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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 and structured finance bonds to collateralized debt obligations (CDOs) domestically and abroad.^{[citation needed]}

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.^{[citation needed]}

Municipal bond insurance was introduced in the US in 1971 by AMBAC, the first of the so-called 'financial guaranty corporations' (also called 'monoline insurers') to get involved. 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.^{[citation needed]} However, the financial crisis of 2007-2010 negatively impacted the monolines to the point where their continued existence is in doubt.^[1]

Contents 1 Terminology 2 Monoline Insurance 2.1 Major monolines 2.2 Monoline history 2.2.1 1970s - 1990s 2.2.2 1990s - 2000s - CDOs, derivatives, and 'structured products' 2.2.3 2007 Subprime Crisis and Credit Crunch 2.2.4 2009 and beyond 2.3 Taxes and Bonds 3 See also 4 References

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.^[2] The term 'monoline' eventually became synonymous with terms like 'financial guarantors', and 'municipal bond insurers', because in 1989 New York State required all guarantors to be 'monoline' companies, thus banning 'multilines' (companies that insure houses, cars, life, etc.) from that market.^[3][4]

Bonds which are insured by these companies are sometimes said to be 'wrapped' by the insurer.^[5]

Monoline Insurance

Monoline insurers (also referred to as "monoline insurance companies" or simply "monolines") guaranteed the timely repayment of bond principal and interest when an issuer defaulted. They were so named because they provided services to only one industry.^[6]

The benefit for governments was 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.^{[citation needed]}

The 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.^[7][8]

Insurance regulations (specifically, the New York State Article 69, of 1989) prevented property/casualty insurance companies, life insurance companies, and multiline insurance companies from offering financial guaranty insurance. The monoline industry claimed that it had the advantage over multilines of sole focus on capital markets.^[9]

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.^{[citation needed]}

Major monolines

The 'big four' monoline insurers used to be AMBAC (1971), MBIA Insurance Corporation (1974), Financial Guaranty Insurance Company (1983) and FSA (1985). 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). ^[10][11][12]

There were/are also a number of monoline reinsurers, such as Radian, ACE Guaranty Re, and AXA Re Finance.^[13]

Monoline history

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.^[14][15] The companies sought to help regional public administrators get better access to cheaper funding.

By 1980, about 2.5 percent of longterm municipal bonds were insured.^[15]

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^[16] 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^[17]. In 1983 the Washington Public Power Supply System defaulted on $2b of revenue bonds from a troubled nuclear power project ^[18]. The 30,000 bond holders lost between 60 and 90 cents on the dollar.^[19]

Until 1989, multiline insurance companies (companies that sold life insurance, car insurance, home insurance, etc.) were permitted to guarantee municipal and other bonds, in addition to their other businesses. This ended with New York State's Article 69^[20], which banned multiline insurance companies from engaging in financial guaranty businesses (and vice versa). A cited rationale was to make the industry easier to regulate and ensure capital adequacy^[21]. Thus, the 'monoline' insurance companies took over the market for bond insurance.

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. In 1990/1991, several GIC-selling insurance companies failed, causing problems for GIC investors. With an insured GIC, the monoline would pay out in case the original insurer failed. ^[22][23]

In the late 1990s, the percentage of bonds that were insured rose to about 50%.^[15]

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

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.^[24]

The reasons were many, but included the desire to diversify, as municipal bond insurance was becoming a 'commodity'. See for example the 1994 Businessweek article on MBIA.^[8]

By the early 2000s, the CDO market (especially mortgage-backed CDOs) was growing quite large. The monolines began to insure (and otherwise become involved in) more and more of these deals, ^[25] and it became a large contributor to their growth during the period. The total outstanding amount of paper insured by monolines reached $3.3 trillion in 2006.^[26] This contingent liability was backed by approximately $34 billion of equity capital ^[27].

2007 Subprime Crisis and Credit Crunch

No monoline insurer had ever been downgraded or defaulted prior to 2007 ^[28].

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.^{[citation needed]}

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.^{[citation needed]}

On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth ^[29]. 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.' ^[30] 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 ^[31]. Finally, on December 19, it was downgraded to CCC by S&P ^[32].

