NEW YORK (Reuters) - At first glance, it is hard to see Detroit's bankruptcy filing as anything but another body blow for downtrodden U.S. municipal bond insurers, which could be on the hook to investors for hundreds of millions of dollars in losses on the city's debt.
But the city's fiscal upheaval may in fact have the opposite effect - providing the marketing spark needed to revive a business decimated by the financial crisis like few others.
For issuers that have mostly gone without coverage since the 2007-09 financial crisis hammered most bond insurers, Detroit's filing may serve as a stark reminder of the wisdom of buying insurance. Put simply, insurers' payment guarantees make their bonds more attractive to investors.
"Investors are going to see the benefit of insurance in action more and more," said Alan Schankel, head of fixed income research and strategy at Janney Capital Markets. "I think this is net-net a positive marketing story for bond insurance."
Once a familiar fixture, bond insurance gave extra financial security to bondholders, including the retail investors who hold almost half of the $3.7 trillion market, while helping local issuers lower borrowing costs.
Before the crisis, about half of all new municipal bonds had insurance from nine insurers, with nearly 60 percent covered in 2005. Last year, just 3.6 percent were insured, and this year the number is just over 3 percent, Thomson Reuters data shows.
Bond insurers collapsed during the financial crisis after they ventured into mortgage-backed securities in the years before 2007. Ratings agencies slashed their AAA ratings to junk or withdrew them altogether. That meant bond issuers no longer benefited from their coverage.
With insurers failing to make promised payments, their stock tanked and so did their businesses.
Insurers are among the biggest players in Detroit's case, as about 86 percent of the city's $8 billion debt is insured by six companies. But the bulk of losses is expected on only about $530 million of unsecured general obligation bonds, which are payable over the next 22 years.
That makes the hit insurers would take from Detroit manageable, analysts say. At the same time, coming after other municipals bankruptcies such as Jefferson County in Alabama or Stockton and San Bernardino in California, Detroit would help investors see the benefit of bond insurance.
In June, Detroit defaulted on $1.45 billion of bonds issued to fund its pension obligations. Syncora, which insured most of those obligations, covered $24.7 million.
But Financial Guaranty Insurance, on the other hand, which is undergoing a court-ordered rehabilitation process, failed to pay about $16.2 million.
Insurers will keep paying debt service to most bondholders but not on the more than $5 billion of Detroit water and sewer bonds, as the city will keep current on those during the bankruptcy process.
Despite the record low presence of insurers on the primary market, some lower-grade, lesser-known issuers have reaped the benefits of insurance, with 645 deals insured for a total value of $6.57 billion so far this year.
The New York Dormitory Authority issued $60 million on behalf of Roosevelt school district earlier this year. Officials said insurance with Build America Mutual (BAM) saved 10 basis points on the borrowing costs, or about $200,000.
In March 2012, the Lafayette Yard Community Development Corporation sold $15.3 million of bonds guaranteed by the city of Trenton in New Jersey. After paying an insurance premium of about $139,000, the issuer saved about $60,000, in present value debt service payments, according to advisers for Trenton.
Not everyone, however, is buying the idea that muni bond insurance is going to make a comeback.
"It's not a very viable business model," said Dan Berger, a muni market analyst at Municipal Market Data, a unit of Thomson Reuters. "The longer people do without insurance, the less they see a need for it."
Still, the ratings of bond insurers are looking healthier. Of the two active insurers, BAM is rated AA by Standard & Poor's and Assured Guaranty's (AGO.N) MAC is rated AA-. S&P upgraded National Public Finance Guarantee, the muni-only insurer formed out of MBIA insurance Corp, to A in May after it settled a lawsuit over restructuring with Societe Generale.
There are signs competition is starting to creep back in. After BAM entered the market in 2012 with a focus on the safest types of municipal bonds, Assured announced its own muni-bond only insurer, Municipal Assurance Corp, in July. MBIA is also tipped for a return to the market.
Assured accounted for 99.8 percent of $11.5 billion of the new issues insured in 2012, according to Thomson Reuters.
Both BAM and Assured say they saw an uptick in interest even before Detroit, and Assured expects the market to gain steam.
Other muni bond insurers either declined to comment or did not return requests for comment.
Any positive Motown impact on the insurance business will come if and only if Detroit is not the start of wave of defaults across U.S. municipalities. Such a scenario would be a severe blow for the bond insurance industry.
"The amounts of losses that we are talking about here are really quite manageable," said Mark Palmer, an equity analyst at BTIG Research. "(But) if Detroit really is the first domino, then it would be an issue. It's our view that Detroit really is a one off," he said.
Palmer has a buy rating on the stocks of Assured Guaranty, MBIA, and Ambac AMBC.O and believes all three insurers are significantly undervalued at current levels.
Analysts and investors who believe bond insurance may have hit bottom do not suggest the industry is headed back to pre-crisis peak. They simply predict a rising demand.
Duane McAllister, a portfolio manager at BMO Global Assets Management who helps oversee about $5 billion in muni bonds, says the insured part of his portfolio has fallen to about 20 percent from 35 to 40 percent before the crisis. He would like to see that climb back to 25 percent, or even 30 percent.
"My view is that the industry has bottomed and that it is climbing its way back slowly," said McAllister. "They are going to get tested obviously in the Detroit bankruptcy scenario, but if they can come through that and they're still in OK shape, then they will have proven their value."
Reporting by Edward Krudy, Editing by Tiziana Barghini and Dan Grebler