Moody's Investors Service plans to announce a 5% capital charge against bond insurers' guaranteed investment contracts, a level significantly higher than company executives had counted on when they began writing such business two years ago.
The rating agency has not made any official announcement, but insurance executives privately confirmed that they have received notice from Moody's that the charge will be 5%. The rating agency had never officially stated its criterion, but the industry had been writing the contracts, known as muni GICs, under the assumption that Moody's charge was 1%, market sources said.
The presumed 1% benchmark stemmed from an article published by Moody's in 1993 that said that AMBAC Indemnity Corp.'s muni GIC subsidiary, AMBAC Capital Management Inc., was sufficiently capitalized at 1%.
Because of the varied way the insurers' muni GIC units are structured and run, one bond insurance official suggested that Moody's criterion is "still under refinement," and that the 5% charge would be used as a base, not an absolute.
Insurance officials said Moody's decision to settle on a higher requirement for the amount of capital they must set aside for each GIC transaction has far-reaching implications.
First, a 5% criterion raises questions about the pricing of existing contracts and whether the firms already involved in the business will change their approach. It also could alter the strategy of other insurers considering a move into the investment contracts business, industry participants said.
And, most importantly according to some sources, the criterion could cause the insurers to rethink plans for diversification into other lines of business, particularly swaps, because of the higher costs associated with the new capital requirements.
Because of the sensitive nature of the relationship between the insurers and the rating agencies -- their de facto regulators -- industry officials were reluctant to speak openly about the issue.
Several insurance officials said they never expected Moody's capital charge to stay at 1%, suggesting that the rating agency was "waffling" on the criterion even when it was first outlined.
Laura Levenstein, vice president and assistant director at Moody's, declined to comment.
When Moody's first announced the 1% charge, the agency told the industry it would prevail" `as long as people run the business the way they say they will,' "one insurance executive recalled.
That explanation prompted concern among some insurance officials that the Moody's criterion was not set in stone.
But the agency's decision to set the capital charge at 5% is more stringent than many market participants expected, and has the most immediate impact on AMBAC Indemnity Corp. and Municipal Bond Investors Assurance Corp.
AMBAC ushered in the industry's participation in the muni GIC business when it unveiled AMBAC Capital Management Inc. in October 1992. At the end of the second quarter, AMBAC's unit had $2.0 billion of muni GICs under management.
Taking into account an incremental 4% charge because of the higher criterion means that Moody's has hit AMBAC with an immediate $80 million charge for those contracts in its capital adequacy model.
"That's not insignificant, but I don't think it's sufficient to change a rating," said an official from another rating agency who asked not to be identified. "If we were to do something that would raise AMBAC's capital charge by $80 million, it would not break the bank."
At June 30, AMBAC had a qualified statutory capital base of $1.2 billion.
MBIA rolled out its muni GIC subsidiary, MBIA Municipal Investment Management Co., in late summer 1993. The unit had $1.3 billion of muni GICs under management as of June 30.
The muni GIC subsidiaries pay municipalities a guaranteed rate of return with their respective bond insurance parents issuing a surety bond on the contracts, guaranteeing full payment of principal and interest to muni GIC buyers and securing triple-A ratings for the contracts in the process.
Profits are derived from the spread between the guaranteed rate offered by the insurers and the investment rate they can obtain on the money paid for the contracts.
But the contracts written by MBIA and AMBAC thus far were priced under the assumption that the capital charge would be 1%, not 5%.
"The fact that you thought you're going to be in the municipal GIC business at 1% and now the benchmark is 5% is pretty significant," said one bond insurance executive. "Given the fixed price [on the contracts], when you multiply the capital charge by five your return goes south."
Neither AMBAC nor MBIA officials would comment on the criterion, or how it will affect their approach to the muni GIC business.
An affiliate of Financial Guaranty Insurance Co., FGIC Capital Markets Services Group, offers a similar product but is isolated from the bond insurance firm in the GE Capital hierarchy. GE Capital, FGIC's ultimate parent, provides a guaranty on investment contracts offered by FGIC Capital Markets Services Group, freeing the insurance company from having to take exposure to the products.
FGIC Officials also declined comment.
Adding to the ambiguity is the fact that Standard & Poor's Corp. has yet to unveil its criterion for muni GICs, although market sources expect it to be released soon.
Standard & Poor's is "very close to finalizing a capital charge" for municipal guaranteed investment contracts, said Robert Green, director at the rating agency, adding that "we expect to see the capital charge to range from 3% to 5%."
Standard & Poor's views the charge as a "dynamic one," Green said, "recognizing that the risk characteristics and liabilities can change over time. If a company should pursue a higher-risk strategy, then the capital charge could change going forward."
Fitch Investors Service is "continually reviewing the [muni GIC] business to assess capital adequacy," said David Litvack, vice president at the rating agency. Litvack would not say whether Fitch has a specific capital charge on the business.
Not only will the Moody's move affect insurers' GIC business, it could also impede their plans to expand into other markets such as derivatives, industry sources say.
Reports have circulated in recent months that the larger bond insurers are interested in creating subsidiaries that would offer issuers interest rate swaps. In July, AMBAC Indemnity Corp. announced the formation of AMBAC Financial Services Ltd., which will engage in such activities.
But the rating agencies have yet to unveil their swaps criteria, which are expected to be more stringent that those for guaranteed investment contracts because of the risks inherent in the derivatives business.
Because Moody's capital charge is going to be stricter than originally expected, insurance officials are privately concerned that the criteria for swaps will be so restrictive that it may preclude the firms from participating in the business as currently envisioned.
"We'd all love to be in the municipal swaps business," said one insurance executive. "But I can't imagine what numbers they'll come up with for swaps and other derivatives. My sense is now that people will be a lot more cautious."