The following month, on January 18, 2008, Ambac Financial Group Inc's rating was reduced from AAA to AA by Fitch Ratings.^[33] 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 ^[34]. Credit default swap markets quoted rates for default protection more typical for less than investment grade credits.^[35] 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^[36]. New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market^[37]. 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.^{[citation needed]}

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.^{[citation needed]}

Commentators such as investor David Einhorn ^[38] 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.^[39]

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 stayed there for many years. MBIA had a similar fate: climbing to the 60s by 2007, but by 2009 trading at about 6 dollars.^[40]

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)'.^[41][42][43]

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.^[44]

Taxes and Bonds

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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).^{[citation needed]}

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.^{[citation needed]}

See also

• Nuclear Implosions: The Rise and Fall of the Washington Public Power Supply System
• Credit rating agency

References

1. ^ Is Municipal Bond Insurance Dead? by Jeff Rose on August 14, 2009, Good Financial Cents, goodfinancialcents.com accessed 2010 4 15.
2. ^ Association of Financial Guaranty Insurers-Advantages of the Monoline Structure
3. ^ Assured Guaranty corporate website FAQ, access 2010 4 11
4. ^ American Insurance Association FAQ, 2008 Feb (access 2010 4 11)
5. ^ the term 'wrap' is used in the various FAQs and documents referenced in this article
6. ^ Association of Financial Guaranty Insurers
7. ^ Major Player: Bond Insurers, publicbonds.org, accessed 2010 4 15, Corporate Research Project / Good Jobs First. (editor Philip Mattera, writer Mafruza Khan, analyst Kevin Pranis)
8. ^ ^{a b} Ninety-Five Percent Of Our Profits Are Locked In, BusinessWeek: May 30, 1994, Tim Smart, Charlie Hoots
9. ^ Association of Financial Guaranty Insurers Advantages of the Monoline Structure
10. ^ New Bond Insurance Firm, American Capital Access, Insures Its First Primary Market Issue PR Newswire , December 18, 1997
11. ^ BOND INSURERS, publicbonds.org, Corporate Research Project / Good Jobs First access 2010 4 11
12. ^ Bond Insurance , WM Financial Strategies , http://www.munibondadvisor.com , access 2010 4 11
13. ^ Fitch Assigns Negative Rating Outlook to Monoline Reinsurers, Business Wire, July 26, 2002 access 2010 4 11
14. ^ Association of Financial Guaranty Insurers
15. ^ ^{a b c} Major Players, publicbonds.org, Corporate Research Project / Good Jobs First, accessed 2010 4 11
16. ^ New York Daily News
17. ^ Recalling New York at the Brink of Bankruptcy, NY Times, 2002 12 5, Ralph Blumenthal
18. ^ Time Magazine
19. ^ Washington Public Power Supply System (WPPSS), Historylink 5482, By David Wilma , July 10, 2003
20. ^ New York State Insurance Department
21. ^ The Law of Miscellaneous and Commercial Surety Bonds By Todd C. Kazlow, Bruce C. King
22. ^ Circular Letter No. 13 (1995), August 17, 1995,STATE OF NEW YORK INSURANCE DEPARTMENT , accessed 2010 5 1
23. ^ Big Insurers In Struggle Over Ratings, MICHAEL QUINT, 1994 May 16, NY Times, accessed 2010 5 1
24. ^ http://www.securitization.net/pdf/EuromoneyHandbook2003.pdf Collateralised debt obligations and the role of monoline insurers, Iftikhar Hyder, XL Capital Assurance Inc, 2002/2003. Pg 38 and etc.
25. ^ Ambac, MBIA Lust for CDO Returns Undercut AAA Success (Update2) Christine Richard, Bloomberg, Jan 22 2008, accessed 2010 4 29. This article is a very nice overview of the monolines problems with credit default swaps on CDOS.
26. ^ "A Monoline Meltdown?", The Economist, July 26, 2007
27. ^ Association of Financial Guaranty Insurers
28. ^ Association of Financial Guaranty Insurers
29. ^ 8-K at Forbes.com
30. ^ 10-Q at Forbes.com
31. ^ Reuters
32. ^ Forbes.com
33. ^ "Ambac's Insurance Unit Cut to AA From AAA by Fitch Ratings" article by Christine Richard Jan. 19 (Bloomberg)
34. ^ MSNBC
35. ^ Reuters
36. ^ Bloomberg
37. ^ Bloomberg
38. ^ David Einhorn remarks at 17th Annual Graham and Dodd Breakfast, October 19, 2007
39. ^ Moody's Downgrades AMBAC and MBIA, June 19, 2008
40. ^ See http://www.google.com/finance?q=MBIA and http://www.google.com/finance?q=ABK
41. ^ New York to Regulate Credit Default Swaps By DANNY HAKIM, September 22, 2008, New York Times
42. ^ Financial Crisis - Organizations Credit Derivatives, Asset-Backed Securities, Monolines - Past And Future The Metropolitan Corporate Counsel , December 01, 2008, Editor Julia R. Dillon , transcription of October 22, 2008 PLI program, Credit Derivatives and the Credit Crisis, Brian D. Rance & Adam W. Glass
43. ^ http://www.ins.state.ny.us/circltr/2008/cl08_19.pdf STATE OF NEW YORK INSURANCE DEPARTMENT Circular Letter No. 19 (2008) September 22, 2008, RE: “Best practices” for financial guaranty insurers
44. ^ An A.I.G. Lesson From Wisconsin By ROLFE WINKLER and UNA GALANI, Reuters / New York Times, March 25, 2010

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