Credit insurance was born in the municipal bond business, to take advantage of a quirk: rating agencies apply different rules in assigning ratings to states and local governments than they do when rating corporations. In essence, they rate local governments against each other. If the State of Upper Anchovia is deemed worthy of a AAA based on its finances, then the State of Lower Anchovia with slightly lower financial strength gets a AA, even though it would be worthy of a AAA if it was judged by itself.
The demand for municipal bond insurance came entirely from individual retail investors who wanted the comfort of AAA-insured ratings, thinking them equivalent to Treasurys. Since municipal bonds rarely defaulted, monoline insurance companies made a pretty penny selling unnecessary insurance to unsophisticated investors. It was like selling snow damage insurance in the Sahara, or as P.T. Barnum said, there's a sucker born every minute.
But then the monolines got greedy and jumped on the structured finance bandwagon, insuring all manner of private, asset-backed bonds. There is nothing wrong with wanting to make extra profit, as long as you price the marginal risk/return properly. Clearly, the monolines did not, choosing instead to buy into the financial engineers' elevated assurances about the implausibility of multi-sigma events and the non-existence of black swans. Oh, and the elevated fees must have played a role, too..
So here's my suggestion: The federal government should guarantee all state and municipal bonds - at least those not tied directly to private-sector projects. It will cost next to nothing and save local governments billions in the process, in lower interest and insurance costs. This will leave the monolines with the weak structured finance part of their insurance book, and undoubtedly result in downgrades and large write-offs. But this is the private sector and it can take care of itself, one way or another. The public sector, on the other hand, must be protected from avarice.
Will there be conflicts from the constitutional separation of power between sovereign states and federal government? I imagine so, though I am not familiar with constitutional law. Nevertheless, there is no reason whatsoever to keep subsidizing private speculators through proceeds derived from duping the public in the name of government. The lucrative loophole that arose from mis-rating local government debt must be shut down, once and for all.
The nonsense of paying loan-shark rates (8%-20%) for adjustable-rate local government debt when T-bills are at 2% has gone far enough.
Update: Several readers objected to my guarantee proposal, mentioning that some local governments are badly mismanaged and thus should not have their debt back-stopped by the federal government. Here is a chart of the overall state and local debt as a percentage of GDP.
By comparison to the household and financial sectors, who have sent their debt soaring, local governments have been paragons of fiscal virtue. Cicero (see masthead) would have been proud.