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.
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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.
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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.
If,
(BC) x (CDS) / (RP) = (FC)
and therefore,
(FC) / (CDS) x (RP) = (BC)
then,
Brisk = FGrisk
where,
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.
Summary
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.
Showing posts with label Economics. Show all posts
Showing posts with label Economics. Show all posts
Sunday, January 30, 2011
Friday, December 31, 2010
The Global Imbalance
Sure there are lots of imbalances in the global economy. But one is more pervasive and persistent than any other. Let me ask you: are emerging markets net exporters? The U.S.? We know the answers. So why? Here's the answers we've heard ad naseum: the U.S. has lost its drive, it's become bloated or slowed by entitlements, taxes, bureaucracy, demographics, over regulation and under regulation.
OK sure. But why would emerging countries, the have-nots endlessly give developed countries more goods than they receive? Not for just for any money. For dollars of course. Perhaps, in focusing on net export imbalances we are analyzing the symptoms and not the disease.
Said another way, one could view the situation not an under production in the US but an over investment. That's right those proletariat types are at it again. Now they are forcing us to into deficit-financing! But why? Law and order. Institutions and property and contract rights. Emerging markets are importing the security of the U.S. system (and military might) when they bring in dollars.
Looking at investments from within the U.S. or a highly developed country, emerging market investments are a no brainer. Look at the growth potential! But consider the inverse. Looking at the U.S. and developed nations from the outside, surrounded by unstable governments, heirarchical non-pluralist bureaucracies, rampant inflation, large criminal organizations, and otherwise lacking and untested law, order, and institutions, well from that point of view, I'ld like a helping of dollars please... and seconds if nobody minds. This is the type of logic that leads me to view capital flows as the tail ever so slightly wagging the net exports dog.
Well all I do here is post diatribes of varying length, but now its time for something really tangential. Both pre- and post- world wars rounds of globalization have been marked by a convergence of institutions. As a communist Deng Xiaoping would have said, we are all just trying to catch mice. In so doing, we seek the best mouse trap (or cat). When the best is found, who wouldn't want to use it? I'ld like the best whether it's black or white, capitalist or communist, 12% risk-adjusted total capital ratios or 9% tier-1 common ratios. Hence, convergence.
Now pretend that I've convinced you that capital flows have an under appreciated responsibility for the persistent net export imbalance. The security of the dollar (and investments in the U.S.) from the perspective of the emerging market based investor is a way of attaining the benefits of the best institutions. Governments that collect dollars attain those benefits as well. Of course, the effect of having a mountain of dollars doesn't replace the need for a proper political-economic systems. Just look at what has happened to Argentina since WWII. Dollars are more of a compliment and only a very slight substitute for institutions. When things get ugly, a country can to a certain extent buy its way out of a problem that might have also been cured by better institutions.
China for example could deal with a currency troubles by preemptively taking 'institutional' actions such as allowing for partial market adjustments and limiting public and private sector borrowing in foreign currency and taking dollar actions in accumulating trillions in reserves.
So far this post has nothing to do with financial guarantee. I can change that with a violent turn. Our institutions are strong. One could argue that U.S. contract laws are its most predictable. For that reason, JP Morgan, Barclay's and myself think their is no reason to even consider the viability of challenges to the MBIA/Nat'l PFG split given the clarity of Article 78. So lets briefly consider the weight of the topic on repurchase litigation. Let's start by way of analogy:
You bought a house with a large basement. You want to flip it. I am a prospective buyer but have worry about termites. I ask you if the house has termites. You say you won't answer, but refer me to various inspectors. You pay the inspectors. When the inspectors come to the house, you tell them it has no basement. The locked door you falsely claim leads only to a broom closet. They find no termites and they tell me the house has no termites. I buy the house. I find termites in the basement, they destroy the house. I sue you. We discover that you hired another, better equipped inspection company three months earlier before you bought the house and they found a massive termite infestation. You used that to negotiate a lower price on the house. You are guilty of fraudulent conveyance. You owe me restitution.
Strong property laws determine that the results of the above example will not change easily. They will not change if we switch the roles of you and me or you and Bank of America and me and MBIA. They will not change due to incorporation. They will not change if it is a house and termites or mortgages and bad credit, inspectors or rating agencies and Clayton, or a basement or underlying loans. And they certainly will not change if you promised to recompense me for termite damage or repurchase non-qualifying loans as the case might be. (B of A argued that fraud claims against them should be dropped because the claims against them were for failure to perform contractual agreements. Their motion was dismissed.)
If I were a defendant in such a case and realized that I was going to lose, then I would come to the table with private investors who could probably only actually cooperate in a suit if they saw huge payoffs. I would show I was willing to talk by dropping other loosely related and weak suits. Defendants have recently done these things.
The value of strong contract law supersedes the financial health of any individual, natural or corporate. Even in a closed economy, predictable property rights and contract laws encourage investment, entrepreneurship and thus growth in prosperity. Yes, somehow I just argued that that the same factors that drive persistent net exports are going to lead to a windfall for financial guarantors. I hope you found it titillating. Perhaps we can flush out the latter part of the post a bit more in future. Tata.
