While the risk of default is remote in the vast majority of asset-backed transactions, the possibility of a ratings decline with a related drop in market value is a real concem.
Transactions whose ratings are based solely on senior/subordinated structuring or cash collateral accounts are vulnerable to downgrade from a number of sources. These vulnerabilities can be eliminated by 100% guarantees from triple-A monoline financial guarantors.
The first vulnerability is asset deterioration. Consider, for example, an 8% subordinate piece on a pool of mortgages. This piece might be judged insufficient to continue to support triple-A ratings if delinquencies and foreclosures were to rise in a recession.
If the same issue were structured with 100% financial guaranty insurance, it would continue to carry the guarantor's triple-A rating regardless of any deterioration in the asset base.
The second type of vulnerability consists of various securitization risks. These risks may be related to legal structure or to performance by third parties such as servicers, pool insurance providers, and swap counterparties. Once again, all these risks are covered by the guarantor in a 100% insured transaction.
Of course, the downgrade protection provided by a 100% guaranty depends on the durability of the triple-A ratings of the insurance company. All monoline insurance companies providing financial guarantees are rated triple-A, something no other industry can claim, and there has never been a downgrade of a monoline financial guaranty insurance company. Monoline Strengths
The recent downgrade of major banks and multiline insurers makes it important to understand the strengths of monoline guarantors relative to other institutions. There are three important distinctions.
First, the investment portfolios of monoline insurers are virtually free of commercial real estate, junk bonds, common stocks, preferred stocks, and other volatile and/or illiquid investments.
Investments are limited to high-grade bonds rated single-A or higher. Recent downgrades of major multiline insurance companies resulted in large part from problems in their investment portfolios.
Second, the nature of a monoline insurance company's guarantee is to pay all scheduled payments of interest and principal when due. This is unlike bank letters of credit, where a default of the borrower results in an immediate acceleration of the bonds, with principal payable by the bank.
It also differs from GIC policies written by multiline insurers, which may be subject to early withdrawals, as in the case of Mutual Benefit Life. As a result, the insurance policies (i.e., guarantees) of monoline insurers do not make the guarantor subject to any liquidity crisis.
Third, the fundamental uiderwriting philosophy of monoline insurers is to identify and avoid loss. This differs from the approach of multiline insurers (such as auto, health, or life), which are in business to accept risk, to measure it actuarily based on historical data, and price their policies accordingly.
This difference is demonstrated by actual case history. Losses of monoline insurers over the past five years were a fraction of those incuffed by multiline insurers (between one-fifth and one-fortieth) and banks (one one-hundredth).
Apart from downgrade protection, the guarantor provides important additional benefits. By simplifying complex transactions, a guaranty improves marketability. Also, the guarantor provides ongoing surveillance and may step in to invoke remedies at early signs of trouble.
PETER E. HOEY Managing Director, Market Development Financial Security Assurance
Peter E. Hoey is managing director, market development, for Financial Security Assurance. Mr. Hoey is responsible for FSA'S activities relating to the sale, syndication, and trading of issues the company insures.
Prior to helping found FSA, Mr. Hoey was senior vice president and manager of the municipal bond department at E.F. Hutton & Co. He also directed Hutton's municipal research department and PAR management, the f irm's tax-exempt investment advisory service.
Earlier in his career, Mr. Hoey served as a national sales manager for municipal bonds at Smith Barney, Harris Upham & Co.. Before entering the securities industry, he was an aerospace consultant.
Mr. Hoey is a past member of the executive committee of the municipal division of the Public Securities Association, a past chairman of PSA'S sales and marketing committee, and has served on several other PSA committees. He also served on the arbitration committee of the Municipal Securities Rulemaking Board.
An honors graduate of Princeton University, Mr. Hoey attended MBA programs at Seattle University and the University of Washington.