Huge losses, downgrades and fears of corporate defaults. If ever there was a case study in the risks associated with a monoline business model, the bond insurance sector has provided it. Helen Yates reports.

“If I was going to be really scathing I would say that the whole monoline business model is effectively relying on everyone ignoring its absurdity,” says Tim Dawson, an analyst for reinsurance shares with Helvea, a stockbroker based in Geneva. Until recently, the bond insurance sector was a bit of an enigma. Rarely reported on, these niche players with their superior ratings quietly went about their business insuring trillions of dollars of debt. Fast forward to the collapse of the US subprime market and everything has changed.

It is clear the current problems plaguing monoline bond insurers hold a wider lesson for the global insurance and reinsurance industry. What the bond insurance failures have revealed are the risks inherent in a monoline business model and the dangers of relying too much on the output of risk and capital models. Financial guarantee insurers had all their eggs in one basket and when the bottom fell out, they were left totally exposed.

Downward spiral
New York governor Eliot Spitzer has called it a “financial tsunami”. The woes affecting the financial guarantee insurers (most of which are based in New York) have been well documented. Hit by substantial losses after the collapse of the US subprime market, many “monoliners” have been downgraded or placed on negative watch by the rating agencies (see table 1). Their capital requirements have also been revised and they now require more funds in order to carry the same level of risk and maintain their credit rating.

The downgrades have led to panic among the customers and investors whose securities the insurers cover. The potential damage could stretch far beyond the insurers themselves. If the securities they cover (or wrap) also lose their “AAA” ratings, many could be liquidated, thus exacerbating the global credit crisis and filtering through to areas that have so-far escaped unscathed. Many anticipate further downgrades, greater losses and even corporate defaults.

“Financial guarantee insurers had all their eggs in one basket and when the bottom fell out, they were left totally exposed

The timing of this is significant. Hurricane Katrina is still fresh in many minds and risk management models continue to be scrutinised. It is a time when the rating agencies are preaching diversification, new risk-based regulation is looming (such as Solvency II) and the industry is extolling the virtues of an enterprise risk management approach. The collapse of an entire monoline sector will make everyone more conservative, predicts analyst Dawson. “They’re going to stick to their knitting now.”

Monoliners in the making
Modern bond insurance began in the US municipal bond market in 1971, when Ambac wrote the first policy. According to the Association of Financial Guaranty Insurers (AFGI): “A bond or other security insured by an AFGI member has the unconditional and irrevocable guarantee that interest and principal will be paid on time and in full in the event of a default.”

With so many of its members – including MBIA, Ambac and XL Capital Assurance – now facing monumental subprime-related writedowns, this pledge is no longer reassuring investors. “The notional value that some of these companies were insuring were so large that effectively if there was ever a systemic problem, almost by default these guarantees would not be worth a great deal,” explains Dawson.

The customers of bond insurers demand bullet-proof “AAA” ratings. In fact, this small group of insurers is the most highly-rated of all financial sectors. In order to maintain them, they are required to only focus on “markets characterised by low probabilities of default” explains the AFGI, hence the term monoliners.

“The collapse of an entire monoline sector will make everyone more conservative

So what happened?
There is tail risk attached to this monoline business model, but until the subprime collapse it was deemed to be very remote. “Did they see this problem coming? The short answer is clearly not,” says an industry source from a global broking firm. No one had predicted that something like the subprime collapse could happen. “The monolines hadn’t anticipated the systemic slowdown and credit tightening. It coincided with such rapid deterioration,” explains Jim Bichard, director responsible for insurance regulatory group at PricewaterhouseCoopers. “It’s easy with hindsight but would you have expected all those things to happen?”

Bond insurers might be extremely well-capitalised, but just a handful of players collectively insure an incredible $2.4trn of debt. “The ratio of capital that the insurance companies hold relative to the debt outstanding has raised some eyebrows,” submits Bichard. Even with a remote tail risk, is this too great an undertaking? “The fiction is that you can take gazillions of dollars of outstanding debt, back it with a $3bn of capital and miraculously transform it onto triple-A paper. It does seem a little optimistic,” is Dawson’s verdict.

While wrapping municipal bonds was all but failsafe (municipalities rarely default on their obligations – the last time was Orange County in 1994 and that was seen as a reminder of the value of bond insurance) the trouble began when the insurers began insuring structured finance. Collateralised debt obligations (CDO) pool together numerous mortgage-backed and asset-backed securities. If the CDO is wrapped by a bond insurer it then takes on the superior rating of the bond insurer.

