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.

Investors were happy to invest in securities with such 'enhanced' credit scores. Issuers were also happy as bond insurance is a much easier way to higher credit ratings, at an acceptable cost. Bond insurers were the happiest as they made hefty profits which insurers of other risks could only dream of.

For many years, bond insurers limited themselves to underwriting securities issued by municipalities. In fact, in the early days, they were not allowed to underwrite any other risks and hence came to be known as 'monoline' insurers.

This is a practically risk free business, as municipalities in the US rarely default. Though their finances are almost always stretched to the limits, they raise taxes when the situation gets out of control and avoid payment defaults. The low risk of default helped the bond insurers to underwrite more than a trillion dollars worth of municipal bonds, with a low capital base.

All was well until the bond insurers got bored with the steady, though lucrative, business. To add some spice to their business, some of the insurers decided to underwrite derivative securities like CDOs, which had become a rage with investors. They also started offering protection to the diverse bond portfolios held by institutional investors. In other words, banks and other large institutional investors could get their investment holding insured against defaults or credit downgrades of the bond issuers. This helped the banks to avoid marking their portfolios to market and making provisions whenever the credit scores of the bond issuers deteriorated.

By nature, the underlying assets - mortgages, corporate bonds and other credit obligations - of these securities are much riskier. Ideally, insurers of such securities should have higher capital base to cover the risks. But the bond insurers didn't expand their capital base, as the credit risk was perceived to have been well spread across a diverse pool of mortgage borrowers and corporate bond issuers.

As we now know, that was a dangerous assumption to make - not just by the bond insurers but also by almost everyone involved in the credit markets. As the CDOs deteriorated in value, claims on the insurers increased. They started posting losses and their capital base shrank. That is when the credit rating companies decided to take a fresh look at the AAA ratings assigned to these bond insurers.

How bad can it get?
If the insurers are downgraded, or fail, it can get really bad. Securities and portfolios that are now 'perceived' to be 'protected', and hence safe, will have to be written down. That could trigger off another wave of huge loss provisions by banks, running into billions of dollars. Total outstanding securities underwritten by the major insurers are estimated at over $2.5 trillion, of which more than half are municipal securities. Estimates of potential losses vary from $10 billion to as high as $200 billion.

More than the potential write-offs, it is the possibility of further tightening of the credit markets that is scaring regulators. Credit availability is already tight for many classes of borrowers and it will become worse if banks and bond investors suffer more losses. That could worsen and extend the US economic recession, which looks increasingly likely. Municipalities and other public bodies in the US, which rely heavily on the bond markets for funds, will be the hardest hit, delaying public investment programmes that could help the US economy recover from the present slump.
 
Auction-rate securities muddle
Until recently, even experienced credit market players were unlikely to have been familiar with short-term municipal debt, commonly called auction-rate securities. This relatively obscure segment of the credit market suddenly attracted attention when yields more than doubled to 20 per cent, in recent weeks. Even then, there were not many buyers for such bonds issued by even the best-run municipalities.

Auction-rate securities are yet another type of innovative instruments invented to satisfy both bond issuers and investors at the same time. Bond issuers like municipalities require long term funds, which cost more, and would be thrilled if they can bring down the cost closer to short-term rates. There are many investors ready to invest in municipal bonds, but are not very comfortable with the long maturity periods.

To reconcile these differing needs of bond issuers and investors, a system of regular auctions for short term securities were introduced - hence the name auction-rate. Under this system, municipalities issue securities that pay lower rates than comparable long-term debt. These bonds are auctioned every week so that investors get a liquid instrument, which, from their perspective, pays more than short-term bank deposits or treasury notes. For issuers, these securities are like short-term credit, which gets rolled over every week from one set of creditors to another. Market for such securities ballooned to over $300 billion.

The only potential trouble for issuers was that, if there were not enough buyers in an auction, the interest rate would be reset closer to long-term rates. When credit markets were healthy, issuers never expected that demand for these securities would dry up. But, that actually happened this month. The reason - investors have become wary of these securities, which are underwritten by the shaky bond insurers.

Regulators are worried because, if the situation does not improve, municipalities and other civic bodies will find it difficult to raise funds. The US state of Michigan suspended a student loan programme after the interest rates on auction-rate securities shot up.

Can the insurers be saved?
Bond insurers can protect their ratings by raising additional capital, sufficient to cover potential losses. The bigger insurers have been seeking capital for many months now and did raise some money from investors. A plan supported by regulators, to get the banks offer additional funding to these insurers has not progressed much as the banks themselves are seeking billions of dollars in additional capital.

If the insurers fail to raise sufficient capital, regulators have threatened to break them up. If the municipal bond insurance business, which is still healthy, can be separated, at least that segment of the market will be protected. The riskier lines covering asset-backed securities can be dealt with separately. One of the larger insurers has already announced a break-up on these lines.

The Buffet proposal is similar, though it does not involve a formal separation. Buffet's Berkshire Hathaway, which started its own monoline insurance business earlier this year, offered to re-insure the municipal bond exposure of major bond insurers. Berkshire's strong balance sheet will protect these securities, even if the bond insurers are downgraded. Buffet's seemingly charitable bail-out offer comes at a very high price - 1.5 times what the insurers charged to underwrite the bonds in the first place. Berkshire's argument is that, the re-insurance will release capital as the insurers will be required to set aside fewer reserves to cover potential claims. Sceptics argue that municipal bonds carry very low risks anyway and Buffet is not willing to re-insure the riskier exposure in other securities.

Whichever option the insurers finally choose, a quick solution is unlikely. They will struggle for a long time before the mess is cleaned up. To make it worse, new entrants like Berkshire will take away new municipal bond business from them.