Bond insurance

Bond insurance is a service whereby issuers of a bond can pay a premium to a third party, who will provide interest and capital repayments as specified in the bond in the event of the failure of the issuer to do so. The effect of this is to raise the rating of the bond to the rating of the insurer; accordingly, a bond insurer's credit rating must be almost perfect.

The premium requested for insurance on a bond is a measure of the perceived risk of failure of the issuer.

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 ranged from municipal bonds andstructured finance bonds to collateralized debt obligations (CDOs) domestically and abroad.

National government bonds are almost never insured because governments can print money. In fact, for this reason, securities that are tied to or backed by government bonds are typically considered by ratings agencies to be high grade.

Municipal government bonds were insured by the so-called monolines starting in the 1970s. The financial crisis of 2008 seriously harmed their business model, to the point where their continued existence is in doubt.

Terminology

Bond insurers are also called "financial guaranty insurance companies" or "financial guarantors".

Companies whose sole line of business is to provide bond insurance services to one industry are called monoline insurers.The term 'monoline' eventually became synonymous in some literature with terms like 'financial guarantors', and 'municipal bond insurers'.

Bonds which are insured by these companies are sometimes said to be 'wrapped' by the insurer.

Municipal Bond Insurance and the Monolines

Municipal bond insurance was introduced in the US in 1971 by AMBAC, the first of the 'financial guaranty corporations'. They guaranteed the timely repayment of bond principal and interest when a municipal debt issuer defaulted.AMBAC was soon joined by MBIA (1974), FGIC(1983), and FSA (1985). These were the 'big four'. They only wrote insurance on municipal bonds, and they became known as the 'monolines'.

In the late 90s/2000s a new crop of competition came up, such as ACA Financial Guaranty Corp (1997), XL Capital (2000), and CIFG (2001)., as well as the reinsurers, such as Radian, ACE Guaranty Re, and AXA Re Finance.

The financial crisis of 2007-2010 negatively impacted the monolines to the point where their continued existence is in doubt.

Real Estate

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 had 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.

Business model

The benefit for governments was purported to be reduced borrowing costs. The companies, which had to be highly rated by the credit rating agencies to fulfill their role, provided 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.

The purported benefit for the insurers was that they had very stable profits from a market that almost never defaulted. As publicbonds.org points out, Businessweek ran an article in 1994 exclaiming that MBIA was a “an almost perfect money machine.” The Businessweek story said that up to 1994, MBIA had only one loss.

However, some have criticized the entire business model. In Confidence Game, Christine S Richard describes the questions regarding the basic assumptions that the industry was based on. A monoline's business can be seen as, basically, selling an AAA credit rating to a municipal bond issuer. However, the credit rating agencies had a separate 'rating scale' they used for municipalities vs corporations. Some argued that if the ratings agencies had rated the municipalities on the same scale they rated corporations, that the municipalities would have been rated much higher to begin with, and thus there was no real need for bond insurance. The question was debated before congress in 2008, at the House Finance Committee under Barney Frank. Richard Blumenthal, the attorney general of Connecticut, Ajit Jain of Berkshire Hathaway, Eric Dinallo of the New York State Insurance Department, and a Moody's representative were also in attendance. Moody's disputed their view.

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, as opposed to municipals, bond insurance is a 'pure credit' business which does not take advantage of tax-induced market anomalies. The insurer seeks to insure credits with little 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 or other anomalies.

Monoline history

1960s - the precursor - Moral obligation bonds

In the 1960s, John N. Mitchell (of later Watergate fame), created the idea of a 'moral obligation bond', when analyzing the affordable housing problem. It enabled municipalities to issue debt without a vote of the people, based on the idea that the government would 'pledge' the 'intent' to repay the bonds if they defaulted. Moral obligation bonds were outlawed in 1976 after they were blamed in part for the New York City financial crisis of the 1970s.

1970s - 1990s

The first monoline insurer, American Municipal Bond Assurance Corporation (now AMBAC), was formed in 1971 as an insurer of municipal bonds. Municipal Bond Insurance Association (now MBIA) was formed in 1973.The companies sought to help regional public administrators get better access to cheaper funding.

By 1980, about 2.5 percent of long-term municipal bonds were insured.

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.There was a high risk that people who had bought NYC municipal bonds would not get their money back, but at the last minute a deal was made with the city's labor unions that saved it.

In 1983 the Washington Public Power Supply System defaulted on $2b of revenue bonds from a troubled nuclear power project . The 30,000 bond holders lost between 60 and 90 cents on the dollar.

