Although financial markets remain in chaos, there’s one clear take-away from the systemic risk re-run: ratings as a determinant of regulation are no more. What’s a lot less clear is what’s to be used instead of ratings. Here, we offer a suggestion: revisit the decades of proven credit-risk absorption by monoline insurers and, despite their recent travails, go back to recognizing that, when capital is at risk, credit risk is reduced. Monoline insurance has historically come in two forms: for municipal bonds and mortgages. As noted, both businesses aren’t at their best at the moment. Indeed, each is experiencing unprecedented stress that challenges its fundamental business model. But, this doesn’t mean that the business model – if done right once again — doesn’t make sense. Put simply, monoline insurance puts a layer of capital between an investor and an investment – the more the capital and the more likely it is to be on hand, the better the insulation from credit risk. So, instead of letting ratings agencies fiddle with their models to cook up something new to beat the regulators, it would make sense to turn to credit risk transfer (CRT). The more robust the CRT based on criteria regulators establish (see below), the higher the ranking for purposes such as risk-based capital, investment eligibility, and the like.
We’ll turn in a moment to how to improve the monoline model. But, first, let’s examine this ratings alternative in light of some of the others that regulators are considering. One of these is reliance on bond or credit default swap (CDS) spreads. The idea here is that markets are efficient and, thus, that they know credit risk when they see it. To say the least, this is uncertain. First, bond spreads remain heavily ratings dependent – just look every day at the market to see how closely correlated ratings are with bond spreads regardless of how wrong the ratings prove to be. The exception, of course, is the slump in T-bill yields after S&P’s downgrade, but we view this as an exception that only proves the rule. Also, bond spreads are deceptive when it comes to smaller issuers – e.g., midsized companies and municipalities. Thus, to rely on them is to disadvantage issuers who otherwise warrant top billing. As for CDS, these are totally traded products based on momentary market expectations about what might happen should a trader be caught holding a CDS. Making regulatory judgments about matters like risk-based capital dependent on trading valuations is like making decisions based on cutting a deck of cards. CDS could be used like monocline insurance, but only if they represent a capitalized commitment to swap the relevant credit risk for cash upon default. Another option bank regulators are considering that the SEC has largely adopted is to require regulated institutions to spruce up their own credit-risk analytics. But, this can be done largely by writing a new book of policies and procedures and, then, using ratings to validate the firm’s seemingly independent results. We view this as dodge ball around Dodd-Frank – ratings requirements are deleted from the rulebook, but only in name and not in fact.
So, back to monoline insurance and other CRT products backed by real capital. How to make them a robust eligibility criterion for top regulatory treatment? The best approach here is to go back to the past, to reinstate what made these CRT instruments true vehicles for moving credit risk from the backs of investors.
First, monoline means monoline. This requires that any CRT product that conveyed regulatory honorifics must be offered by a company engaged in no businesses that could conflict with its claims-paying capacity. If part of a larger firm, the CRT provider must be full insulated from other operations and separately capitalized and regulated, preferably by a regulator who knows something about the business.
Secondly, it would mean that the monoline only takes on one type of credit risk. What brought down municipal bond insurers is that they went from a reliable, conservative business model to a high-flying one – a business model by the way wholly enabled by the rating agencies, which allowed the muni-bond firms to pretend that their coverage for complex mortgage collateralized debt obligations was just like backing a local bond.
Monoline CRT must also be able to honor its claims, even under catastrophic risk. Most importantly, the resolution model for these CRT providers must be based on run-off – that is, continued claims payments even post bankruptcy. Regulation must also require a combination of conservative rules that address issues like capital (including counter cyclical requirements), investment limits to prevent wrong-way and correlated risks, prudent and independent underwriting standards and funding requirements to ensure liquidity is always on hand to honor claims. To execute this regulatory model will require a lot of repair to monoline standards, especially for credit derivatives, but it can be done without fundamental redefinition of the business model and – importantly – its prospective profitability.
Using monoline credit risk transfer instead of ratings is only part of the solution. The business has yet, for example, to take on sovereign debt. This isn’t, though, to say that it couldn’t. Indeed, efforts are well under way in the EU to build a new insurance facility for sovereign debt. The more capitalized, regulated credit risk transfer, the more viable this option becomes to ratings. But, even in a limited way, it’s an important piece of a reformed regulatory system that doesn’t bow to the credit rating agencies and isn’t held hostage to their manifold errors.