Monoline insurance

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Monoline insurers (also referred to as "monoline insurance companies" or simply "monolines") guarantee the timely repayment of bond principal and interest when an issuer defaults. They are so named because they provide services to only one industry. ^[1]

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 range from municipal bonds and structured finance bonds to collateralized debt obligations (CDOs) domestically and abroad.

Insurance regulations prevent property/casualty insurance companies, life insurance companies, and multiline insurance companies from offering financial guaranty insurance. The monoline industry claims that it has the advantage over multilines of sole focus on capital markets.^[2]

[edit] History

The first monoline, Ambac Financial Group Inc, was formed in 1971 as an insurer of municipal bonds. MBIA Inc was formed in 1973. ^[3]

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 a very small 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 after years of financial mismanagement^[4]; in 1983 the Washington Public Power Supply System (WPPSS) defaulted on $2b of revenue bonds from a troubled nuclear power project ^[5].

Under New York State's Article 69, passed in 1989^[6], 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^[7].

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. ^[8] This contingent liability is backed by approximately $34 billion of equity capital ^[9].

[edit] 2007 Subprime Crisis and Credit Crunch

Main article: 2007 subprime mortgage financial crisis

No monoline insurer had ever been downgraded or defaulted prior to 2007 ^[10].

In 2007, amid a housing market decline, monoline insurers suffered losses from insurance of structured products backed by residential mortgages. Defaults soared to records 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.

On November 7, ACA, the only single-A rated insurer, reported a $1B loss, wiping out equity and resulting in negative net worth ^[11]. 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.' ^[12] 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 ^[13]. Finally, on December 19th, it was downgraded to CCC by S&P ^[14].

The following month, on January 18, 2008, Ambac Financial Group Inc rating was reduced from AAA to AA by Fitch Ratings.^[15] 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 ^[16]. Credit default swap markets quoted rates for default protection more typical for less than investment grade credits. ^[17] 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^[18]. New players such as Warren Buffett's Berkshire Hathaway Assurance entered the market^[19]. 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.

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 ^[20] 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.