Despite waning demand for U.S. municipal bond insurance, a startup company believes there is value in exporting the credit enhancement model to the world’s emerging markets.
David Stevens, an industry veteran who was the chief executive officer at XL Capital Assurance, plans to launch Affinity MacroFinance, a mutual financial guaranty insurance company, in the second quarter of 2011.
Stevens believes AMF could increase investment in development while securing returns for investors. He is convinced a bond insurer devoted to nascent markets could be more profitable than the monolines ever were. And, he argues, it could be safer, too.
“It’s a business model that failed, but it’s a business model that also worked pretty well for a long time,” Stevens said of bond insurance, which first came into the U.S. municipal market in 1971 when total net par outstanding was just $146 billion.
“If you fixed just a couple of things, you could make it work again and orient it towards these countries,” he said.
The company aims to raise $300 million of capital from socially conscious investors such as government development aid agencies, and believes it could generate up to $12 billion in financings from this capital base in the early years of operation.
AMF has no interest in wrapping U.S. municipal bonds. Instead, it seeks to take an amended version of the monoline business model and apply it to public projects in emerging markets where issuer needs are arguably greater — and where premiums could be higher, too.
AMF’s business model won top honors in March for innovative financial solutions at a competition hosted by the World Bank, the Bill and Melinda Gates Foundation, and the Agence Francaise de Developpement. AMF won $100,000 in cash from the sponsors, who said its concept could “help emerging nations become increasingly financially self-sufficient in their development activities.”
Stevens is known for growing XL Capital — since renamed Syncora Guarantee Inc. — into the fourth-largest municipal insurer in the industry from 1999 to 2004. He said AMF has so far received a $100 million funding commitment from a multilateral development agency, but declined to say which agency, citing legal constraints.
His experience in insuring debt in emerging markets stems from his days as a senior vice president at MBIA Insurance Corp. Beginning in 1990, Stevens built up the firm’s credit and surveillance group, and in the late 1990s he played a role in closing MBIA’s first local-currency infrastructure deal in Latin America.
It was there that he learned how credit enhancement could unlock a virtually untapped source of capital in emerging markets. He believes Affinity MacroFinance could do the same in 77 emerging-market countries.
The idea of launching a bond insurer devoted to enhancing debt in emerging economies first hit Stevens in 1998 on a trip to Chile, which was spending more than $3 billion to upgrade about 1,200 miles of its national toll road system.
The toll road project financing was being done by a private company working in tandem with the government. It had a triple-B rating on the local credit scale and few investors had the appetite to invest in the underlying credit. That group included local pension funds, which held more than $30 billion of pent-up savings but were restricted by regulation to investing in more highly rated credits.
MBIA, then the largest issuer of U.S. municipal guarantees, agreed to insure $150 million of toll road bonds in 1999, which brought the rating on the triple-B credit to triple-A. That allowed local, private pension funds — usually prohibited from investing in long-duration debt or infrastructure projects because of their low credit grades — to become investors.
Bond insurance didn’t just save the borrower interest costs in Chile, as it does in the U.S. It unlocked $30 billion of national pension savings as a source of capital for investment.
In doing so, Chile became the first country in the region to allow pension funds to purchase infrastructure bonds, according to a 2006 study by Javier Santiso, chairman of the Organization for Economic Co-Operation and Development’s Emerging Markets Network.
That step followed a series of reforms that began in 1981 when Chile privatized its government-run retirement system. Further reforms allowed the funds to invest in the stock market in 1985 and international capital markets in 1992.
Each of these developments helped to diversify pension savings away from risk-concentrated central government bonds. By 2002, government bonds represented less than one-third of Chile’s retirement account investments, according to Santiso, compared with more than 70% in Argentina, Mexico, and Bolivia.
The revelation that insuring bonds could unlock a virtually untapped source of national savings, while also serving as a catalyst to stimulate development, convinced Stevens that deals in emerging markets could bring more meaning to his career.
“I saw how powerful this was in these markets,” he said. “Frankly, it had a lot more value there than it did here.”
TARGETING EMERGING MARKETS
Stevens is hoping to sell bond insurance in emerging markets that observe contract law and pass a due diligence test. Eligible countries must have a local bond market and a local-currency pension fund.
The bond market is essential so projects can be funded in local currency, which Stevens believes will dramatically reduce the chance of default.
“We all think of the emerging markets as markets where every five years or so there’s a major market crash,” Stevens said. “And it’s true — these countries did have these meltdowns all the time — but throughout most of the 20th century, these countries were developed using foreign capital.”
Using local currency means revenue from the debt-financed project and payments to bondholders will match. That way, project revenue will never have to be inflated to meet a currency exchange gap.
The pension funds are necessary as a major investment source.
AMF has calculated that 45 of its 77 target countries have accumulated pension savings of $1.1 trillion in local currency.
Rwanda holds the equivalent of $250 million in pension fund cash, and Ghana has $1.5 billion, according to AMF. More developed nations have greater savings: Chile reported $74.3 billion of pension savings at the end of 2008, while Mexico reported $67.7 billion.
In other words, holding capital isn’t necessarily the problem in these countries — accessing capital is.
“The low volume of lending to the private sector in developing countries is not primarily due to a lack of funds in the banking sector,” a 2004 study by the U.S. Agency for International Development reported. Rather, it is “the absence of robust credit markets.”
