This week, FGIC shuffled off with the parent companies of other monoline bond insurers into the oblivion dictated by a bankruptcy proceeding. The lack of drama attendant to its demise stands in sharp contrast to the systemic risk resulting from the discovery in the fall of 2008 that these seemingly-regulated insurers had bet the farm on complex structured-finance instruments about which they had nary a clue. Shortly before the world came unglued, we looked at one of these firms for a private-equity client, noted a huge book of business related to structured second liens and politely inquired about risk management. We were told that there was no need to worry because the bonds this insurer backed were better than everyone else’s second lien paper. Oops. But, that was then. Now, virtually each parent company of the global monoline bond insurers is in bankruptcy as the municipal-bond market soldiers on. How and why is a critical case study in understanding systemic risk and structuring resolutions to punish only perps, not innocent bystanders.
We think the monoline-bond-insurance events before, through and after the crisis are such an important case study that a full understanding of them should guide policy in the coming deluge of new rules. To that end, we’ll spend time on an analysis of all of this to give clients additional summer reading to fortify them for a vigorous autumn in the policy-making vineyard. For now, we’ll only outline some of the key conclusions we think in-depth analytics will demonstrate. First, it’s important to understand what monoline bond insurance is and to differentiate it from private mortgage insurance (MI), which is also required by state insurance law to be “monoline” – that is, to back only one type of risk. If anyone should be a case study in systemic risk, it should have been the MIs. They back only residential mortgages with high loan-to-value ratios. They thus stood at the front of the line in the nation’s mortgage debacle. Monoline bond insurers (also called financial guarantee insurers or FGIs) seemingly backed only state and local debt, much of which is doing just fine. So, why are most MIs still standing and most FGIs in the dust-bin?
Simply put, the answer lies first in being truly monoline and in – yet again – capital adequacy. Bond insurance was a nice business over the quiet decades on which muni issuers grew to depend on it, but it wasn’t a big earner. As Wall Street waltzed to the subprime serenade in the early 2000s, the bond insurers felt left out with their slow and steady ROEs. So, they kept that business more or less as is, but took their AAAs – yes, there are the rating agencies again – and plunked them on far higher-risk paper. The returns here were dazzling – until they weren’t of course. Private MIs did some dumb things seduced by the same siren song, but nowhere near as many and thus they have suffered nowhere near as much.
The second reason for the difference is capital. MIs have a unique contingency reserve – the type of counter-cyclical capital bank regulators now seek to emulate. Bond insurers had enough capital to sustain their muni business, but not enough at the parent level to handle all the other claims that came their way.
From this, we have a first glimpse of why the bond insurers failed while the MIs survived. Now, on to what one can learn from the parts of the FGIs that failed and those still open for business.
Moral hazard comes from bailing out the un- or under-regulated institutions that get to keep ill-gotten gains in good times and then be rescued under stress. If regulation is appropriate to risk and imposed when this risk touches the innocent – depositors, policyholders and the like – then rescue from on high is right because its costs were initially borne by the regulated entity. Monoline bond insurers weren’t initially structured to ensure a clean break between the regulated entities backing muni bonds and other, highflying activities because state insurance regulators were beguiled into allowing too much integration of all of the not-so-monoline activities at the bond insurers. But, once the crisis began, the states used the powers they had to force the bond part of the FGI from the higher-risk segments and – most important – from the parent company. It wasn’t easy, it wasn’t quick and it wasn’t clean, but it more or less happened.
As a result, we see before us ongoing bond insurance for the state and local bond market – a vital part of the national financial system – and disappearing parent companies. Shareholders and bet-holders of the parent firms are punished and counterparties outside the muni-bond part of the business have also taken big lumps. No tax dollars were used to repair this part of the financial system (although that’s not to say the bond insurers didn’t do their damnedest to get into TARP). This example shows that complex financial firms can be resolved. That this resolution – mostly orderly and much of it through liquidation — was accomplished at all under pre-rescue law is a tribute not only to creative state insurance regulators, but also to the protections that supported the critical parts of bond insurers and sustained private mortgage insurance through unprecedented stress. Understanding what these are and how they worked is vital to distinguished needed new rules from the plethora of those proposed under Dodd-Frank to get the balance between risk and regulation right this time around.