Certain concepts in the bond insurance industry are being treated as gospel by municipal participants without the support of empirical evidence or common sense. These concepts are: Increased market share means increased profits; the greater the market share, the stronger the product; and market share equals success. When analyzed objectively, these assumptions generally prove false for any industry, but especially so for the long-term business of insuring municipal bonds.
Over time, the bond insurance industry will prove itself no different than the vast majority of businesses. Assembling cars, selling computers, or mortgage lending may appear to have nothing in common with selling 20year guarantees. But appearances deceive. Focusing on market share would appear to be a smart way to grow a business. For a bond insurer, it means having a larger book of business, a modicum of prestige, and something tangible to show the owners. For a carmaker, it is much the same: More cars sold means a potent advertising angle or an impressive slide show at the annual meeting. As long as a company can show growth, everything else will take care of itself, the argument goes.
The problem is that, over time, the market-share strategy may be self-destructive. A recent study compiled by professors at the University of Pennsylvania's Wharton School and Case Western Reserve University's Weatherhead School demonstrates clearly that concentrating on "competitor-oriented" strategies is a flawed way to go. Especially if a company is in the business for the long haul.
The study compared two kinds of strategies -- market share and profitability -- and it extended for a remarkable span of 35 years, from 1947 to 1982. It concluded that two-thirds of the market share-oriented companies did not survive, while 100% of the "profit-oriented" companies survived.
Let's return to the carmakers. "The Big Three" wrote off upstarts Honda and Toyota in the early 1970s. GM, for example, was devoted to taking market share from its historical rivals Ford and Chrysler. We all know the end of this story.
It is abundantly evident that size alone does not guarantee long-term achievement, excellence, or survivability. On the contrary, the WhartonWeatherhead study points out that size did nothing for National Steel and American Can. They're history. Such empirical evidence, unfortunately, has a way of being ignored. For example, Fitch Investors Service recently published a report extolling size as critical to a bond insurer's viability and prowess.
In the early 1960s, San Francisco-based Bank of America was the biggest in the
world; it was profitable, efficient, technologically and financially innovative. By the mid- 1980s, it was nearly extinct. At IBM, it was only 10 years ago that the firm was at the summit of the expanding computer industry. The Fitch criterion, untested by the passage of time, certainly didn't apply in these cases.
Bond insurance is uniquely suited to long-term analysis and various survivability tests because municipal guarantees themselves can extend beyond a quarter of a century. It is short-sighted, then, to concentrate on the size of an enterprise or its current market share when its business is longterm viability.
Following are some key credit criteria which identify a bond insurer's long-term prospects:
*Efficiency of operations:
Profitability depends directly on cost management and quality product. The less productive a firm becomes, regardless of its size, the shorter its horizon of survivability. Consequently, firms like GM or IBM, which refused to acknowledge that size could be a liability, are destined for painful business contractions.
Adequacy of pricing: Pricing policies must be adhered to, to ensure that rate-of-return goals are kept firmly in sight. Bond insurers must keep one eye on returns in 2014, not just the third quarter of 1994, because they have to pay the "opportunity" cost of capital. Every single risk a bond insurer takes on is backed by a corresponding capital allocation, and that allocation stays intact for the entire duration of the respective guarantee. So the price at which insurers obtain new business is crucial to long-term financial health.
* Quality of risk: The credit characteristics of the bonds being insured are paramount and should be viewed from a similar long-term perspective. Will the debt issuer grow stronger or weaker in the next 10 or 15 years? Have potential changes in the social and political landscapes been factored into the decision to insure? These and other key questions must be answered.
The above criteria are also key determinants of growth in book value and return on employed capital. Moreover, if looked at closely, they tend to run counter to the simplistic "bigger is better" theory. Hard facts show that (a) survivability depends on profitability, and (b) market-share strategies, in effect, have resulted in two out of three companies going out of business in the post-war era.
This latter point cannot be overemphasized because market-share thinking is diabolically seductive. The Wharton-Weatherhead study points out that the resulting self-destruction is nearly unconscious: "It is not simply that there are many people who are so competitively oriented that they will sacrifice profits to be No. 1. Information on a competitor's performance alters many managers' decisions, thereby reducing profits."
The "monoline" insurance industry is very young. It cannot escape the same laws of finance and psychology that apply to the rest of the business world. The industry should not forget this corporate history, for it cannot afford to repeat it.
Michael Djordevich is chairman and chief executive officer of Capital Guaranty Insurance Co.
