Good Summary of How the Bond Insurance Business Works

The excerpts below from an article in the WSJ, gives a good summary of how the bond insurance industry works as it applies to CDOs. It also goes over some of the problems that bond insurers currently face with the downgrading of the CDO markets. This post dovetails well with yesterday’s post on bond insurers. Text in bold is my emphasis.

Investors are fast losing confidence that bond insurers, who provide a financial anchor for roughly a trillion dollars in debt, will weather the credit-market storm.

Rising defaults on subprime mortgages and downgrades to bonds' credit ratings are intensifying the fear that insurers of mortgage-related securities will be hit. Bond insurers agree to cover interest and principal payments in the event of default.

The immediate concern is that insurers will need to raise more capital to maintain their triple-A credit ratings. If a bond insurer's rating slips, it could trigger a domino effect of bond-rating downgrades.

At a minimum, investors are concerned that deterioration in credit markets could weigh on insurers' earnings if they are forced to pay out on more losses than they factored into their models. For years, bond insurers were stock-market darlings because of their strong earnings growth.

While the likelihood of insurers' ratings being cut appears remote, "if their credit ratings were downgraded, then the whole industry would go away," said Ann Rutledge, a principal at R&R Consulting, a structured-credit consulting company.

Such a collapse would hurt investors ranging from retirees to banks to hedge funds -- anyone owning debt insured by these financial guarantors. A bond becomes more risky to hold if its insurer is perceived to be weaker.

Historically, Ambac and other bond insurers have been a conservative bunch, insuring mostly municipal bonds issued by state water authorities, public schools and the like. Few such bonds ended up in default over the past 30 years, making the business highly profitable. Like many on Wall Street, however, bond insurers got caught up in the mortgage frenzy and strayed from their roots.

Lured by larger profits and higher growth rates, some expanded their businesses to writing insurance on collateralized debt obligations, which pooled bonds backed by subprime home loans to higher-risk borrowers. Most guarantors insured only CDO securities that had the highest triple-A credit ratings to begin with, and the added protection they provided made the securities more attractive.

Now, with record volumes of subprime mortgages going bad and thousands of mortgage bonds and CDOs, including some triple-A-rated securities, being downgraded, some insurers are in a precarious position.

The values of credit-default -swap contracts they have entered into to insure CDOs must be reflected in the bond insurers' earnings through mark-to-market adjustments, which isn't the case with municipal bonds.

Investors are worried insurers will need to increase their capital levels to support their guarantees on bonds that grow riskier, as required, and to maintain their own high credit ratings.

Tuesday, Fitch Ratings said it will update its analysis of the CDOs insured by guarantors including Ambac and MBIA Inc. to determine whether certain loan pools are likely to be downgraded and how that could affect the insurers' capital requirements. One or more of the guarantors "may no longer meet Fitch's 'AAA' capital guidelines," Fitch wrote in a release.

Ambac insured $29 billion of CDOs backed by subprime mortgages, the most among U.S. guarantors, according to J.P. Morgan research, which expects the company to take a loss of $4.4 billion on that exposure. ACA Capital Holdings, MBIA, Security Capital Assurance Ltd. and FGIC, which is partly owned by PMI Group Inc. also insured sizable amounts of CDOs.

According to Fitch Ratings, guarantors have written insurance on more than $80 billion of CDOs that pooled subprime-mortgage bonds.

"They did it very aggressively, and a lot of it was underwritten in the last few years" when loan underwriting standards were poor, said Thomas Abruzzo, a managing director at the ratings company.

"It's an area of concern because there's definitely been deterioration" in some of the insured CDOs, he said.