Stagnant insurance laws that don’t allow for needed innovation are preventing a revival of the bond insurance industry, according to executives from the BondFactor Co. start-up.
George Butcher, chief executive at the new insurer, wants to “restore vitality” to the business of wrapping bonds. However, he maintains that New York State legislation needs to be amended first to allow his company to gain market access and add some competition to a monopolized market.
BondFactor is a New York-based outfit created two years ago by public finance people who once worked at Goldman, Sachs & Co. It is currently working on its business model before attempting to raise capital and apply for credit ratings.
Since the bond insurance industry collapsed in 2008, new entrants have struggled to enter the sector. Rating agencies are reluctant to bestow gilt-edged ratings on insurers and private equity has been hard to come by since Warren Buffett created an insurer in early 2008 but then stopped it from writing new policies after deeming the business too dangerous. Standard & Poor’s stripped the one active insurer, Assured Guaranty Ltd., of its lone triple-A rating in October.
The muni bond insurance industry wrapped more than 50% of new volume before the credit crisis. In 2009 the penetration rate fell to less than 9%, and this year it slipped to about 6%, according to Thomson Reuters.
Many industry participants contend that supply is the primary problem, despite the apparent drop in demand. Only one company is wrapping munis these days, and the lack of competition hurts market perception of the product’s viability.
Butcher’s solution to this conundrum is to “modernize” Article 69 of the New York insurance law, which governs financial guaranty insurance.
Article 69 stipulates that bond insurers must maintain a surplus to policyholders of at least $65 million. In addition, they must hold contingency reserves, an amount that varies with the quality and volume of insured bonds outstanding.
Butcher wants the law to allow highly rated assets held in a trust — which would be used to pay policyholder claims — to be taken into account when evaluating an insurer’s capital and reserve requirements.
“Unless the New York State insurance law can be interpreted to permit new, innovative capital structures which address the flaws in the legacy model, the current law will represent a barrier to new competition,” Butcher said at a public hearing held Dec. 21 by the state Assembly’s Standing Committee on Insurance.
Assemblyman Joseph Morelle, who chaired the committee, proposed amendments to Article 69 to the New York Legislature in June, under bill A. 11342. The amendments would allow a bond insurer to use the net value of a qualified trust to be counted among the insurer’s assets with respect to its unearned premium reserves, he wrote in the bill’s memo.
“This legislation would facilitate a novel yet robust method to provide bond insurance to municipal bond issuers using a capital structure involving the acquisition and management of municipal bonds whose debt-service payments secure payments related to defaults on insured bonds,” Morelle wrote.
“This is accomplished through a dedicated trust formed by the bond insurer and approved by the superintendent.”
The New York Insurance Department, which regulates the major players in the bond insurance industry, has spent 18 months looking at BondFactor’s model. It does not oppose the bill.
“We feel it’s something that’s intriguing and could add capacity to the marketplace in a way that would not be disruptive to the market,” said Jack Buchmiller, supervising risk-management specialist at the NYID.
There are some technical issues with the bill that are somewhat inelegant in the context of Article 69, according to Michael Campanelli, supervising attorney at the department.
“We don’t feel they are fatal,” he said.
The BondFactor model is outlined in a patent granted to the company in June 2008. It works like this: the insurer creates a trust with a certain number of pools, and populates each pool with a tranche of insured municipal bonds and a smaller tranche of uninsured munis.
The company sells two positions in each pool — a senior position entitled to the insured tranche and a junior position entitled to the uninsured tranche. The senior positions are comprised of highly rated bonds that appeal to retail and institutional investors; the junior positions are comprised of higher-yielding trust certificates that appeal to institutional investors.
If bonds in the trust were to default, BondFactor would intercept the cash flow from the junior portion to repay the senior portion.
If the junior portion is not enough to compensate the senior tranche, then BondFactor would intercept payments from the junior portions in other pools to repay the senior portion in the pool with the default.
That way, all the senior tranches are senior to all the junior tranches. And no uninsured bondholder in the trust would be paid until all the insured bondholders were paid first.
“Under current New York State insurance laws, the assets that we hold in the trust are not counted for purposes of net equity and capital requirements and reserves of insurance companies,” said Faye Boatright, BondFactor’s chief of issuer marketing. “So what we’d like to see is the laws change to incorporate the fact that you can hold assets in the trust, and those assets can be counted for various insurance purposes.”
