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Credit-rating crisis triggers suits by cities

By Richard Binder

The $2.6 trillion municipal bond market has been brought to its knees by the loss of triple-A credit ratings on the bond insurance sold to cities, rendering the policies worthless and prompting a wave of lawsuits by California cities against their bond insurers.

The litigation is almost certain to mushroom nationally, given the number of municipalities, utility districts and others hit by the public bond rating crisis, according to the attorney who has filed the California actions, Nanci Nishimura of Cotchett, Pitre & McCarthy in Burlingame, Calif.

In addition, Connecticut Attorney General Richard Blumenthal weighed in earlier this year with the first suit in the country against the nation's three largest credit rating agencies, accusing them of low-balling credit ratings on municipal bonds, creating a demand to purchase bond insurance. Connecticut v. McGraw-Hill Cos. Inc., No. HHD-cv-08-4038927-S (Hartford, Conn., Super. Ct.).

'Wall Street tax'

He said the rating agencies employ a double standard by weighing municipal and corporate bonds with different scales, which gives companies higher ratings despite their higher default rate.

"In effect, they imposed a Wall Street tax on Main Street," said Blumenthal. "Our cities have been compelled to pay higher insurance rates or premiums, based on ratings that were lower than they deserved," he said.

The rating agencies, Moody's Corp., Fitch Inc. and Standard & Poor's, owned by McGraw-Hill Cos., have called the Connecticut lawsuit meritless. McGraw-Hill spokesman Frank Briamonte in a statement said the company would "defend against it vigorously."

On Oct. 9, San Francisco became the latest city to file suit against five bond insurers, alleging fraud, negligence, misrepresentation and antitrust violations. San Francisco v. AMBAC Financial Group Inc., No. CGC 08-480708 (San Francisco Co., Calif., Super. Ct.).

The problems stem from the cities' need to purchase bond insurance so that they can use the triple-A credit rating enjoyed by the insurers and thus entitle the city to a lower interest charge on variable-rate bonds.

But the insurers also backed subprime mortgage pools at the center of the current credit crisis. This forced a downgrade of the insurers' own ratings in February below triple-A. Suddenly, the cities no longer had the insurer's elite rating guarantee paid for in the premiums.

Their bond interest rates spiked, and banks that provided the liquidity for city bond projects exercised the right to force early bond repayment at higher interest rates, further squeezing cities.

"That is the key to this case, bond insurers scoured America selling the insurance and saying they were sound, but they failed to disclose they were investing in risky subprime mortgages and credit derivatives," said Nishimura.

The five bond insurers named were AMBAC Financial Group Inc., MBIA Inc., XL Capital Assurance Inc., Financial Guaranty Insurance Co. and CIFG Assurance North America Inc.

AMBAC spokeswoman Vandana Sharma, MBIA spokesman Kevin Brown and CIFG spokesman Steve Pachella all declined to comment on the litigation. XL Capital and Financial Guaranty did not return calls seeking comment.

But MBIA's Brown said, "What we're seeing is a number of insurers studying ways to reactivate dormant subsidiaries and get back into public finance securities."

The borrowed money, used to build roads, schools and sewer systems, became much more expensive, interest rates and insurance premiums rose, and new money has become far tougher to obtain.

"We've paid increased interest on the airport construction," said Dennis Herrera, San Francisco's city attorney. He said the city suffered tens of millions of dollars in damages when bond insurers lost their credit ratings.

On July 24, Stockton, Calif., at the epicenter of the housing foreclosure crisis, and Los Angeles, the second-largest U.S. city, sued their bond insurers, followed by Oakland and San Mateo County, both in California. San Diego is reportedly considering similar litigation, and transit agencies that must borrow to fund expensive equipment purchases or leases may follow.

It is no accident the litigation began in California.

The state, the largest municipal bond issuer in the United States, has roughly $44 billion in general obligation debt outstanding. The state sold $12 billion in bonds during 2007, according to State Treasurer Bill Lockyer.

-- Pamela A. MacLean

Full post as published by Legal Pad | LA on November 03, 2008 (boomark / email).