UK: Credit Crunch: Monoline Insurers

Last Updated: 31 July 2008
Article by Belinda Schofield and Chris Chapman

Monoline insurers have in recent times provided essential insurance for structured finance products like collateralised debt obligations and credit default swaps. However with the major monoline insurers being downgraded, and confusion over credit risk the demand for reliable guarantees is increasing. This is likely to bring changes to the monoline insurance industry.

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Monoline insurers have in recent times provided essential insurance for structured finance products like collateralised debt obligations and credit default swaps. However with the major monoline insurers being downgraded, and confusion over credit risk the demand for reliable guarantees is increasing. This is likely to bring changes to the monoline insurance industry.

A version of the article that appeared on Finance Week online on Wednesday 18th June is below . The article looks at the evolution of the monoline insurers, their role in the world economy and the challenges they face.

Since the article was written, both MBIA and Ambac have also had their financial strength rating downgraded from triple-A by Moody's. Further to this in the last week, FSA and Assured Guaranty have both had their financial strength rating placed on review by Moody's.

The repercussions of the sub-prime mortgage crisis have thrust monoline insurers into the limelight. Unlike traditional insurers, these firms write insurance for one line of business only, consequently the name 'mono'. They guarantee an estimated $2.4 trillion of outstanding debt. But who are they exactly, what do they do and how will recent events change their industry?

The monoline insurers' origins are in the US municipal bond sector and the largest still operate from the US, although they insure both domestically and abroad, including in the UK. The first of them started out in the 1970s only insuring municipal bonds (a debt security issued by a state, municipality or county to finance its capital expenditures). The monolines' business has expanded since then, to infrastructure projects, and the insurance of other structured finance products, like collateralised debt obligations (CDOs) and into the credit default swaps (CDS) market.

In the private structured finance arena, monoline insurers guarantee payments of corporate bond principal and interest against issuer defaults. They provide credit enhancement to capital markets transactions, providing financial investors and issuers with financial security and liquidity. The credit enhancement enables the public authorities, or companies offering the bonds, to save on interest costs because of the reduced risk for investors. In essence, the monolines extend their high credit ratings to 'paper' they consider sound, in return for a premium. They are an exclusive group, with the three biggest - MBIA, Ambac and FSA - controlling about 70% of the market.

A credit default swap is like an insurance policy against a credit default, though for technical reasons it is not, strictly speaking, 'insurance'. The huge worldwide CDS market accounts for a significant part of monolines' business, as it does for the financial markets generally. While monolines only write a small proportion of the total CDS market, some estimates suggest they sold up to 50% of the CDSs purchased to hedge against defaulting sub-prime related securities.

The monolines' share prices have plummeted this year as the depth of the sub-prime crisis has been revealed. Over the 52 weeks to June 2008, Ambac's share price had fallen 97%, while MBIA's had dropped 90%.

There have been well-publicised concerns that the loss of ratings at the monolines will automatically devalue the trillions of dollars of securities they have insured. The New York Attorney General's Office has threatened government intervention, including breaking the monolines up into good business (the backing of municipal bonds) and bad business - CDOs and the like. Some commentators say that a forced break-up of the historical business of monolines was never likely. It would have unfairly favoured public issuers, like New York itself, over investors in private issues who had already priced their investments on the basis that money from the monolines' municipal business would be available for their benefit.

Although some smaller monolines have failed, until recently the big players have managed to hold on to their all-important ratings. In fact, MBIA recently revealed its involvement in twenty-four new municipal bond issues in the last quarter, suggesting a climb back into the market.

At the beginning of June MBIA and Ambac both had their triple-A ratings cut by Standard & Poors, in line with an earlier cut by Fitch while Moodys promised to follow suit. The consensus has been that cuts by all three rating agencies would probably spell the end of their businesses. It remains to be seen whether they can instead change their business approaches and live to fight another day. Whatever the ultimate outcome, reports suggest that at least three banks, UBS, Citigroup and Merrill Lynch are likely to have to find another $10bn to account for the most recent downgrades.

Regardless of the future for MBIA and Ambac, the rest of the monoline industry is likely to change the way it operates in the future. For a start, market participation is shifting, with monolines less exposed to sub-prime, such as FSA, gobbling up market share and new players, like Warren Buffet's Berkshire Hathaway, entering the arena. Business structures may also change.

In the future, monolines might split new business along the lines of the New York Attorney General's February suggestion - with one set of reserves allocated to municipal bonds and another to riskier securities. Commentators argue that the problems for monoline insurers were brought about by their unwise foray away from municipal bonds and into other structured finance products. Municipal bonds were perceived as having a very low chance of default and so gave the monolines a secure position. The potential rewards of the new products brought new risks. That might not be enough, with municipal authorities in the US questioning the value monolines have provided in the past and the adequacy of their reserves - which some estimate at 1/150th of the value of their outstanding guarantees. One group of states has even proposed setting up a publicly run competitor. That debate is likely to continue, with the monolines insisting that their business models are conservative and properly stress-tested and their reserves adequate - distinguishing the theoretical total value of their guarantees from their realistic exposure.

Those monoline insurers that survive the turmoil might reap benefits. Although overall investor demand for CDOs and other complex financial products could fall, some say the general confusion over credit risk will increase demand for reliable guarantees. Recent evidence suggests that, with the right reserves in place, premiums are currently three times what they were before the sub-prime crisis. So there are incentives to stay in the industry, if possible.

The monolines business models will also be examined in another way - by litigation, primarily in the US. Historically, with their very low loss ratios, monolines have been relatively litigation-free. They have prided themselves on prompt claims payment. Now, some monolines in financial difficulty are disputing payments and finding themselves on the receiving end of court proceedings - or they are bringing litigation themselves to challenge commitments and free-up capital reserves. Some policy wordings and CDSs will be examined in court for the first time. All of this, along with the media attention, will encourage a greater understanding of the monolines and their role in the financial markets.

A version of this article first appeared on Finance Week online. Since the article was written, both MBIA and Ambac have also had their financial strength rating downgraded from triple-A by Moody's. Further to this in the last week, FSA and Assured Guaranty have both had their financial strength rating placed on review by Moody's.

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 30/07/2008.

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