Monoline insurance

Monoline insurers (also referred to as "monoline insurance companies" or simply "monolines") guarantee the timely repayment of bond principal and interest when an issuer defaults. They are so named because they provide services to only one industry. [ [http://www.afgi.org/monoline.htm Association of Financial Guaranty Insurers] ]

The economic value of bond insurance to the governmental unit, agency, or company offering bonds is a saving in interest costs reflecting the difference in yield on an insured bond from that on the same bond if uninsured. Insured securities range from municipal bonds and structured finance bonds to collateralized debt obligations (CDOs) domestically and abroad.

Insurance regulations prevent property/casualty insurance companies, life insurance companies, and multiline insurance companies from offering financial guaranty insurance. The monoline industry claims that it has the advantage over multilines of sole focus on capital markets. [ [http://www.afgi.org/monoline.htm Association of Financial Guaranty Insurers Advantages of the Monoline Structure] ]

History

The first monoline, or bond insurer Ambac Financial Group Inc, was formed in 1971 as an insurer of US municipal bonds. MBIA Inc was formed in 1973. [ [http://afgi.org/facts-tline.htm Association of Financial Guaranty Insurers] ] . The companies sought to help regional public administrators get better access to cheaper funding.

The companies , which must be highly rated by the credit rating agencies to fulfill their role, provide a back-up guarantee to debt issued by lower rated borrowers in exchange for insurance premiums. Thus a city or regional municipal borrower rated A, by paying a premium could enjoy AAA rating. Many more kinds of investors would then buy that bond significantly reducing the interest cost of that debt. Since public administrators often had large balance sheets of real estate assets, monolines soon started building up portfolios of bonds that had real estate assets backing them. The difficulty for analysts has always been understanding how similar are municipal assets often funded from secure tax revenues compared to private asset portfolios funded by profits from a variety of fluctuating markets . To counter criticism, bond insurers claimed they had sophisticated risk management maths and in the event of claims, paid slowly over time to match the profile of the debt issued rather than lump sums. Taxable investors benefit from the exemption of municipal bond interest from Federal income tax. In many cases local bonds are also free of state and local taxes. Taxable investors face a compelling incentive to purchase local bonds. However, an investor holding a large portfolio allocation in local bonds carries a risk of substantial loss if the local economy becomes depressed, for instance if a local industry declines or a major natural disaster strikes, and defaults ensue. On the other hand, diversifying nationally causes loss of the tax benefit. If a AAA-rated monoline insurer guarantees a municipal bond, the investor gains the benefit of owning a diversified portfolio and retains the local tax benefit. (The investor is even better off than owning a diversified national portfolio, which might suffer an occasional default: the insured bond can only default if the issuer defaults, and the insurer experiences defaults on its entire portfolio in excess of the insurer's capital).

When insuring taxable bonds, bond insurance is a 'pure credit' business. The insurer seeks to insure credits with a very small likelihood of default, which the market will nevertheless pay a premium to insure, perhaps because of investor restrictions on the amount they can invest in non-AAA credits .

2007 saw a crystallizing crisis in US subprime mortgage related bonds. The spillover into broader structured credit markets had a huge impact on bond insurers. The worst hit was RADIAN Group which insured mortgage-backed debt. Shares in Radian Group tumbled by over 67 per cent in the space of months. The falling share price reflected the almost nine fold rise in the cost of protecting debt against default. Bond insurers have a tiny capital base compared to the volume of debt insured . Rating agencies have come under increasing scrutiny by regulators for their methods as bond insurers lend their high credit ratings to securities issued by others in return for a fee.

Until 1989, multiline insurance companies were permitted to guarantee municipal and other bonds, in addition to their other businesses such as property/casualty and life insurance.

As the number and size of insured bond issues grew, regulatory concern arose that bond defaults could adversely affect even a large multiline insurer's claims-paying ability. In 1975, New York City teetered on the edge of default during a steep recession after years of financial mismanagement [ [http://www.nydailynews.com/features/bronxisburning/battle-for-the-city/Ford-to-New-York-Drop-Dead.html New York Daily News] ] ; in 1983 the Washington Public Power Supply System (WPPSS) defaulted on $2b of revenue bonds from a troubled nuclear power project [ [http://www.time.com/time/magazine/article/0,9171,955183-1,00.html Time Magazine] ] .

Under New York State's Article 69, passed in 1989 [ [http://www.ins.state.ny.us/regspart.htm New York State Insurance Department] ] , multiline insurance companies are not permitted to engage in financial guaranty businesses (and vice versa). A cited rationale was to make the industry easier to regulate and ensure capital adequacy [ [http://books.google.com/books?id=Ngb1lNMGqVEC The Law of Miscellaneous and Commercial Surety Bonds] By Todd C. Kazlow, Bruce C. King] .

