Flavors of Insurance, Part VIII (Financial)

Financial guarantee insurers insure creditworthiness in a number of related, but different areas. They insure home mortgages for lenders who accept low down payments. They insure the debt of municipalities, who often find it cheaper to sell insured debt. In structured finance they guarantee the senior-most debt branches of residential mortgage [RMBS], commercial mortgage [CMBS], and asset-backed securities [ABS]. In the corporate credit arena, they guarantee the senior-most debt branches of collateralized debt obligations, and occasionally, single issuer project finance.

There are generally two types of companies in this sub-industry, with a slight overlap of business between them. One group guarantees low down payment mortgages for lenders. The other group engages in the rest of the businesses listed above. Financial guaranty and mortgage insurance are regulated separately from other types of property and casualty insurance. For the most part, companies that engage in these lines of business are specialists, though their continued high profitability is attracting new entrants.

Financial guaranty insurers have a primary function of credit enhancement for the corporate, municipal and consumer credit. In this function, securitization both competes with and facilitates their business. RMBS, CMBS and ABS can be structured as insured deals, or as deals where the senior bonds are protected by subordinated bonds sold to institutional investors at yields appropriate to compensate them for the risk. Even so, insured bonds trade with greater liquidity than uninsured bonds. The financial guaranty insurers are vital to the smooth functioning of structured finance.

The mortgage insurers have faced problems in the recent past. Loss experience on subprime borrowers has been disappointing. There have been bulk loan transactions that have also had poorer loss experience than ordinary transactions that flow one-by-one from lenders. Mortgage insurers are adjusting their pricing to reflect the differing loss costs.

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

There are yet other threats that mortgage insurers face. Fannie and Freddie could get their charters adjusted to allow them to accept uninsured mortgages with lower down payments. Large lenders could decide that they don’t need insurance for loans that they keep on balance sheet. Second mortgages compete with mortgage insurance. Inflated appraisals inflate the true amount at risk to the mortgage insurers. Finally, refinancing makes it difficult for the insurers to retain business on their books.

Aiding the mortgage insurers is the continued price appreciation of housing, which lowers the incidence and severity of claims. Homes are critical to most people who own them; it usually is the last thing that people will miss a payment on. Finally, there are significant barriers to entry for new competitors in the mortgage insurance business.

With the financial guaranty insurers, the issues are different. The amount of leverage is huge; the face amount of debt insured at a AAA financial guaranty insurer can be more than one hundred times greater than their surplus. Financial guaranty insurers underwrite to a zero loss tolerance. In other words, every transaction is expected to produce no losses; anything less than that would make the ratings agencies downgrade them severely.

Balance sheet complexity is large in terms of the many contingencies insured. Remember our phrase “too smart for your own good risk?” That may apply here. The rating agencies consistently affirm that these insurers are AAA, but we will argue that the rating agencies are co-dependent with them. The financial guaranty insurers indirectly generate a lot of revenue for the rating agencies. If an insurer begins to slip, initially it would pay the ratings agencies to delay the recognition of that, and work with them to lower leverage; the damage to the ratings agencies and financial guarantee insurers from a downgrade of a financial guarantee insurer to less than AAA would be huge. It would throw into question many of the fundamental underpinnings of the structured securities markets. It would also lead to turbulence in the AAA-only portion of the fixed income markets, which are quite large, but can’t deal with any degree of uncertainty.

Against this, the financial guarantee insurers have the following big advantage: they only guarantee the timely payment of principal and interest of obligations. If it is to their advantage to pay off the obligation immediately, they will do so. If it is to their advantage to string out the payments, they can do that as well. In a time of financial stress, the financial guaranty insurers can pay off claims slowly, and reduce the writing of new business, which would allow them to delever rapidly.

The twin engines of the rise of structured finance and low down payments on mortgages amid a rapidly growing housing market have fueled the performance of this sub-industry. The stocks in this industry have performed well. Valuations today are not outlandish, but they are kept low by the concerns that we have listed above.

In general, we believe that the future will be more risky for this sub-industry than the past. Both engines of growth will be slower in the future. In addition, the mortgage insurers have to contend with borrowers that are reliant on the low interest rates on ARMs in order to continue making payments on their homes. Consumer credit is overextended, and that will affect the loss experience on RMBS and ABS.

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Bringing it to the Present

I wish I had screamed louder.  Yes, I told the party line story back in 2004, but I tried to highlight the risks involved.

When I went to work for Hovde, I had a hierarchy of trust for reserving:

  1. Life
  2. Personal lines / Health
  3. Commercial Lines
  4. Reinsurance
  5. Title
  6. Financial

Financial insurers and mortgage insurers have proven less than sound.  They are just another example of what happens when leverage collapses.

As a bond manager, I never trusted the rating agencies on structured finance.  I wanted my AAA bonds to be AAA without support.

The financial insurers were too critical to the system.  We needed them to work.  That should have been the signal that something was wrong.  When something has to work, we are in big trouble, that is a sign that things are out of balance.

As it is now things are broken, and we are in an intermediate state where we are waiting for guarantors to be created.  The system needs third parties to take risks for pay.