Financial guarantee business may not be as healthy as it appears.
Not all financial guarantors are created equal,” says Kevin Kime, associate director of Standard & Poor's International Structured Finance Group. Since early 2000 S&P has led a warning cry against non-monoline financial guarantee insurers, declaring that the insurance industry's traditional approach to claims paying is incompatible with credit enhancement. In the past two years non-specialist insurers have piled into the business of providing guarantees to improve the credit rating of a bond or other security issue by using their own creditworthiness to prop up the rating of the issue, but many of these players don't understand the rules, S&P alleges.
Guaranteeing public-sector bonds and asset-backed securities is a fairly benign business. Issuers such as utilities and municipalities rarely go away, and face far fewer of the potential fatal blows that loom over corporate enterprise. Asset-backed deals have predictable cash flow and solid security. The monoline financial guarantee companies, led by MBIA Insurance Corp and AMBAC Insurance Corp, and their reinsurers, including Enhance Re and ACE Guarantee Re (formerly Capital Re), tend to stick to the sure bets. But two reasons have emerged for a second look at the guarantee business: SoCal Edison and PG&E.
The two shareholder-owned California electricity utilities, properly known as Southern California Edison and Pacific Gas & Electric, have defaulted on capital repayments and interest owed to bondholders. Insurers' exposure is in the order of $1.4bn, but few of the companies carrying the risk will see large losses because of hefty assets backing the loans. However, making good on any shortfall is only part of the guarantors' role. Much more important is the promise of financial guarantors to make principal and interest payments in a timely fashion, despite the circumstances of the insured's default. Years of delay while solicitors argue over coverage and exclusions – a common feature of commercial claims – is not acceptable in financial guarantee business. The capital markets rule is pay now, ask questions later.
Blue chip, monoline insurers were backing the California power companies, and they paid up. The ratings agencies are unanimous in their belief that the default, even against a background of general US economic gloom and worrying increases in defaults on corporate debt, is not likely to lead to major strife for the monoline financial guarantee industry.
“The economic downturn will impact municipalities, but we do not anticipate an appreciable level of default by cities or counties or water distributors,” says Richard Smith, a financial guarantee analyst at S&P in New York. “That's not to say there won't be problems popping up, but we are not looking for wholesale levels of defaults. The marginal credits [issuers achieving less than investment-grade ratings] will be impacted first, but they don't find their way into the bond insurers. Only the good credits that have become weak credits in recent years are likely to default,” he says. For guarantees of asset-backed issues, some consumer loans may weaken, but that has been considered in the underwriting. “All these deals are sized to counter some level of defaults. No one thinks it will exceed the projected worst case.”
Frank Bivona, chief financial officer at AMBAC Assurance Corp, the second-largest bond insurer in the US, explains why. “Our underwriting approach is to assume that there will be significant downturn in economies, and our standards take account of recessions.” Thus he is confident that the coming slump, even if severe, will not cripple his company. “We are not at all concerned about our book of business from that perspective. In fact, downturns tend to be a positive, because the value that our product brings increases.”
So what is S&P's worry? The impact of the behaviour of Lexington Insurance Co regarding its guarantee of two film finance instruments illustrates. Hollywood Funding No 6 Ltd issued $100.7m of notes secured by revenues from a slate of films. Based on Lexington's guarantee, S&P rated the notes AAA. However, on 2 February the ratings agency announced the paper was to be re-rated CCC-, after it learned that Lexington had told the trustee of the bankrupt SPV Hollywood Six that, due to a breach of policy warranties, it is not liable to meet its commitments. Sister company Hollywood Funding No 5 Ltd saw a similar downgrade for the same reasons: Lexington says it will not yet pay a claim, pending investigation, despite lengthy and seemingly airtight language in the policies serving to ensure the insurer has no exit route for claims avoidance or postponement – war notwithstanding.