The trusts would be managed by an underwriter working with BondFactor to issue the bonds. But the cash flow from these trusts can only be interrupted to pay the senior position holders.
So if the trusts can be counted as claims-paying resources, as the proposed amendments to Article 69 would allow, then the total amount of a company’s claims-paying resources would grow as it insured more deals and issued more junior positions.
BondFactor also would have the usual surplus to policyholders set aside for paying claims. That surplus could be deployed to the insured parties if the flow of cash from the junior tranches was insufficient to pay senior tranches.
If this model sounds wholly different from the existing model, that’s because it is.
Indeed, Sean McCarthy, chief operating office of Assured Guaranty and chairman of the Association of Financial Guaranty Insurers, argues that what BondFactor is proposing does not even constitute insurance.
“As proposed, BondFactor is not a financial guarantee company, it is a structured finance trade,” McCarthy said at the hearing. “They plan to act as an intermediary between hedge fund investors and other equity investors, and the municipal bond market.”
He and other critics of the proposed amendments also question whether flaws in Article 69 played any role in the financial crisis.
BondFactor’s Butcher argues the monoline insurers fell because of a highly leveraged-based capital structure and an overly-competitive market.
The capital structure was based on raising capital in the equity market, he said. When it became difficult to continue making profits amid increasing competition, the monolines began to insure lower-rated municipal credits and venture into the structured-finance market.
The result was that the monolines ended up guaranteeing toxic mortgage-backed assets.
According to the NYID, the monolines have collectively paid out nearly $14 billion on these losses.
“Problems with the mortgage portfolios that backed the [collateralized debt obligations], which the legacy monolines either insured or invested in, led directly to the demise of the monolines industry,” Butcher said during his testimony at the Dec. 21 hearing.
BondFactor claims it would avoid these problems by operating with a leverage ratio of 25:1 — about six times less than existing insurers.
Paul Williams, president of the Dormitory Authority of the State of New York, one of the largest issuers in the muni market, spoke in support of that argument at the hearing.
Williams said the proposed amendments to Article 69 are needed because the financial turmoil “uncovered weaknesses in the financial model of the monolines.”
McCarthy, who works for Assured Guaranty, maintains that Article 69 played no role in the failure of the monolines.
“It was the perpetration of a massive fraud against the financial guaranty insurance industry,” McCarthy said, “by several large financial institutions that packaged defective mortgages into residential mortgage-backed securities.”
That argument is currently winding its way through the courts.
MBIA Inc., which maintains the largest insured public finance portfolio in the business, has been the most proactive player in seeking compensation from loan originators for breaches of warranty and representations.
It is currently involved in 11 court cases alleging that a plethora of financial institutions induced it to wrap asset-backed securities that didn’t live up to stated underwriting standards. It hopes to recover at least $2.2 billion through these cases.
William Fallon, MBIA president and chief executive of its muni-only insurer National Public Finance Guarantee, opposed the proposed amendments to Article 69 at the hearing on grounds that the market should be driving towards transparency and simplicity.
He said new structures using special-purpose vehicles that resemble “a muni CDO” should not be encouraged.
“The bill would allow an extremely complex capital structure for a bond insurer that would likely confuse issuers and investors and undermine confidence in our industry just as we are trying to restore it,” he said.
Fallon called the proposed amendments “intentionally vague and difficult to follow.” He said they are “intended to mirror the structure and vehicles used by one new entrant to the marketplace, BondFactor, rather than to have broad application to existing and any other new possible entrant.”
McCarthy called the proposed amendments troubling because the Legislature would be embedding a patented product into law, thereby creating “a statutory monopoly.”
He proposed that BondFactor relinquish its capital structure patent.
Butcher dismisses these criticisms. He argued that BondFactor’s critics are competitors who don’t want a superior model undercutting their business. The proposed legislation “merely allows assets held in a trust to be counted against capital and reserve requirements,” he said.
That hardly constitutes a threat to the muni market, according to Butcher, who maintains that BondFactor’s patents are necessary so it can gain market access and add competition to a monopolized and underserved market.
The only threat they pose is to existing insurers still operating under a model that imploded during the credit crisis, he said. The patents were granted after more than 10 years of work.
“New competition,” Butcher said, “is never in the interest of an existing industry.”