Moody's Investors Service yesterday questioned whether a standalone Aaa financial guarantor is viable.
Developments over the past year in the financial guaranty industry "have ... called into question the extent to which the business fundamentals of financial guaranty insurance are supportive of standalone Aaa ratings," Moody's said in a report.
The dramatic changes in the bond insurance landscape have led Moody's to reevaluate the key characteristics it uses to rate financial guarantors. Moody's has already downgraded six bond insurers - three to below investment grade - and has Assured Guaranty Corp. and Financial Security Assurance Inc. on review for downgrade.
Berkshire Hathaway Assurance Corp. remains the only other insurer rated Aaa by Moody's, but the rating agency has said in the past it would not be rated that high without its guaranty from affiliate Columbia Insurance Co.
"The financial guaranty industry is facing the biggest stress of its 30-plus-year history," Moody's said in the report titled "The Changing Business of Financial Guaranty Insurance."
"The experience of these firms over the past year has provided significant new information about the risks and opportunities inherent in the financial guarantor business model."
Moody's also said that it would be "quite challenging" for a municipal-only guarantor to overcome many of the hurdles it faces to becoming Aaa rated. And although pricing may be attractive now, competitive pressures in the municipal market are what pushed the industry participants into global structured finance products in the first place, the agency said.
"Achieving a stand-alone Aaa rating for a muni-only guarantor would likely be difficult absent its ability to defend against product encroachment, secure reliable access to new funding in stress scenarios, and protect against the removal of capital and risk management resources in a run-off scenario," Moody's said.
FSA has already said it plans to focus only on insuring public finance credits, and MBIA Inc. and Ambac Financial Group Inc. - parents of downgraded bond insurers - have both said they plan to capitalize muni-only subsidiaries.
The Municipal and Infrastructure Assurance Corp. - co-sponsored by Macquarie Group and Citadel Investment Group - also plans to enter the market and will not back structured finance credits.
Although the municipal-only insurers will have advantages over current insurers in some rating categories, such as having a lower-risk portfolio, they will also face issuers and investors who have become "more cautious about relying on the industry."
Insurance penetration has dropped both due to a lack of supply from the downgrades to insurers and a decrease in demand, Moody's said. Demand will exist for the product in the future, but insurance penetration is unlikely to reach its past levels of above 50%, Moody's said.
The municipal market currently discounts the value of almost all insurance except for that provided by BHAC, according to Andrew Clinton, president of Clinton Investment Management LLC. That could change in the long term, but market participants will be more cautious about which insurers they trust, he said.
"In terms of the generic aspect of what the municipal insurance sector used to be where folks used to assign a similar value to every insurer, I think it's going to be more on a case-by-case basis going forward," Clinton said.
The structured finance exposures that have plagued nearly every bond insurer shook the market in a relatively short period of time. Over the past five quarters, bond insurers have accumulated approximately $19 billion in pre-tax residential mortgage-backed securities loss reserves and credit-related impairments on collateralized debt obligations of asset-backed securities, Moody's said.
The turmoil in the market has exposed how sensitive industry participants' franchise values are to changes in their risk profiles. A "fine line" exists between a strong company and one with "limited value" to shareholders, and "even a moderate decline in financial strength may have a dramatic impact on a guarantor's future business prospects," Moody's said.
The credit crisis has also shown the volatility of many insurers' portfolios, in contrast to their historical tendency to have low risk portfolios where any losses were moderate. Exposures to structured finance products in the U.S. housing market have already hit insurers, and other types, such as corporate pooled exposures, "could be susceptible to weakening performance in an economic downturn."
Great volatility also exists when evaluating an insurer's capital adequacy, which must be taken into account even for companies that exceed a given ratings threshold. Moody's said that owners' "incentives for restoring impaired capital positions to former levels will likely be weak in a severe stress scenario."
Moody's also said financial guarantors have less financial flexibility than before the credit crisis. Recent events "no longer support" the belief that financial guarantors would be "extraordinarily motivated" to raise capital when needed and that they would have access to markets to do it.
"While the assessment of financial flexibility varies considerably from firm to firm, it is apparent that even the best-positioned firms could experience a dramatic constriction of financing options if material losses were to be incurred and/or uncertainty about their potential losses was high," Moody's said. "Such sensitivity to event risk and market confidence is typically associated with financial strength scores falling below the Aaa level."