Credo in the Least Common Denominator: Bond Insurance Issuers

The Bond insurance business for beginners
In our view the market was down yesterday because of the bond insurance business.

What is the bond insurance market?
About ten companies (MBIA, AMBAC, FSA owned by Dexia, CIFG owned by Natixis, Radian and a few others) have insured a total of $US 2.5trn municipal bonds and ABS. Roughly 2/3 are municipal bonds and 1/3 ABS (that's roughly US$800bn of ABS). Insuring means that if the bond issuer defaults, the bond insurer substitutes itself to the issuer and pays capital and interests as they are due.

Why does the business exist?
An issuer that is AA or A or BBB rated should in theory issue respectively a bond rated AA or A or BBB, unless it insures it. The issuer pays a premium of say 10-20bps to the bond insurer, the bond insurer collects the premium and commits that it will pay the coupon and interest if there is a default of the issuer. The issuer then saves the difference between the AA or A or BBB spread and AAA minus the premium it has paid to the bond insurance.

How does a bond insurer manage the risk?
The main sources of buffers are
* Over-collateralization, i.e. the value of the underlying assets
exceeds that of the senior tranches that are insured
* Excess spread whereby the coupon paid to the ABS is lower than the
yield on the underlying assets. This creates an additional buffer, the 'spread account'
* The issuer is often required to put equity in the instrument, which
will absorb some of the first losses if subordination is not enough
* Cross-collateralization (sometimes) whereby one bond insured can
collect excess cash flow from another bond from the same issuer
* Reinsurance

Additionally the bond insurers have very small reserves (probably a
combined US$1-2bn)

The bond insurer insures for example 80% of the value of the bond,
such that if the losses are of 20%, the insurer pays nothing. Usually bond insurers have priced in the bond insurance premium assuming that default rates would be say 3-4 times higher than the expected default rates. In total the bond insurance companies have capital of about US$20bn, or less than 1% of the total bond insured. Leverage is therefore significant, and this is really the cushion of last resort. As a result, there have been enough cushions for the bond insurers to rarely have to put any extra money in any bonds they have insured.
Put it in basic terms: 'if the assumed default rate on the assets underlying an insured bonds is of X, there should in theory be enough cushions built in the insurance contract to allow the actual losses to be for example 3 times X (sometimes much more) without the bond insurer losing money. The problem is that the market is starting to wonder whether the default rates could actually exceed the level of 3 times X for example.

What are the problems?
With the ABX and TABX index going down by the day, the default rates on all sorts of securities implied by the price available in the market are
significant: an ABX Index at 20 cents to the dollar for BBB tranches suggests implied loss of 80%. The problem is that the index currently does not reflect a fair value but rather an available price. Because nobody wants the security the price is low. If the default rates implied by these indices were to materialize then the bond insurers would likely be bankrupt. And this is what is causing the markets concern.

What if the bond insurers default?
You could think that it should not matter because they are small companies (we said a combined US$20bn of equity). The problem is that overnight the 2.5trn US$ of insured bonds would reverse back to the rating of the issuer, ie AA A or BBB as mentioned at the beginning. Imagine the impact on the economy of a downgrade of US$2.5trn worth of assets. The current LBO and CDOs write downs experienced by the banks during Q3 would appear very small in comparison to what could happen.
If banks have tens of US$bn losses, this means less capital available with the obvious implications for buy-backs, dividends, and even lending.

Conclusion
What we have described is a very gloomy scenario which we cannot imagine the regulators would allow to happen because of the far reaching economic consequences, but increasingly the market may start to worry about the bond insurance business, not just for bond insurers but for the economy as a whole.
Until the real estate market in the US stabilizes and market participants get reinsured that the buffers built-in are indeed sufficient I would be cautious about banks exposed to the business. This includes Dexia and Natixis (rated Neutral)."