security was originally issued without insurance, but some part of the issue was subsequently insured in the aftermarket. Conclusions are presented, briefly, in Section 3. 1. Private Municipal Bond Guarantees A variety of private firms and government agencies provide some form of guarantee or insurance for the timely payment of municipal bond obligations. This enhancement of the creditworthiness of municipal bonds affects the cost of borrowing by local governments and the extent of the market for the securities issued by those governments. The net cost of borrowing is affected by the cost of insurance, but also by tbe fact that the more secure guaranteed bonds with higher credit ratings can be marketed to investors at lower interest costs to tbe issuer. The routine award of AAA credit ratings for these securities, based on the credit history of the guarantor, increases the liquidity of tbe bonds, particularly those issued by smaller jurisdic-