That bond issue to build a new school or road just became more expensive. Say hello to higher property and sales taxes or cuts in services. Strap on the ol' thinkin' cap and I'll get to 'splainin' it.
Got it strapped on tight? Good.
If you're a municipality and you want to float a bond to build a water reclamation plant, you would want the lowest interest rate possible, just as you yourself would if you were buying a house. Many municipalities don't have good bond ratings (or as good as they would like), so they therefore pay higher interest rates. This opened the way for municipal bond insurers. They would back the bond, essentially insuring it against default, so the bond would have a higher rating and lower interest rate.
This worked out well for all parties: the tax-paying public would end up with a lower cost bond, the purchasers of the bond would not lose their money if the municipality defaulted, and if the insurer is reasonably intelligent and reliably assesses risk, will make money.
So what went wrong? Well, the municipal bond insurers went into the Big Shitpile business--the bundled subprime loan business. After all, assessing risk is just assessing risk, right?
Erm, not so much:
Unfortunately, real estate prices nationally have gone down. Defaults on mortgages in the U.S. are rising and in some sectors of the market are at record levels. No end is in sight. The monoline insurers are being called on to honor their guarantees, and they simply do not have the capital to do so for the amounts involved.
All told, the insurers have $2.4 trillion in guarantees outstanding for municipal bonds and mortgage-related structured investments. It seems inevitable now that the ratings on all this paper will deflate. If Moody's decides that AMBAC deserves a non-investment grade rating rather than a Aaa rating, then much of the paper insured by AMBAC becomes junk debt. And junk bond debt is really what we are talking about here. While the ratings agencies might toy around with a progressive series of downgrades, the stock market has already decimated the shares of the monoline insurers, declaring them virtually bankrupt.
Now, if you own some of this paper, you'll be fine as long as the municipality doesn't default and you decide to hold the bond until maturity. Good luck, though, if you're trying to sell it (you'll take a bath)--which means that if you invested in a mixed bond portfolio because you thought it would be low risk, its earnings will probably drop (it serves you right for trying to be fiscally conservative. Oh my, the cognitive dissonance....).
But what will be devastating is the effect on local governments. Not only will there be more defaults, meaning unfinished roads, schools, and other public needs, but the ratings of any new bonds will drop. This will require a raise in taxes to make up the shortfall, in an environment where property values and thus property taxes are already sliding. Alternatively, local governments may delay these capital investments which...
...is precisely what you do not want in an economy teetering on recession.
This is the Mother of All Bubbles.
Heckuva job, deregulation fanatics....
Here's a little problem I have with the bond reinsurance idea, at least in the kind of cases you describe above:
"...and if the insurer is reasonably intelligent and reliably assesses risk..."
But the bond rating of the municipality is supposed to reflect that risk quite reliably already. That rating is done in a very similar way by several ratings agencies employing people with exactly the same kind of expertise as the bond reinsurer.
So, either the bond rating - the risk of default - of the municipality is consistently evaluated as worse than reality (by not one but three or four ratings agencies) and the bond insurer can arbitrage that discrepancy; or the bond rating is pretty accurate and the reinsurer has been deluding itself and its customers in order to drum up business and has just been lucky during a string of good economical years.
This is way overblown. Insurance is not such a big deal. What will hurt municipalities is the impacts to the tax base from declining real estate markets and a potential recession. But they will get through this just like every other cycle.