Counterparty Credit Risk in the Municipal Bond Market

Abstract

A large number of municipal bonds are guaranteed by monoline insurers who are at the center of the subprime crisis. This article investigates the effect of insurer-related counterparty risk on municipal bond pricing using a comprehensive dataset. The authors estimate both insurer-specific and systemic components of a counterparty risk effect. Results show that the magnitude of the counterparty risk effect is of economic significance even in normal times and is magnified during the crisis. The findings also indicate that this effect is much larger than that documented for the credit default swap and repo markets. The counterparty risk premium is higher for speculative-grade and illiquid bonds and for bonds issued by troubled states.