Lexington hopes to extricate itself from of the guarantee under a precedent set by the decision in the UK case HIH Casualty & General Ins Co v New Hampshire Ins Co and Others. HIH had agreed to make good on claims under an unrelated film finance guarantee even though it suspected fraud on the part of the insured. However, reinsurers refused to follow the fortunes, and the court held that HIH had not been obliged to pay because of warranties in the policy and on the slip which the court deemed to have been breached. Lexington is, so far, refusing to pay based on its assertion that the same policy conditions apply. Both Lexington and New Hampshire are subsidiaries of American International Group.
Lexington's decision not to pay immediately, and the similar decision by New Hampshire in the HIH case, support S&P's assertion that some insurers may be playing in the financial guarantee business without following the rules. “The attitude to writing the business varies quite a lot,” says Corrine Cunningham, a director of S&P Financial Service Ratings. “Some companies are well used to playing by the rules of the capital markets world, and understand what clients and bondholders expect of them. Others may think they are writing conventional insurance business, but in financial guarantee there is no ability to appoint a claims director or to explore whether or not a claim should be paid.”
When one of the ‘dabblers' is a counterparty in a structured credit deal, S&P will seek a written commitment from the financial or managing director of the company's group parent outlining their understanding of the nature of the guarantee they are making – what Ms Cunningham describes as a moral and legal commitment.
“We are trying to raise awareness among investors, the intermediaries structuring the deals, and the insurers themselves... so down the road we do not see insurers facing losses they hadn't planned for, and to ensure the integrity of structured transactions,” she says. “Film finance has been a graveyard. Most of the contracts have incurred losses.”
Rival ratings agents are also concerned. Alan Murray, an analyst with Moody's Investors Services, has noticed the increase in general insurers providing credit enhancement through surety bonds. “We have been concerned. Surety is not quite the same as financial guarantee, but it is being applied to these transactions almost as though it is financial guarantee,” he says. “If we are in a recession, or near one, the insurers' enhancement of non-investment grade bonds could be a question. The real concern we have there is whether general insurers understand the financial risk they are taking on.”
Other guarantee insurance lines, such as for credit derivatives and residual value, have been profitable. Thus interest in the market is growing.
“There is an opportunity for companies to get in because the monoline [financial guarantee] insurers generally only write high-grade credit. The prices are high, and the market is growing very rapidly as banks and other companies try to find new ways to lay off their own risks,” Ms Cunningham says. “Banks have been keen to see other participants as a source of capital, and some intermediaries – banks and brokers – have seen [the multiline insurance market] as naïve capacity, and a way to push off unwanted risk.” The risk for insurers? “These types of risks will tend to coincide, because they are all credit sensitive and cyclical,” the analyst says. “If the US economy starts to suffer, it wouldn't be surprising if credit derivatives and property residual value markets started to suffer, and you might see some of these deals start to unwind.”
Admitting he is “worried about the credit business,” Erwin Zimmermann, chief executive of Swiss Re New Markets, says: “If a general [economic] deterioration happens, we will be impacted.” SRNM classifies roughly one third of its business as ‘credit solutions,' of which the bulk is credit or surety insurance, although a large slice – from about 10% to about 20% depending on which of Swiss Re's GAAP bases is used – is structured credit. However, Mr Zimmermann is comfortable with his company's exposure. “We are prudent underwriters. I don't exclude that the results will worsen, but not to a critical level,” he says.
However, current conditions have changed his approach. “We have got very restrictive now in our underwriting. Credit spreads have gone thin over the long bull market period, and a lot of insurers have probably gone into the business as naïve capacity. We have a pretty intensive business flow with banks, and they unload a lot of their business at terms and conditions that we cannot follow, but they find takers. That worries us,” he says. “Credit risk is a cyclical phenomenon with a significant macroeconomic factor. We have invested very seriously over a long time to get our credit risk management up to the standard of banks, which is not the rule for credit insurers. They consider it a risk class like the other hazard risks.”