The monoline bond insurance industry is at a critical point. Many have fallen over, and although many have managed to commute their CDS exposure to the worst assets, or reinsured their portfolios, doubts remain as to whether they will ever be able to do business again. Only a handful have limped through and look likely to survive the large deterioration in the credit quality of structured finance, and these will face a whole new set of challenges to survive.
Monolines will have to persuade investors that have watched almost the entire industry implode and seen once triple-A rated wraps become effectively worthless that monoline credit enhancement is still worthwhile. Legacy monolines with structured finance exposure will also have to compete with new companies set up to go after the US municipal bond market.
"Things will change," says Stanislas Rouyer, senior vice president on Moodys financial guarantor team in New York. "The stress weve seen in the financial guarantee industry, and the uncertainty, is likely to create a need for alternatives, if there are such alternatives. Its hard to go back to an industry that saw such tremendous stress without being a little nervous."
Return to munis
Only Assured Guaranty looks like it will survive the crisis more or less unscathed in terms of business structure. Those others that are not teetering on the brink of run-off have been forced to restructure their businesses in order to survive. MBIA and Ambac have announced plans to split their structured finance and municipal insurance businesses. But third parties have thrown up obstacles which threaten to scupper even these last ditch moves. Furthermore, the spin-off municipal guarantors will face competition from new insurers coming in hoping to take up some market share.
Ambacs Everspan and MBIAs National Public Finance Guarantee Corporation will be competing with Municipal and Infrastructure Assurance Corporation (MIAC), a Macquarie Group and Citadel Investment Group joint venture, as municipal-only bond insurers.
However, MBIA, which has advanced furthest in splitting a municipal-only bond insurer from its main insurance arm, has been hit by a lawsuit by 18 structured finance policyholder banks, who argue that the split deliberately left the structured finance arm undercapitalised.
Ambac is trying to set up a municipals-only subsidiary, but has been delayed because of rating agency concerns over its separateness from the parent.
"Ambacs plan to restart its municipal business appears dead in the water," said CreditSights in a report published in May on the monolines first quarter results. The rating agencies have indicated that a minority investment from an independent third party would help its case.
Ambac said in its results that it was in discussions with external parties about a possible investment in Everspan.
If they can overcome these obstacles, the municipal-only insurers may do fairly good business in the near term there is still some demand and a limited number of suppliers of municipal insurance. Assured Guarantys market share of the US public finance new issue market was 10.5% in April this year.
Arlene Isaacs-Lowe, a senior vice president in Moodys financial guarantor team, estimates monoline penetration in the US municipal market to be about 10%-12% in the first quarter of 2009, down from around 50%, or even 60%.
Yet there are concerns that a municipal-only insurer, while looking like the only way forward for businesses in an industry scarred by its overexposure to structured finance, will not be able to make a decent return on capital once spreads become closer to their historical levels.
"In a normalised market its difficult if youre just going to be in the municipal business, because its difficult, if the market normalises, to earn a good enough rate on the amount of capital you have to commit," says Rob Haines, strategist at CreditSights in New York. "There will be very slim margins and you have to have a lot of capital dedicated to it. Right now you can get some pretty good prices because there arent a lot of players out there that can sell a wrap on these things, so Berkshire Assurance is able to come in there and cherry pick some attractive deals, but once we have a normalisation in the credit markets the margins you will earn will be very low.
Assured Guaranty and FSA will have to be able to do structured products. The municipal insurance business is a steady earner and low risk, but theyll have to go into structured finance insurance, because if not they just wont earn the margins to make an attractive business they should just go and do something else."
One way around the problem would be for municipals-only businesses to be run effectively on a not-for-profit basis.
"It also speaks to what may be the motivation of the investors in the recent structures or the new entities that may pursue this business," says Isaacs-Lowe from Moodys. "Theres been some press about the mutual financial guarantor, Issuers Mutual Bond Assurance Co, thats being proposed by The National League of Cities. The profit motivation may be very different for a company that may be publicly owned or that have private investors attempting to maximise profit, versus a mutual insurance company that is owned by a range of municipalities across the country."
However, monoline bond insurance is not the only way to reduce costs in the muni market some new form might be found to replace it.
"You could see some more CDOs of municipal bonds, not a form of credit enhancement as such, but more as a form of increased liquidity for the market," says Rouyer. "People could just pool these municipal securities in a way that is cost-effective as providing liquidity and hopefully for the market, possibly narrowing the credit spread on some of the exposures."
Structured finance insurance what for?
The ratings agencies have now downgraded all but the very strongest monolines. None of the monolines rated by Moodys are rated triple-A.
"Our current assessment of franchise value given recent changes in the operating environment tends to fall in the single-A to double-A range for the best positioned financial guarantors," said Moodys in a special comment on the monolines industry issued in November last year. It later downgraded Assured Guaranty and FSA to Aa2 and Aa3 respectively.
And now that the monolines have all lost their triple-A ratings, the demand for credit enhancement could be reduced on the structured finance side. One of the main motivations for having monoline insurance on some structured finance transactions during the boom years was for regulatory capital arbitrage. With a lower guarantor rating, the capital benefits are greatly reduced.
"I think the whole market is going to be migrating towards a lower ratings standard," says Rob Haines. "I dont think any insurance company should have a triple-A, because theyre in the business of underwriting risk and youre inherently exposing yourself to potential fat tail events, and I dont think that job involves a triple-A rating."
However, some market participants are confident that, when structured finance issuance comes back, there will be a demand for credit enhancement regardless.
"There may be less use of financial guarantees for regulatory capital arbitrage, but investors will still look at the probability of possible default, and do they want to take a 30 year exposure to a single source or do they want to manage risk by taking insurance?" says Sabra Purtill, managing director, investor relations and global communications at Assured Guaranty in New York. "Bond insurance is often used for new assets. If an investor is looking at a new deal, particularly if they were burned in this crisis, theres a point where they say, for x basis points, I can get insurance. We want to emphasize that our product is insurance, not just credit enhancement for regulatory capital purposes, but insurance. Principal and interest payment default insurance."
Another potential issue is that structured finance issuance, when it comes back, is likely to be conservatively structured and in the more traditional, safe asset classes. Perhaps investors will see less need for a guarantee on such safe products.
"The core business for financial guaranty has been the US public finance market. In structured finance weve always been more tied to the emergence of new asset classes," says Purtill.
But again, insurance serves a purpose to facilitate issuance and liquidity in the market.
"What the wrap does for investors is that its an overly onerous task to have analysts continuously digging through each of these deals," says Haines. "If youre a buy side shop and you buy a lot of these things, then you should be doing that work but you need some sort of standardisation and some kind of framework that will allow for distribution at a real time speed as opposed to you put together a securitisation deal and you have to wait for five or six weeks for your analysts to get a handle on it."Even the monolines like Assured Guaranty who have managed to come out of the crisis on top are facing searching questions over whether they will be able to continue as successfully as before. Although in the near term municipal-only businesses look to do well, it would be unwise to say that the monoline insurers can afford to walk away from structured finance for good. The question is whether the structured finance industry wants them back.