When money managers buy bonds offered by state and local governments, they gladly accept the tax-free interest payments that come with them. But they’re no fools. They know they can lose their investment if a state or local government goes into default. [See: “12 States in Financial Distress”] So these money managers buy insurance. And these days, most of those bond insurance policies are being underwritten by one company.

Assured Guaranty (NYSE: AGO) surely hopes that state and local governments can fix their finances without the need for bankruptcy protection, because if they can’t, the company would be on the hook for hundreds of millions of dollars — at least.

Back in August, I wrote a fairly bullish profile of Assured Guaranty. At the time, it looked as if the Obama administration — with a supportive Congress — would keep the aid flowing to states into 2011. Shares went up +20% from the time I wrote about Assured Guaranty, but by late October, investors started to realize that a change in Congressional leadership likely spelled the end of federal aid to states. As a result, shares of Assured Guaranty have given up those recent gains, and could head well lower.

A deceptively low P/E
To be sure, shares of this municipal bond insurer look quite cheap when you look at earnings per share (EPS) forecasts, trading for around five times projected profits. And profits are on the upswing, thanks to a higher volume of business after rival Ambac (NYSE: ABK) had to seek bankruptcy protection and MBIA (NYSE: MBI) experienced severe financial distress.

The real reason Assured Guaranty sports such a low price-to-earnings (P/E) ratio is that investors don’t trust the “E” part of the equation. Value investors also note that shares trade below book value. (And if earnings forecasts come to pass, book value would exceed $25 within a year). But here again, unexpected losses, possibly severe, would sharply erode book value.

A massive market
Assured Guaranty underwrites more than $30 billion in municipal bonds every year. And up until now, the company has not seen much distress on that massive debt exposure. Yet Standard & Poor’s recently downgraded the company’s bonds from “AAA+” to “AA+” on concerns that the company’s financial exposure might deteriorate.

But even a small amount of defaulting bonds would wreak havoc. The company is on the hook to insure losses that are 150 times its entire capital base. If just 5% of the bonds it underwrote defaulted, Assured Guaranty would be wiped out. The company has some protection in the form of reinsurance, but not nearly enough to handle more than a few defaults. And if it saw defaults rise, the cost of getting its own reinsurance would rise sharply, effectively making its business model financially unfeasible.

Wiser than the peers
The fact that Assured Guaranty is still operating at healthy levels is a testament to management’s savvy. The company wisely avoided much of the mortgage meltdown while rivals sought to profit from seemingly attractive opportunities in mortgage bond defaults. (And we know how that turned out.)

But that doesn’t mean this is a low-risk model. Indeed it’s quite high risk when you consider the deep financial stress that state and local governments are feeling. Since I wrote this article two months ago, states have made scant headway in their battle to close looming 2011 budget gaps. And as I subsequently wrote, recent elections ensure that states shouldn’t expect any more federal help.

A curious breakdown
Are signs of trouble emerging? Closed-end funds that own municipal bonds just popped up on many radars. For example, PIMCO’s California Municipal Income Fund II (NYSE: PCK), which traded above $10 in late September, and above $9.50 as recently as last Monday (November 8), has now fallen for six straight sessions to a recent $8.22, the lowest level in nearly two years. Other muni bond funds have traded poorly in the past few days. The only explanation: heightened concerns that distressed state and local governments may have trouble meeting 2011 obligations.

Action to Take –> This is a difficult stock to handicap, as it is clearly cheap and could rise if state and local economies rebound or come up with ways to close budget gaps. But right now, shares of Assured Guaranty look poised to drop further as the headlines become ever more daunting. I think this is a great stock to short if we hear more about state and local distress, but aggressive investors may want to jump in now.