Earlier today, you received an in-depth FedFin forecast of the challenges confronting credit-risk insurance. We undertook this work not just because of our longstanding focus on mortgage and municipal-bond insurance, but also because it poses a pressing question: can capitalized credit-risk transfer products bring private capital back to U.S. residential mortgages and/or muni bonds? So far, mortgages are wards of the state and muni bonds are on their own, and not doing so well thereby, despite their critical importance to state and local governments. So, forecasts for these products and their key competitor – credit derivatives – pack both immediate franchise impact and long-term implications for two critical financial sectors. What did we find? First, that the basic business model of credit-risk insurance doesn’t just make sense; it’s also increasingly important given capital constraints across financial markets. Second, because of the damage done in the run-up to the crisis, traditional insurers are at great risk of being supplanted by big banks – the flip-side of the shadow-banking fears that normally draws our attention.

First, to what we found about private mortgage insurance (MI), financial guarantee insurance (FGI) – the broad moniker for this sector, and credit derivatives. The paper provides a detailed update on the status of each, focusing in particular on the attrition in MI and FGI providers as the financial crisis progressed. This results from factors assessed in the report, several the result of – my view – grievous failures in the regulatory model in the run-up to the crisis. These were most egregious in FGI, where state insurance regulators left insurers to stray from their muni-bond mission to back high-flying instruments like mortgage CDO-squared structures even as these assets – granted AAAs based solely on FGI insurance – were held in large amounts in their own investment books. This was correlation risk writ large – FGIs offered insurance based on presumed capital even as their capital was betting big on the same types of assets the insurance purported to cover. Worse still, use of FGI resulted in the aforesaid AAAs, meaning that market demand for it on speculative structures became rapacious. When things went bad, the immediately-apparent inability of FGIs to back their claims created a major driver of systemic risk, exacerbating the 2008 downward cycle. In its wake, most FGIs are gone or barely holding on, leaving muni finance largely to fend for itself as fiscal problems press hard for new avenues to global financial markets.

MIs are still here, with new entrants as recently as last week proving the viability of the sector. However, older players are either gone or licking big wounds, leading regulators and investors to discount its value. And, if private MI doesn’t have value as meaningful insulation from mortgage credit risk, why bother? These days, the Federal Housing Administration stands ready to provide the same coverage, doing so at prices lower than private MIs think sound with a full-faith-and-credit guarantee against which no one can compete.

Is it any wonder that marketshare migrates to the FHA? And, as it does, a premise of private MI – premium income from new business that buttresses claims-paying ability – comes undone, further weakening MI now and undermining faith in its long-term future.

MI’s problems aren’t just because FHA is eating its lunch – undue risk was taken in the run-up to the crisis. But, the catastrophic-reserve capital structure backing private MI – unique in credit-risk transfer, to our knowledge – finds it hard to withstand the lethal combination of old risk and new government competition.

Which brings us back to credit derivatives. These have also taken their knocks in the crisis, but regulators still stand by them. The reason isn’t so much that credit default swaps (CDS) and similar instruments have paid their claims – many CDS holders are traders who lack any capacity actually to handle credit risk. Rather, credit derivatives are the strongest players in a weak sector.

First, the systemic risk resulting from any call on the CDS bluff has been averted in cases like Greece by complex debt restructurings largely engineered by regulators precisely to prevent defaults that would then trigger CDS. Second, a series of reforms are now under way in credit derivatives designed to cure the systemic risks posed by these “naked” counterparties. As required by Dodd-Frank and other global rules, credit-derivative counterparties will need to trade on central counterparties (CCPs) or back their bets with real capital.

Will this be enough to give credit derivatives the edge over credit-risk insurance? It shouldn’t be when the two regulatory regimes and the capital they require are stood side by side. Even post-reform, CDS counterparties will either be uncapitalized or hold far less against their obligations than demanded for MI and FGI.

The real benefit credit derivatives get is that the products are offered by banks and bank regulators set the rules for global finance. Thus, calling the weaknesses in this market for what they were and still are requires an even far larger rewrite then the contentious one slowly moving forward. Bank regulators might like this, but they know it won’t happen and, at the least, reforms here are under way and, perhaps even more important, under their own control and that of fellow regulators they trust in the securities and derivatives arena.

In sharp contrast, global regulators have little confidence in the insurance construct for MI and FGI. In the U.S. – where virtually all of this industry is based despite its global reach – state insurance regulators govern. That means that fifty states and the District of Columbia set the rules – often different ones under supervisory processes very different from the bank-examination model. Much in the state prudential standards failed to take financial risk – particularly legal, liquidity and operational ones – into account, hoping that robust capital rules would do the trick (which, as noted, they didn’t). Worse still, these sectors are also exempt from the state guaranty associations that handle resolutions when an insurer fails, meaning that policy-holders for MIs and FGIs have no recourse if the insurer falls short.

And, why does anyone want credit-risk transfer protection? First, it’s to have a credit-risk backstop – that’s why use of MI is mandated for Fannie Mae and Freddie Mac and, before the ratings agencies went wild, higher ratings went with MI and FGI. Second – and, now especially important – it’s to get lower regulatory capital for mortgages or muni bonds. Under tough capital constraints, banks – key markets for these assets – need this credit insurance to take on new risk. Which brings us back to bank regulators. Distrusting MI and FGI, they are unwilling going forward to distinguish assets with this protection from those without it. Absent this recognition, who would pay for MI or FGI?

So, how to get it again? The sector needs a new regulatory model, one the FedFin paper takes a first crack at constructing. Federal regulation is a first criterion so that policy-makers are held responsible for uniform standards developed in concert with fellow federal and global agencies. The lapses in the current prudential model need work even as the benefits of the capital one need touting. From this, we see a major new role for credit-risk insurance – if it lives to tell the tale.