The reality is that “AAA” ratings were being awarded to CDOs with a high exposure to the subprime market – mortgages and assets owned by low income families with a poor credit history. A rise in interest rates and a mass of consumer defaults later and the value of these “AAA”-rated CDOs suddenly appeared ludicrous. “No one really anticipated quite how extreme these stressful scenarios were or quite how murky these products were,” says Bichard. “It was exacerbated by the lack of information and a lack of transparency.”

“A rise in interest rates and a mass of consumer defaults later and the value of these 'AAA'-rated CDOs suddenly appeared ludicrous

Good bank/bad bank
The broking source predicts many monolines will now go back to basics. “There’s a suggestion that monoline insurers should go back to their roots and concentrate on guaranteeing debt of the municipalities and leave the structured finance alone,” he says. If the bond insurers fail to recapitalise, Eliot Spitzer plans to split the business along these lines. The analogy of “good bank/bad bank”, which harks back to the US savings and loans crisis of the 1980s and 1990s, is now frequently mentioned.

Certainly Warren Buffett has separated the two. In his rescue plan for the bond insurers he has offered to take on their “safe” municipal bond business for a massive 150% premium, but he’s not touching the CDO business. As the broking source puts it: “Warren Buffett is generously offering to take all the good stuff off your hands and leave you with the crap, to which most of them have said: ‘Thanks but no thanks’.”

Bichard doesn’t think it is right to characterise the municipal bond business as the “good” book of business, while structured finance is considered “bad”. “That’s in the eye of the beholder,” he explains. “There’s a reason why monolines expanded into structured credit – it was more profitable.” He predicts that some bond insurers will want to continue playing in that market… if they can.

Downgrades may prevent bond insurers from writing more business. The capital markets insist on superior ratings and will not want to do business with less-than-pristine monoliners. As featured in the December/January edition of Global Reinsurance, the rating agencies themselves are now subject to increasing scrutiny and criticism. “The role of the rating agencies has to be brought into question,” says analyst Dawson, allowing that they are in a difficult position as their downgrades “risk wreaking havoc in segments of the financial system”.

“The calibration of the risk models is still too optimistic

Short memories
Is this all just an isolated bond insurance issue – or are there wider lessons. Certainly, questions surrounding modelling, stress testing and risk management are being asked. The industry’s efforts to diversify since Hurricanes Katrina, Rita and Wilma now seem even more justified. “People have lost confidence in the basic monoline business model,” says Dawson.

Another lesson for insurers and reinsurers are the dangers of relying too much on model output. Dawson points out that severe events, such as the failure of Long Term Capital Management, Russian bond defaults, collapse of the Far Eastern currencies, accounting scandals in 2001 and 2002 – and from a property catastrophe perspective, 9/11 and Hurricanes Katrina, Rita and Wilma – are happening more frequently than the models would suggest. He suggests the calibration of the risk models is still too optimistic. “We all applaud companies for being more rigorous in their approach to risk management but the risk of doing that is that you maybe lose a little bit of your commonsense reality check.”

“Sometimes you have to think the unthinkable. Nobody thought it was a risk that two planes could fly into the World Trade Center,” warns the broking industry source. Bichard agrees. He thinks firms should be doing more stress testing but worries that ultimately memories are short and such lessons can be forgotten. “Hopefully we’ll get through this particular time and the monolines will survive. They will be happy when they go back to obscurity,” he adds.

Helen Yates is editor of Global Reinsurance.

Timeline of bond insurer woes

August 2005 through 2006: Higher borrowing costs start to impact the US housing market. Defaults on subprime mortgages increase.
5 November 2007 - Fitch reveals it will assess the structure finance CDO exposures held by each financial guarantor and that one or more of the financial guarantors may no longer meet its "AAA" capital guidelines.
17 January 2008 - Moody's puts Ambac ratings on negative review after it reveals a $5.5bn writedown.
18 January - Fitch downgrades Ambac and announces rating actions on more than 137,000 securities insured by Ambac.
28 January 2008 - AM Best downgrades XL Capital; says it likely has further subprime exposures.
30 January 2008 - Fitch downgrades Financial Guaranty Insurance Company (FGIC).
31 January 2008 - MBIA reveals a full year $1.9bn loss and writes off Channel Re; reiterates commitment to $2bn capital raising.
5 February 2008 - Fitch puts CIFG and MBIA's "AAA" ratings on watch negative, and announces the next phase of analysis of the bond insurers.
6 February 2008 - Fitch updates its financial guarantee modelling and places Ambac, FGIC and Security Capital Assurance ratings on watch negative.
13 February 2008 - Ambac rejects Warren Buffett's offer to reinsure its municipal bond securities.