Members of a National League of Cities-led commission are advocating a nonprofit, national mutual credit-enhancement company. We agree and are supportive of the commission's efforts and believe their proposal merits serious consideration.

However, last week a senior executive at a major rating agency commented that his agency has not changed its opinion regarding assessing the credit quality of a financial guaranty company. If true, we find this a troubling attitude for the agencies to advocate.

For many years the rating agencies have sought to convince the investing public that each of the bond insurers could withstand their Great Depression-styled "stress test" and be able to pay all claims with money left to spare. We believe the time has come to completely reevaluate their stress-test models and all criteria used to evaluate current and future bond insurers. Only then will the rating agencies be able to begin the process of restoring the trading value of their triple-As.

Prior to the current economic crisis, the worst credit emergency faced by a financial guaranty company was the bankruptcy filing of Baldwin United in 1983. At the time Baldwin United was the ultimate parent company of Ambac, which was then led by Russ Fraser. As Ambac headed into this crisis, Fraser directed a small team of professionals to create the industry's first financial model that would predict how the company's insured book of business would react during a period of high stress mirroring the Great Depression.

The goal was to illustrate that Ambac had sufficient capital and cash flow capabilities to survive the Great Depression with a meaningful margin of safety and without need of additional support from its parent. This model was made public across the country to let policyholders, regulators, and rating agencies know that Ambac-insured bonds were safe. In essence, senior management proved that the company was over-capitalized with respect to its insured book of business.

Since its introduction, each of the rating agencies has created and subsequently modified their own versions of the original Ambac stress-test model to incorporate, among other things, new lines of business such as structured finance, non-U.S. public finance, collateralized debt obligations, credit default swaps, etc. However since none of these new lines of business has ever experienced the ravages of the Great Depression, the rating agency models have required significant assumptions of their performance under stress.

Some can argue that the current crisis has been extraordinarily painful and unprecedented. But at the same time, the fact remains that the municipal bond insurers have collapsed despite over $10 billion of new capital in 2008 and at no time was this collapse foreshadowed by any of the rating agencies' models or commentaries.

In addition to changing the stress-test model, the rating agencies have modified over time the other criteria used to evaluate municipal bond insurers. The amount of capital required to enter the business has grown to at least $500 million, and the perceived motivations of investors is now a criterion. Private equity providers are not considered as good a source of capital as "strategic investors." Two of the more critical criteria used to evaluate a municipal bond insurer are return on capital and franchise value.

We believe those two criteria have little to do with credit quality and more to do with establishing an attractive investment for equity investors. To us, credit quality for a financial guaranty insurance company should be a function of that company's ability to pay and their willingness to pay. The Baldwin United example proved that Ambac had adequate capital and cash flow to survive without need for additional capital from its parent, and demonstrated Ambac's willingness to pay claims.

A mutual-style insurance company is not geared to produce the kinds of equity rates of return demanded by the rating agencies in their criteria. And so, to the extent that the agencies do not modify their criteria to allow for a mutual insurance company, then the prospect of such a company earning a triple-A would seem remote.

HRF Associates has been a strong proponent of a new mutual-styled credit-enhancement company and applauds the efforts of members of the blue-ribbon commission in their pursuits. If properly managed, we believe a well-run mutual insurance company could be successful and provide significant value and much-needed assistance to municipal issuers all across the country. We do believe, however, that there needs to be a much larger capitalization than the levels proposed by the commission specifically as it relates to the entity's single risk capacity.

In summary, we would urge the rating agencies to seriously consider modifying their criteria. We believe new entrants into the municipal bond insurance market are definitely needed and encourage their entrance, especially mutual-styled companies. HRF Associates strongly urges the re-evaluation of non-credit criterion such as return on equity and franchise value from consideration of a financial guaranty company's credit quality.

The authors are representatives of HRF Associates LLC. For more information contact Robert M. Smith at 530-620-7128 or

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