In 1989 New York State Article 69 prevented property/casualty insurance companies, life insurance companies, and multiline insurance companies from offering financial guaranty insurance. A cited rationale was to make the industry easier to regulate and ensure capital adequacy. The monoline industry claimed that it had the advantage over multilines of sole focus on capital markets. Thus the 'monoline' insurers, who dealt only in one line of business in theory, took over the municipal bond insurance market.

In 1995 the New York State Insurance Department enabled the monolines to write insurance on Guaranteed Investment Contracts. GICs were supposed to be 'stable' investments that insurance companies had sold, largely to pension funds from the 70s and 80s. With an insured GIC, the monoline would pay out in case the original insurer failed.

In the late 1990s, the percentage of bonds that were insured rose to about 50%.

1990s - 2000s - CDOs, derivatives, and 'structured products'

By 2002 over 40% of municipal bonds were insured, often by a procedure involving payment of a single premium at the purchase of the bond. But this was not enough for the monolines. They had been moving to diversify and grow. Municipal bond insurance was becoming a 'commodity'. See for example the 1994 Businessweek article on MBIA.

At some point the monolines started becoming involved with mortgage-based Collateralized Debt Obligations and other 'structured' financial products. The involvement especially grew in the mid 1990s. They were involved via 'Financial guarantee policies' and 'Credit default swaps', which insured parts of certain CDOs.

By the early 2000s, the CDO market (especially mortgage-backed CDOs) was growing quite large. The monolines began to become involved in more and more of these deals, typically by selling Credit Default Swap protection on the CDO tranches. This was at the same time that more and more of the CDOs were being based on subprime mortgage debt. This business became a large contributor to the monoline's growth during the period. The total outstanding amount of paper insured by monolines reached $3.3 trillion in 2006. This contingent liability was backed by approximately $34 billion of equity capital .

Bill Ackman, of Gotham (and later Pershing Square) hedge funds, grew increasingly suspicious of the viability of one monoline in particular, MBIA. He dove into their company reports and their business model, and subsequently shorted their business by purchasing credit default swaps on MBIA corporate debt. He also released reports to the public and tried to bring the problem to the attention of government regulators and other corporate executives. He was largely ignored.

2007 Subprime Crisis and Credit Crunch

Main article: 2007 subprime mortgage financial crisis

No monoline insurer had ever been downgraded or defaulted prior to 2007 .

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 ninefold rise in the cost of protecting debt against default. Bond insurers had 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 lent their high credit ratings to securities issued by others in return for a fee.

When the housing market declined, defaults soared to record levels 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. Monoline insurers posted losses as insured structured products backed by residential mortgages appeared headed for default.

On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth . 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.'  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 . Finally, on December 19, it was downgraded to CCC by S&P.

The following month, on January 18, 2008, Ambac Financial Group Inc's rating was reduced from AAA to AA by Fitch Ratings. 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 . Credit default swap markets quoted rates for Monoline default protection more typical for less than investment grade credits. 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. New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market. 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  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 19, 2008 Moody's also downgraded Ambac and MBIA from Aaa to Aa3 and A2 respectively.

The stock prices for the publicly traded monolines, like AMBAC and MBIA, fell dramatically. AMBAC had climbed from the teens in the early 1990s to a price of 96 in 2007. By mid 2008, it was trading at around 1 dollar, and by the end of 2010 it was trading at 10-13 cents. MBIA had a similar fate: climbing to the 60s by 2007, but by 2009 trading at about 6 dollars.

2009 and beyond

In 2009, the New York State Insurance Department introduced several new regulations regarding credit default swaps, CDOs, Monolines, and other entities involved in the financial meltdown. These regulations were described in the document entitled 'Circular Letter No. 19 (2008)'.

It is extremely important to note that Circular Letters have frequently been used by the New York Insurance Department to attempt regulatory actions. In fact, a Circular Letter is no more than an opinion of the Department, and cannot be used as the legal basis for a regulatory action. Only New York Statutes and regulations adopted following the Administrative Procedures Law of New York can be used as the basis for department enforcement actions. An attempt to use a Circular Letter as the basis for an enforcement action has been ruled a violation of the New York State Constitution by the Albany Supreme Court.

In 2010, the Wisconsin insurance commissioner took over the credit default swap contracts of Ambac, with the plan to pay about 25 cents on the dollar to the 'counterparties' that are owed.

In 2009, Berkshire Hathaway got out of the municipal bond insurance business.

On November 8, 2010, Ambac filed for Chapter 11 bankruptcy.