Upon the release of S&P's recent request for comment on proposed criteria for rating bond insurers, an astonished Mark Tapley looked to the available formal compositions for reference on the matter. He found very little and resolved to think it out himself. So sit back, relax and let The Blue Dragon cure your insomnia... or skip to the end to read the summary.
This post attempts to shed light on leverage as it relates to bond insurance. The discussion focuses on components of the risk premium by way of comparison with banking as that is a more widely understood and accepted practice. An obvious mathematical relationship unveils itself to relate capital ratios between banks and bond insurers. Extrapolating upon that relationship reveals basic, common sense rules for evaluating bond insurers.
Some market participants have observed that bond insurance is an uneconomical business. The usual claim identifies the leverage in the business as unsustainable. As an introduction and to the end of better understanding the historical precedence in which entire sectors of finance are misunderstood, we start with a little history and a definition from Merriam-Webster: "Usury - 1. archaic: interest."
This term once applied to charging any interest at all. Interest has been considered criminal at many different times across a wide range of nations and religions including Islam, Judaism and Christianity. Today, a claim of usury in the Western world would refer to the charging of exorbitant interest rates. The development of this word has followed the development of finance. The modern banking system takes it for granted that interest rates provide a just and proper incentive for entities to lend by compensating for the risks inherent in lending.
That it has not always been so should give pause to those that would dismiss the idea of bond insurance as nonviable. A similar effect should be caused by the history of insurance. Almost 4,000 years ago, ancient Babylonians developed a system as part of the Code of Hammurabi that smacks of debt insurance. In the system, a borrower could pay a premium to a lender for the lender's guarantee that it would forgive the loan under certain circumstances (i.e. the borrowers goods are stolen.) This is the reverse of modern bond insurance. A simple understanding of markets informs us that the premium and risk in such circumstances could be forwarded by the lender to another party. The role of that hypothesized third party is the role bond insurers play today; the present and the ancient display two sides of the same coin.
But history is good for so much preambling. The economics are what count.
The economics of credit risk are a large determinant of the economics of the bond insurance business. The economics of the entire risk premium are a large determinant of the economics of banking. One may observe that the risk premium of a bond can be sliced and diced various ways but there exist three basic components: interest rate risk, liquidity risk and credit risk. These three risks have been separately priced in actual markets. For example, municipal entities have issued bonds in which an issuer bears interest rate risk, banks bear liquidity risk via stand-by purchase agreements and bond insurers bear the credit risk through financial guarantee contracts. The isolation of these three components of the risk premium are not merely theoretical.
A traditional bank exposes itself to all of these risks when lending without credit enhancement, so an examination of that institution behooves an understanding of these risks. A bank funds long-term loans with short term liabilities. The potential for swift withdrawals exposes a bank to liquidity risk above and beyond the contingent demands on liquidity experienced by other market participants. This funding risk is normally benign but spikes during panics, depressions and recessions. The Federal Reserve Bank System was in large part created as a lender of last resort (a role previously played by John Pierpont Morgan, Sr.), to help alleviate the vicious cycles of runs on banks.
On the other hand, a financial guaranty insurance company (an FGI) with a typical capital structure has negligible funding risk. The collateral calls that destroyed AIG Financial Products were an example of funding risk that must be considered when assessing the risks of an FGI. Exposure to mark-to-market settlement and its implication for potential ballooning and acceleration of insurance liabilities should also be considered in the risk profile of a particular FGI. With properly written insurance contracts an FGI faces neither interest rate nor liquidity risk in its portfolio of insured exposures. A well structured FGI then will only face interest rate and liquidity risk in its investment portfolio which is of a size many times smaller than its insured exposure. Importantly, the FGI is not in the business of mismatching assets and liabilities; rather, the FGI optimizes its investment portfolio through some process that balances contingent liability immunization and return on investment maximization.
If we consider all risk to be accurately priced then it is possible to mathematically relate bank capital ratios with those of bond insurers. Specifically, a bank's loan portfolio requires a certain amount of capital to achieve a certain overall risk profile. An FGI exposed to the exact same loan portfolio but through insurance will require a smaller capital ratio to obtain a risk profile equivalent to the bank. The exact relationship between those ratios is mathematically determined by a simple and eloquent formula.
(BC) x (CDS) / (RP) = (FC)
(FC) / (CDS) x (RP) = (BC)
Brisk = FGrisk
BC = the bank's capital ratio
CDS = cost of the credit insurance with negligible counter party risk
RP = the entire risk premium
FC = the financial guarantor's capital ratio equivalent
Brisk = bank's risk profile
FGrisk = the financial guarantor's risk profile
The greatest insights will be garnered from this equivalence when normalized (cycle-neutral) numbers are used. Analysts must be careful in applying the necessary assumptions to obtain such normalization. The formula can be applied to garner information across industries or to particular insurers. In evaluating particular bond insurers, the weighted average components of the risk premium of the particular insurer should be applied.
The sensitivity of the model to the CDS component highlights the sensitivity of appropriate capital ratios for a given risk profile. Intuitively, if the loan portfolio has less credit risk, the FC:BC ratio will be higher at a given risk profile. This can be extrapolated across FGIs that maintain equivalent risks other than the credits in the insured portfolio. (Assuming such equivalent risk maintenance is unrealistic but allows for the following insight. Also, embedded within such assumption is the equivalence of debt service outstanding distribution and present value on the insured portfolio.) With all else equal, consider a low risk FGI taking on one half the credit risk per unit of debt-service insured compared to a base case FGI. The low risk FGI will have an equivalent risk profile to the base case FGI when the low risk FGI insures twice the debt-service as the base case FGI.
The same logic that proves that an FGI will have a higher capital leverage ratio than a bank of equivalent risk, also proves that an FGI insuring better credits than another FGI must insure more credits to reach an equivalent risk profile. Both aspects of this conclusion are intuitively pleasing. They also highlight the importance of the credits being insured.
This has been a very preliminary look at the nature of bond insurance and the credit leverage inherent to the business. Traces of bond insurance are found in ancient history, indicating that the economic benefits of insurance have long applied to credit. However, the actual economics of the business determine its viability and the best methods for assessing the industry. In assessing the risks inherent to the business, certain prescriptions for capital structure and policy writing present themselves. As applied to total capital leverage, appropriate levels can be surmised by a simple mathematical extrapolation from better established capital ratios in the banking sector. Those formulas and that logic can be used to assess capital leverage of particular FGIs and draw conclusions about the FGIs risk profile. Capital leverage ratios are only one component of the risk profile of an FGI. Further consideration regarding the distribution of debt-service insured, credit diversification, capital structure and economic catastrophe is warranted and will be discussed at a later time.