OK sure. But why would emerging countries, the have-nots endlessly give developed countries more goods than they receive? Not for just for any money. For dollars of course. Perhaps, in focusing on net export imbalances we are analyzing the symptoms and not the disease.
Said another way, one could view the situation not an under production in the US but an over investment. That's right those proletariat types are at it again. Now they are forcing us to into deficit-financing! But why? Law and order. Institutions and property and contract rights. Emerging markets are importing the security of the U.S. system (and military might) when they bring in dollars.
Looking at investments from within the U.S. or a highly developed country, emerging market investments are a no brainer. Look at the growth potential! But consider the inverse. Looking at the U.S. and developed nations from the outside, surrounded by unstable governments, heirarchical non-pluralist bureaucracies, rampant inflation, large criminal organizations, and otherwise lacking and untested law, order, and institutions, well from that point of view, I'ld like a helping of dollars please... and seconds if nobody minds. This is the type of logic that leads me to view capital flows as the tail ever so slightly wagging the net exports dog.
Well all I do here is post diatribes of varying length, but now its time for something really tangential. Both pre- and post- world wars rounds of globalization have been marked by a convergence of institutions. As a communist Deng Xiaoping would have said, we are all just trying to catch mice. In so doing, we seek the best mouse trap (or cat). When the best is found, who wouldn't want to use it? I'ld like the best whether it's black or white, capitalist or communist, 12% risk-adjusted total capital ratios or 9% tier-1 common ratios. Hence, convergence.
Now pretend that I've convinced you that capital flows have an under appreciated responsibility for the persistent net export imbalance. The security of the dollar (and investments in the U.S.) from the perspective of the emerging market based investor is a way of attaining the benefits of the best institutions. Governments that collect dollars attain those benefits as well. Of course, the effect of having a mountain of dollars doesn't replace the need for a proper political-economic systems. Just look at what has happened to Argentina since WWII. Dollars are more of a compliment and only a very slight substitute for institutions. When things get ugly, a country can to a certain extent buy its way out of a problem that might have also been cured by better institutions.
China for example could deal with a currency troubles by preemptively taking 'institutional' actions such as allowing for partial market adjustments and limiting public and private sector borrowing in foreign currency and taking dollar actions in accumulating trillions in reserves.
So far this post has nothing to do with financial guarantee. I can change that with a violent turn. Our institutions are strong. One could argue that U.S. contract laws are its most predictable. For that reason, JP Morgan, Barclay's and myself think their is no reason to even consider the viability of challenges to the MBIA/Nat'l PFG split given the clarity of Article 78. So lets briefly consider the weight of the topic on repurchase litigation. Let's start by way of analogy:
You bought a house with a large basement. You want to flip it. I am a prospective buyer but have worry about termites. I ask you if the house has termites. You say you won't answer, but refer me to various inspectors. You pay the inspectors. When the inspectors come to the house, you tell them it has no basement. The locked door you falsely claim leads only to a broom closet. They find no termites and they tell me the house has no termites. I buy the house. I find termites in the basement, they destroy the house. I sue you. We discover that you hired another, better equipped inspection company three months earlier before you bought the house and they found a massive termite infestation. You used that to negotiate a lower price on the house. You are guilty of fraudulent conveyance. You owe me restitution.
Strong property laws determine that the results of the above example will not change easily. They will not change if we switch the roles of you and me or you and Bank of America and me and MBIA. They will not change due to incorporation. They will not change if it is a house and termites or mortgages and bad credit, inspectors or rating agencies and Clayton, or a basement or underlying loans. And they certainly will not change if you promised to recompense me for termite damage or repurchase non-qualifying loans as the case might be. (B of A argued that fraud claims against them should be dropped because the claims against them were for failure to perform contractual agreements. Their motion was dismissed.)
If I were a defendant in such a case and realized that I was going to lose, then I would come to the table with private investors who could probably only actually cooperate in a suit if they saw huge payoffs. I would show I was willing to talk by dropping other loosely related and weak suits. Defendants have recently done these things.
The value of strong contract law supersedes the financial health of any individual, natural or corporate. Even in a closed economy, predictable property rights and contract laws encourage investment, entrepreneurship and thus growth in prosperity. Yes, somehow I just argued that that the same factors that drive persistent net exports are going to lead to a windfall for financial guarantors. I hope you found it titillating. Perhaps we can flush out the latter part of the post a bit more in future. Tata.
Monday, December 20, 2010
The economics of the firm called RAM
This is a reinsurance company in runoff. They have 1 employee. They issued reinsurance contracts to share in insurance contracts. Those insurance contract guaranteed bonds, debt contracts. Some of those debt contracts are backed by other debt contracts such as mortgage contracts. Some of those mortgage contracts are warranted to meet certain representations in seller/servicer contracts.
The firm has over $19B Net Par Outstanding of guaranties, a $330M investment portfolio, about as many contractors as I have fingers and David Steel.
I'm not sure if Nexus really captured the essense of this one. Maybe Easterbrook/Jensen/Meckling should have gone with "cluser ****" of contracts.
(I'm not being critical, I just think it's a fun idea.)
(I'm not being critical, I just think it's a fun idea.)
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