Bond Insurance scare
18 February 2008
Bond insurers in the US are in a desperate struggle to save themselves from disaster. If they fail, it will be yet another disaster for global credit markets. By Vivek Sharma
Global credit markets struggling to recover from last year's sub-prime meltdown are facing a new scare - potential credit downgrades and even failure of bond insurers in the US. Until recently, the AAA credit ratings of bond insurers were never in doubt as the business was considered to be stable and low-risk. That is no longer the case and stock prices of bond insurance companies have crashed.
New York governor Elliot Spitzer has given the bond insurers' time till this week to find additional capital, or face regulatory action including possible break-up of their businesses. This follows the initiatives taken by insurance regulators to protect the municipal bond market from a meltdown and an offer from legendary investor Warren Buffet's Berkshire Hathaway to re-insure some of the risks underwritten by the major bond insurers.
If these companies are unable to arrive at an early solution to the problems they face, global banks will suffer more losses and credit markets will face further turbulence. To make it worse, the true extent of the bond insurers' troubles is not yet clear.
What do the bond insurers do?
Those who have at least faint memories of an era before 'pre-approved personal loans' would recall that, those days, one of the conditions for getting a loan was a personal guarantee from someone with a better credit standing than yours. This guarantee immediately enhances the borrower's creditworthiness as the lender has 'recourse' to the guarantor, in case the borrower fails to repay the loan.
Bond insurers are similar to these loan guarantors, but they do it for a fee. A civic body like a municipality can issue bonds at low interest rates if it has a superior credit rating. It is also important for issuers to have higher credit rating as many institutional investors have a policy of not investing in lower-rated instruments. But, because of the very nature of municipal bodies and the different methodology adopted by rating agencies, most municipalities find it difficult to get the top credit scores.
Given the propensity of politicians to overspend, finances of municipalities are almost always in a bad shape. Before the advent of bond insurers, the only way for these public bodies to improve their ratings was to strengthen their finances by cutting costs or raising additional funds. After the bond insurance business took off, issuers could get AAA credit ratings simply by getting their bonds insured by a top-rated insurer. It was not very difficult for insurers to get AAA ratings, as long as they had sufficient capital to cover the risks underwritten.