In recent years, much of the monolines' growth has come in structured products, such as asset backed bonds and collateralised debt obligations (CDOs), and the total outstanding amount of paper insured by monolines reached $3.3 trillion in 2006. [ [http://www.economist.com/finance/displaystory.cfm?story_id=9552987 "A Monoline Meltdown?"] , "The Economist", July 26 2007] This contingent liability is backed by approximately $34 billion of equity capital [ [http://afgi.org/claims.htm Association of Financial Guaranty Insurers] ] .

2007 Subprime Crisis and Credit Crunch

No monoline insurer had ever been downgraded or defaulted prior to 2007 [ [http://afgi.org/who-fact.htm Association of Financial Guaranty Insurers] ] .

In 2007, amid a housing market decline, monoline insurers suffered losses from insurance of structured products backed by residential mortgages. Defaults soared to records on subprime mortgages and innovative adjustable rate mortgages, such as interest-only, option-ARM, stated-income, and NINA loans (No Income No Asset) which had been issued in anticipation of continued rises in house prices.

On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth [ [http://finapps.forbes.com/finapps/jsp/finance/compinfo/secfilings/SECFilingsSummary.jsp?cn=ACA+CAPITAL+HOLD+INC.&tkr=ACA&secn=0001047469-07-008632&frm=8-K 8-K at Forbes.com] ] . On November 19, ACA noted in a 10-Q, that, if downgraded below A-, collateral would have to be posted to comply with standard insurance agreements, and that 'Based on current fair values, we would not have the ability to post such collateral.' [ [http://finapps.forbes.com/finapps/jsp/finance/compinfo/secfilings/SECFilingsSummary.jsp?cn=ACA+CAPITAL+HOLD+INC.&tkr=ACA&secn=0001104659-07-084173&frm=10-Q 10-Q at Forbes.com] ] On December 13, ACA's stock was delisted from the NYSE due to low market price and negative net worth, but ACA retained its A rating [ [http://www.reuters.com/article/governmentFilingsNews/idUSN1325383920071213 Reuters] ] . Finally, on December 19th, it was downgraded to CCC by S&P [ [http://www.forbes.com/2007/12/19/aca-bond-insurers-markets-equity-cx_ra_1219markets33.html Forbes.com] ] .

The following month, on January 18, 2008, Ambac Financial Group Inc rating was reduced from AAA to AA by Fitch Ratings. [ [http://www.bloomberg.com/apps/news?pid=20601087&sid=asLtTQyLRQQs&refer=home "Ambac's Insurance Unit Cut to AA From AAA by Fitch Ratings"] article by Christine Richard Jan. 19 (Bloomberg)] Due to the very nature of monoline insurance the downgrade of a major monoline triggered a simultaneous downgrade of bonds from over 100,000 municipalities and institutions totalling more than $500 billion.

Credit rating agencies placed the other monoline insurers under review [ [http://www.msnbc.msn.com/id/22329095/ MSNBC] ] . Credit default swap markets quoted rates for default protection more typical for less than investment grade credits. [ [http://www.reuters.com/article/bondsNews/idUSN1740166120071217 Reuters] ] Structured credit issuance ceased, and many municipal bond issuers spurned bond insurance, as the market was no longer willing to pay the traditional premium for monoline-backed paper [ [http://www.bloomberg.com/apps/news?pid=20601087&sid=aSt9mAsai4Mw&refer=home Bloomberg] ] . New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market [ [http://www.bloomberg.com/apps/news?pid=20601103&sid=aIy4h.TX4q3k&refer=us Bloomberg] ] . The illiquidity of the over-the-counter market in default insurance is illustrated by Berkshire taking four years (2003-06) to unwind 26,000 undesirable swap positions in calm market conditions, losing $400m in the process.

By January 2008, many municipal and institutional bonds were trading at prices as if they were uninsured, effectively discounting monoline insurance completely. The slow reaction of the ratings agencies in formalising this situation echoed their slow downgrading of sub-prime mortgage debt a year earlier.

Commentators such as investor David Einhorn [ [http://nakedshorts.typepad.com/nakedshorts/files/EinhornOnCredit.pdf David Einhorn remarks at 17th Annual Graham and Dodd Breakfast, October 19 2007] ] have criticized rating agencies for being slow to act, and even giving monolines undeserved ratings that allowed them to be paid to bless bonds with these ratings, even when the bonds were issued by credits superior to their own.

On June 19th 2008 Moody's also downgraded Ambac and MBIA from Aaa to Aa3 and A2 respectively. [ [http://www.marketwatch.com/news/story/moodys-downgrades-aaa-rating-ambac/story.aspx?guid=%7BDB5108E9%2D0B27%2D46C8%2D9BA6%2DBCD2DD48AC63%7D#comments Moody's Downgrades AMBAC and MBIA, June 19 2008] ]

References


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