| Monoline 101 |
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| 10/02/2008 | |
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Allan Nebbou and Sonia Benarouch, ABS and CDO analysts at Natixis, answer this week's questions on monoline insurers. 1. What are monoline insurers? The monoline insurers are insurance companies that provide different forms of credit enhancement to participants in the financial markets. The first enhancements were aimed at guaranteed bonds issued by local authorities. Thus, Ambac and MBIA were established in 1971 and 1973 respectively to guarantee municipal bonds. However, since 1985 these guarantees have also applied to structured products or derivatives such as ABSs and CDSs. According to the AFGI (Association of Financial Guaranty Insurers), out of total guaranteed bonds worth $2300bn, 62% are securities issued by municipalities, while 38% are structured products. In the beginning, this financial guarantee could be supplied by any insurance company, whether it was a "monoline" or a "multiline", but Article 69 enacted by the State of New York Insurance Department in 1989 transformed the industry. This law banned multiline insurers from conducting credit enhancement activities and restricted the activities of the monoline companies, for example by imposing minimum capital levels, eligible investments and individual risk limits. Until recently, the financial strength of the monoline insurers ranged between AAA and A. The best rated among them adhered to professional standards according to which they restricted themselves mainly to insuring securities with a low risk of default. To keep to these standards, they therefore mostly insured investment grade bonds. 2. What sort of guarantees do monoline insurers offer? There is an irrevocable guarantee without conditions, for the repayment of the principal and the payment of the interest on a bond at predefined dates, irrespective of the cause of the issuer's default. In this case the monoline insurer waives the right to claim before redemption. This differs from the multiline insurers whose approach involves a long claim procedure with an unpredictable outcome. Monoline insurers have the possibility of investigating and making claims; however, before exercising this right, they are contractually bound to pay. Moreover, any recourse concerning a guaranteed bond concerns the issuer of the security, not the investor. A guarantee can also take the form of a CDS of ABS. In this case, the investor buys a AAA-rated tranche by the agencies and decides to hedge his risk by arranging a CDS with a monoline. Unlike a standard CDS, a CDS of ABS is generally of the the Pay As You Go type. This means that the CDS behaves in a similar way to the tranche of the underlying ABS. Thus, the monoline guarantees payment of coupons and principal on a set date. 3. What are the monoline's obligations to an investor in the case of a default event? If the fund is unable to make the agreed payments on a given payment date, the investor covered by the CDS requests payment from the counterparty (the monoline). However, in the event of a default event, in certain cases provided for by the structure's legal documentation, the repayment schedule can be revised so that these payments are made not on the payment date but at final maturity of the transaction. Thus, the monoline is not obliged to continue to repay the principal on each payment date. It can repay it on the date of final maturity, which considerably extends the lifespan of the tranche and therefore reduces the discount margin on the security, as the monoline is obliged to pay interest on each payment date. While profiting from the extended payment period, it is penalised by the obligation to pay a coupon until final maturity of the transaction. The consequences of a rating downgrade for a monoline in this type of guarantee are not dramatic for the investor because there is no regular margin call on these products. The consequence is therefore an increase in counterparty risk and thus the creation of rebates or provisions, on account of the increased capital requirement necessitated by the downgraded counterparty. 4. What has been the involvement of monolines in subprime related products? With around $250bn of capital guaranteed for US RMBSs and CDOs of ABSs, the monolines are highly exposed to subprime. In the current environment in which the performance of subprime loans is deteriorating, the monolines must meet their repayment obligations for the defaulting deals, while on the other hand, given changing assumptions for defaults and potential losses, they are obliged to book more provisions. As a result, they need to increase their capital in order to adhere to regulatory ratios and to preserve their ratings, as required by the rating agencies. Fitch's downgrade of Ambac triggered a similar action on some of the ABS classes guaranteed by the monoline insurer. In Europe, Ambac guarantees around €14bn of ABSs. The intrinsic rating of the underlying asset is not generally notified to the public. However, recent statements by Fitch on the downgrades of securities guaranteed by Ambac indicate whether or not this has been affected. European ABS guaranteed by Ambac has also been downgraded on account of Ambac's downgrade. Securities that remain under review for a possible downgrade have not yet affected the rating of the underlying without Ambac's guarantee. |
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Articles of the same Serie : 101 |
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