Bond insurance
From Wikipedia, the free encyclopedia
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.
Government bonds are almost never insured; municipal bond insurance was introduced in the US in 1971, and 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.
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[edit] Major bond insurers
The major bond insurers in the US include AMBAC, CIFG, FGIC, AGC, ACA Financial Guaranty Corp and MBIA Insurance Corporation. [1] In December of 2007, Warren Buffett announced that Berkshire Hathaway, his holding company, would start its own bond insurance company, Berkshire Hathaway Assurance [2][3].
Companies whose sole line of business is to provide bond insurance services to one industry are called monoline insurers.[1]
[edit] History
The first monoline insurer, Ambac Financial Group Inc, was formed in 1971 as an insurer of municipal bonds. MBIA Inc was formed in 1973. [2]
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).
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.
Until 1989, multiline insurance companies were permitted to guarantee municipal and other bonds, in addition to their other businesses such as property/casualty and life insurance.
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[3]; in 1983 the Washington Public Power Supply System (WHOOPS) defaulted on $2b of revenue bonds from a troubled nuclear power project [4].
Under New York State's Article 69, passed in 1989[5], multiline insurance companies are not permitted to engage in financial guaranty businesses (and vice versa). A cited rationale was to make the industry easier to regulate and ensure capital adequacy[6].
In recent years, much of the monolines' growth has come in structured products, such as asset backed bonds and collateralised debt obligations (CDOs), and the total outstanding amount of paper insured by monolines reached $3.3 trillion in 2006. [7] This contingent liability is backed by approximately $34 billion of equity capital [8].
[edit] Bond insurance problems in 2007
No monoline insurer had ever been downgraded or defaulted prior to 2007 [9].
In 2007, amid a housing market decline, 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.
On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth [10]. 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.' [11] 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 [12]. Finally, on 12/19, it was downgraded to CCC by S&P [13].
The following month, on January 18, 2008, Ambac Financial Group Inc's rating was reduced from AAA to AA by Fitch Ratings.[14] 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 [15]. Credit default swap markets quoted rates for default protection more typical for less than investment grade credits. [16] 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[17]. New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market[18].
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.
Commentators such as investor David Einhorn [19] 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. Others, such as bond portfolio manager Bill Gross [20] and hedge fund manager William Ackman [21], have suggested that the monoline business model is flawed and that they have insufficient capital to backstop trillions of dollars in bond issuance. Other analyses indicate that municipal bonds tend to default more rarely than the bond-insurance models would have suggested, and therefore that insurance on municipal bonds was generally much more expensive than the value of the backstop provided by the monolines' relatively small capital cushion.
[edit] References
- ^ Association of Financial Guaranty Insurers-Advantages of the Monoline Structure
- ^ Association of Financial Guaranty Insurers
- ^ New York Daily News
- ^ Time Magazine
- ^ New York State Insurance Department
- ^ The Law of Miscellaneous and Commercial Surety Bonds By Todd C. Kazlow, Bruce C. King
- ^ "A Monoline Meltdown?", The Economist, July 26, 2007
- ^ Association of Financial Guaranty Insurers
- ^ Association of Financial Guaranty Insurers
- ^ 8-K at Forbes.com
- ^ 10-Q at Forbes.com
- ^ Reuters
- ^ Forbes.com
- ^ "Ambac's Insurance Unit Cut to AA From AAA by Fitch Ratings" article by Christine Richard Jan. 19 (Bloomberg)
- ^ MSNBC
- ^ Reuters
- ^ Bloomberg
- ^ Bloomberg
- ^ David Einhorn remarks at 17th Annual Graham and Dodd Breakfast, October 19, 2007
- ^ Bill Gross Financial Times op-ed, February 7, 2008
- ^ Joe Nocera, New York Times, December 1, 2007
