Fitch Ratings is revisiting the often-considered but never-implemented idea of giving municipal bond insurers the ability to enhance credits beyond their own credit grade.
The idea was floated in a special report issued March 29 in which Fitch proposed formulating new ratings criteria for rating financial guarantors.
The new criteria shows the agency has become more pessimistic on the industry since Fitch stopped rating insurers in February 2010.
While the agency sees potential for a resurgence of the industry, it called the “natural range” for insurer financial strength ratings “within the 'A’ category … regardless of strong performance on a capital model.”
If applied to Assured Guaranty’s two platforms, Fitch’s ratings would be the lowest of the three main credit agencies. Both platforms are rated Aa3 by Moody’s Investors Service and AA-plus by Standard & Poor’s, though the latter has also proposed new criteria that could slash Assured by a full category.
However, Fitch’s proposal also contains something of a loophole, which, if approved, could be a boon to the market.
The loophole is this: Fitch is considering an alternative ratings approach that recognizes the value for an issuer to boast two payment sources: itself, and the financial guarantor.
That secondary payment source would allow an issuer to receive a credit enhancement that is several notches above what issuers currently receive.
For instance, if an issuer with an underlying rating of A-minus were to receive a credit wrap from an A-rated insurer, Fitch would give the issuer an enhanced credit rating of AA-minus.
That would be a full category upgrade for the issuer, whereas the current model would bestow an A-rating, representing a one-notch enhancement. Fitch would cap the uplift at AA.
Keith Buckley, global head of insurance at Fitch, reiterated in a teleconference Wednesday that the agency is not currently endorsing this alternative model. But he called it intriguing and said it could offer increased transparency and reduced volatility.
“One of the concerns we heard during the financial crisis was that wrapped ratings were generally too volatile … [and] there was not adequate transparency with respect to underlying ratings,” Buckley said. “This alternative approach certainly addresses both of these issues.”
Lisa Washburn, managing director at Municipal Market Advisors, said the seemingly modest proposal, if endorsed, would actually redefine what it means to insure a bond.
She said Fitch’s proposal contains aspects of joint-default analysis, a model commonly used in the letter-of-credit space but not in the insurer space.
In joint-default analysis, both parties are equally obligated on a payment and both would have to default at the same time for the investor to lose money. Because that probability is lower, the agency allows for a rating that is higher than either of the two parties.
But Fitch’s proposal differs from joint-default analysts in one crucial respect — it would allow for the enhanced rating to fall below the insurer’s own rating.
For instance, if the underlying rating were BBB-minus, an A-rated wrap would only enhance it to A-minus, Fitch says in its proposal. That’s still a full category upgrade, but under the traditional model the enhanced rating would be one notch higher. This means that Fitch’s proposal would do away with the credit substitution model, in which the insurer essentially rents out its rating.
“What they are suggesting is that the rating of the insurance isn’t always given full credit in the assignment of the rating,” Washburn said. “It floats with the underlying rating of the bond, likening it more to an enhancement of the underlying rating than standing on its own as a support mechanism.”
Washburn calls it “a redefinition” because, under the traditional model, the enhanced rating spoke to the insurer’s ability to pay claims. But if the enhanced rating can now be below the insurer’s own rating, that’s no longer true.
“It questions the value provided in the insurance,” Washburn said. “Its value is determined based on the credit it is enhancing.”
An Assured spokesperson said the company had no comment on the proposal.