The recent downgrade of American International Group and doubts surrounding some MBIA credit derivatives trades are leading to renewed pressure for monoline insurance companies to put collateral behind their trades. But, some officials argue this would mean monolines would be taking on market risk, in addition to credit risk, and this might dry up the liquidity they bring to the market.
Over the last couple of years there has been a move toward using collateral, even between highly rated counterparties, but monolines have largely avoided this requirement. The International Swaps and Derivatives Association estimates USD1.2 trillion of collateral is in circulation, an increase of 20% over last year's figure.
Hao Wu, managing director of global structured products at Radian in New York, explained the purpose of the monoline is to take credit risk and it is able to do this by paying claims as they occur. Posting collateral will mean the insurers are also taking market risk, because if the mark-to-market value of the instrument falls the insurer will have to post more collateral. Wu argues this will increase the liquidity risk to monolines unless the monoline charged more for the service and invested the extra premium in short-term assets. This may, however, reduce the appetite for monoline guarantees.
One solution, could be for the monolines to launch derivatives operating companies that could go long and short risk and therefore net positions. In credit derivatives, for example, monolines only sell protection, but some officials argue that if they could also buy protection then they would receive collateral and could use this to post collateral against the positions they have sold. The operating vehicle would be able to achieve a AAA rating if it was separately capitalized from its monoline parent and ringfenced, noted rating agency officials.
James Crabb, global head of collateral management at Deutsche Bank and European co-chair of ISDA's collateral committee, said, "I would expect those counterparties that don't post collateral today, to post collateral in the future." He added, however, that this is not particularly on the back of the AIG downgrade it is more of a general trend in the entire derivatives market. In addition, he explained that as dealers move from ratings driven collateral matrices to zero or minimal risk threshold collateral support annexes the counterparties rating is of less importance.
Thomas Abruzzo, managing director at Fitch Ratings in New York, said monolines having to post collateral would be a real concern to the way they are rated. He explained that the monoline needs to maintain its resources to pay defaults as they occur rather than assign them to specific trades.
