Overview of the Monoline or Financial Guaranty Insurance Business and Recent Events
Monoline Insurance Overview
Monoline insurers provide credit enhancement in the form of a “guarantee” of
payment of principal and interest to bond issuers in the municipal
and structured finance markets both in the U.S. and internationally.
This guarantee takes the form of an insurance or “wrap” contract
and is an unconditional and irrevocable pledge to pay principal
and interest when due in a timely manner in the event of an issuer
default (there is no acceleration of payments). This financial
promise to pay typically requires a “AAA” rating. As
of year-end 2007, there were seven “AAA” monoline companies
that carried AAA ratings (although one, Assured Guarantee, was
split rated for most of the year). In January of this year, Ambac
was downgraded by Fitch Investors to AA and XL Capital was downgraded
by Fitch to A. Since these companies do not underwrite any other
lines of business they are often referred to as “monolines” or “bond
insurers” and participate in the financial guaranty business.
To maintain their “AAA” rating, monolines historically adhered to a “no-loss” or “remote loss” underwriting standard. This means that monolines generally wrap investment-grade bonds that have a low default probability. Then they structure their contract to secure their exposure so that in the event of default, there are liquid assets or resources backing any liability. These insurance contracts employ a structure that allows for aggressive corrective action if credit deterioration does begin to occur. As part of their underwriting process, monolines also model transactions extensively under a variety of high-stress scenarios and only accept deals that show full collectability in all cases. The goal is to underwrite exposures that have a low probability of default to begin with and then to build multiple layers of protection so that losses can be avoided or mitigated should deals deteriorate or default.
If a claim is made, the monolines are then obligated to continue to make interest payments and ultimate principal on these securities. It is important to note, that if an insured bond does have problems, the financial guarantor is not on the hook to immediately return principal, just to continue to pay interest and principal when due. Monoline insurers are under no obligation to pay principal until a given deal’s stated maturity. With structured securities, they tend to wrap the higher part of the structure where they have more protection.
This remote loss underwriting standard means that wrapped bonds are carefully analyzed before insurance is offered and that the insurance contract itself is structured so that there is a reasonable chance that the insurance company will never be called upon to pay a claim. Claims have been very rare although they do occur from time to time. Monolines have historically insured (guaranteed) primarily municipal bonds, which have historically maintained a very limited risk of default but had limited growth opportunities. In recent years, monolines have sought to augment growth by wrapping structured products such as various ABS structures.
Underlying Assets and Credit Ratings
Structured Finance: When insuring structured finance such as asset-backed
securities (ABS) or collateralized debt obligations (CDOs), monolines
also look at the cash flow coverage generated by the assets,
the characteristics of the structure (bankruptcy remoteness,
covenants, and cash flow waterfalls), and the seller of the assets.
There is an evaluation of the legal structure and documents in
the transaction. Underwriting teams will generally only approve
deals with multiple layers of protection in the form of over-collateralization,
subordination, and covenants that enable swift action if the
credit quality of the underlying assets begins to deteriorate.
Municipal Bonds: When insuring municipal bonds such as general obligations (GOs), monolines also look at the size of the jurisdiction and the tax base as well as the diversity of taxes and taxpayers. With public special revenue projects the monoline insurer looks at the importance of the project to the community and market factors such as competition, diversity of users and revenue, growth projections, liquidity measures, and debt service measures.
As part of both processes, a major rating agency (S&P, Moody’s, or Fitch) reviews and models each deal before the insurer will issue its guaranty. In this way, rating agencies are aware of the general risk exposure each monoline has taken on.
Rating agencies also have the job of assessing the overall risk profile of the monoline insurer itself in order to provide the AAA rating that monolines have required to write new business. Each rating agency has a proprietary model that measures the capital adequacy of guarantors under stress scenarios. Rating agencies assess a “capital charge” for each risk exposure of the insured portfolio. The guarantors are expected to maintain capital levels at, or in excess, of each agency’s required amount (a capital cushion). This process is meant to ensure that each monoline has an adequate level of capital to cover all potential liabilities.
Recent Events
With the deterioration in the housing market and growing concern
regarding the wrapped exposures of the monolines to various types
of related exposures in structured transactions, the rating agencies
recently ran “what if” scenarios on each guarantor’s
insured portfolio stressing assumptions (on subprime loans and
CDOs) in order to see if the capital cushion was maintained.
The rating agencies incorporated their models to stress specific
exposures such as Alt-A, subprime and CDOs with residential mortgage-backed
(RMBS) exposures. This analysis also reflected considerations
for vintage of the underlying collateral. As a result of each
rating agency’s
analysis, the industry was effectively put on notice to shore
up its capital cushion in order to maintain the “AAA” rating.
Monolines who do not restore their respective capital cushions
within the time frames designated by the rating agencies will
likely lose their “AAA” rating, as evidenced by the
recent Fitch downgrades.
The loss of a “AAA” will effectively eliminate the monoline’s ability to underwrite new business. There is also concern in the marketplace that the proliferation of downgrades of structured finance products have raised concerns that the models used by the rating agencies seem to have failed, particularly as they relate to subprime RMBS and CDOs. Should claims materialize, it is important to note the “pay as you go” business model employed by the monolines will spread the losses over many years. During that time the profits from the untroubled municipal side of the business combined with the insurance company efforts to mitigate their losses through structural features written into these contracts will likely make actual losses less than those modeled. Also the conservatism of the old “AAA” model—even if it proves to be worthy of only a “AA” or “A” rating under new rating agency assumptions—should be sufficient in our view to allow the monolines to reduce overhead and manage a closed book to a profitable outcome, absent unforeseen events. We will continue to monitor these events closely.