Financial Security Assurance may not be out of the commercial real estate woods yet.

A report from Standard & Poor's Corp., while generally praising the company for strides in strengthening its risk profile, warns that FSA's long-standing problems with commercial real estate will continue for the foreseeable future.

In addition to possibly having to increase the loss reserves already established, FSA could face problems with "several" other commercial real estate transactions, Standard & Poor's said in its annual review of the bond insurer, which was published Monday.

Meanwhile, Moody's Investors Service said in an assessment set for release next Monday that large weak corporate credits to which FSA is exposed have the potential for continued deterioration.

Last December, FSA established a $25 million reserve to cover losses expected on commercial real estate transactions and a $15 million general reserve for any other unexpected losses. In addition, FSA set up a $100 million letter of credit with its parent, U.S. West Inc., for commercial real estate problems.

To date, FSA's commercial real estate-related reserves total about $53.4 million, and stem from transactions with Heron International, Universal Hotels, and Tollman Hundley.

Betsy Halpern, managing director of corporate communications at FSA, said the company does not disagree that reserves already set aside for the three deals may have to be increased in 1993. But she said that the rating agencies do not view commercial real estate as a major problem for the company, and focused most of their attention on FSA's "strong capital position and the impact that conservative underwriting and risk management policies have had on our overall insured portfolio."

FSA's AAA rating from Standard & Poor's is not threatened by its commercial real estate woes, but they could depress future earnings, according to Robert E. Green, director in the rating agency's financial guaranty insurance division.

Because of "the volatility associated with [FSA's] commercial real estate portfolio ... attainment of profit margin parity [with its competitors] will take several years," the rating agency's report says.

Some "profit margin compression" will "drag company earnings" as a result of expenses associated with the sector, Green said. He cited such expenses as a $25 million deductible on FSA's $100 million letter of credit, as well as workout, surveillance, and legal costs.

Market sources say FSA is planning an initial public stock offering. But any future commercial real estate problems would hinder the effort, bond insurance stock analysts say.

"Investors will penalize you on the multiple they'll pay on your stock," one equity analyst said. "Clearly, investors seem to be leery of the non-municipal businesses, even if they are good businesses."

However, "it doesn't mean you can't have a successful offering," the equity analyst said. "Look at Enhance [Financial Services]; they worked through some asset quality and commercial real estate problems and had a successful IPO."

One concern with FSA, Green said, is that some outstanding issues have "capitalized levels below net insurance exposure," assuming current levels of cash flow and interest rates remain intact until maturity.

Declining to name specific transactions, Green said that none has "near-term maturities" and all have sufficient cash flows to service debt. "The risk is at maturity," he said. "If the situation plays out so current market rates and cash flows are the same at maturity as they are today, [FSA] may have losses."

If the maturity for a transaction was approaching, and cash was adequate to service debt but the market value was not optimal, FSA could choose to extend the maturity by refinancing, pay off the debt, draw on its letter of credit from U.S. West, or liquidate assets to repay debt, Green said.

In a rising interest rate environment, the strategy of refinancing becomes less viable, Green said, and "the value of cash flow in relation to a higher capitalization rate equals lower property value, resulting in a lower market value."

New loss reserves for these transactions are not expected by the rating agency executive. "[FSA] would argue that if you have cash flow adequate to service debt, establishing a reserve in light of maturities not near-term would be premature," Green said.

"S&P may look at the worst-case scenario, but we don't see additional problems at this time," FSA's Halpern said. "We're closely watching all the transactions, and the vast majority are performing well. At the point we think we have a problem, we're going to take the appropriate steps."

FSA officially exited the business of insuring commercial real estate transactions in February 1992, but the company says it has not insured such a deal in more than two years. Municipal issues now account for 50.9% of the insurer's total net principal and interest outstanding, according to the Standard & Poor's report. Municipals total about 40% of gross par insured, however. The commercial real estate sector totaled $2.1 billion, or 10.1% of FSA's total net insured portfolio at Dec. 31, 1992, the Standard & Poor's report says.

The report says that losses in other sectors industrywide have been "nominal" and "the results from these sectors have validated the soundness of the concept of investment-grade underwriting linked with low-risk sectors."

FSA's weighted average capital charge has declined to 1.7% currently from 3.35% at Dec. 31, 1990. Also, FSA's margin of safety is 1.3 times to 1.4 times, even without considering the U.S. West LOC, placing it "safely in compliance with S&P's standards for AAA-rated bond insurers," the rating agency said.

Aaron Task is a reporter for The Guarantor, The Bond Buyer's credit enhancement newsletter.

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