U.S. banks keep roughly 6% of their deposits in liquid assets and use most of their capital for private loans, according to the USAID study. By contrast, banks in developing countries tend to keep more than half of their deposits in liquid assets and provide minimal credit to the private sector.
The study concluded that innovative ways to leverage private-sector resources — including loan guarantees denominated in local currency — are needed.
Finding ways to boost development in emerging markets is important today due to world economic conditions, Stevens said. The future of investment from developed nations is precarious given the financial crisis and widespread concern to reduce deficits.
“The inflows might stagnate or actually decline, given economic conditions in the developed world,” Stevens said. Bond insurance could encourage greater financial self-sufficiency, he said.
“Most of the development industry is either in the business of giving money or they are in the business of lending foreign currency,” he added. “So what we at AMF are talking about is quite revolutionary.”
In aspiring to insure emerging-market debt without any exposure in the United States, AMF would be embarking on new territory within the bond insurance industry. But insuring debt in overseas markets isn’t unprecedented.
More than a decade before the financial crisis, in 1995, MBIA and rival bond insurer Ambac Financial Group joined forces to insure debt in international markets.
According to Diana Adams, a senior managing director at Ambac who oversees its international offices, the joint venture “was more successful than had been anticipated.” It was dismantled in 2000 so each insurer could pursue these new markets on its own.
The success of the joint venture drew the interest of other monolines. Most opened offices in Latin America to expand their operations. XL Capital, under Stevens, went a step further and wrapped deals in Chile, Brazil, Mexico, Turkey, Jamaica, Korea, El Salvador, Costa Rica, and Turkey, among other countries.
MBIA, the most active bond insurer before it stopped writing insurance in 2008 because its exposure to risky mortgage bonds wrecked its credit rating, would eventually insure 58 financings in Latin America for a total of $13.5 billion.
Eugenio Mendoza, president and chief executive of LatAm Capital Advisors, a subsidiary of MBIA, said a return of bond insurance into the region could “absolutely” help growing pension funds diversify away from government securities.
“Cash accruing in these funds exceeds the amount of eligible medium- and long-term investments,” Mendoza said of local pension funds.
Mendoza said it can be difficult to ascertain today’s trading value of insured bonds. The markets are too illiquid, he said, but investors continue to recognize the value of credit enhancement because most monoline insurers have honored their claims.
In the U.S., a segment of the retail market also continues to believe in the value of bond insurance.
The problem with the product is supply — start-ups have not been able to attract enough capital to attain high ratings, and existing insurers remain troubled by mortgage-related debt.
AMF seeks to avoid these capital problems by only seeking a single-A rating, as opposed to the triple-A ratings sought by the U.S. monolines.
A lower rating means AMF won’t have to raise or maintain nearly as much capital as the other monolines. However, the lower rating shouldn’t stop AMF from bestowing a triple-A-rated credit enhancement on its insured bonds.
That’s because none of the targeted countries’ sovereign credits are rated higher than single-A on a global scale. However, the sovereign credit assumes a “best possible” rating of triple-A on their country-specific or local scales. That allows a global single-A rated insurer to offer a local-scale credit enhancement of triple-A — high enough for regional pension funds to invest.
“The sovereign rules in any of these countries,” Ambac’s Adams said, noting that these small markets price risk with a kind of bell curve around the sovereign credit. “There isn’t any value to add by being triple-A versus single-A.”
Adams said in the 1990s, MBIA and Ambac would try to persuade emerging market investors to recognize that a global triple-A was even better than the local triple-A, but it didn’t work.
“We weren’t able to have the Mexican market buy us at cheaper than what they buy at their government, because that’s their benchmark,” she said.
LatAm’s Mendoza called it “very inventive” for AMF to only seek a global scale single-A rating, because it will require less capital to maintain it.
“When you go to a market that is triple-B — as is the case of Mexico — with a global triple-A rating, you’re arbitraging against yourself,” Mendoza said. “The market will not pay for your insurance any more than they pay for the local government.”
Insured deals with a local triple-A rating also won’t be as liquid as the local sovereign debt, he added, so there’s also going to be a premium on insured debt — another reason why triple-A global scale insurance wouldn’t necessarily be so competitive.
AMF plans to seek its rating from Global Credit Ratings, a South Africa-based rating agency that was founded in 1996 and specializes in emerging markets.
The deals AMF seeks to insure are local, investment-grade bonds with a secure revenue stream and a high degree of essentiality. It wants deals that are simple to understand. These include housing, education, health care and consumer-asset bonds, pools of micro-finance loans, and infrastructure, export, and remittance future flows. The target market does not include sovereign debt, but does include a small portion of sub-sovereign debt.
In the United States, infrastructure and public service bonds are usually issued by government agencies. The public sector in emerging economies often lacks the resources, but projects can be funded under a privatization model with a company that agrees to build and operate the infrastructure asset.
As with Chile’s toll road, private borrowers can issue debt with longer maturities. In return, they receive the right to collect the public project’s revenue for a set period.
The payoff for AMF from these public-private partnership, local-currency bonds is their wide credit spreads relative to the U.S. muni market.
In the heyday of the monolines, the 10-year credit spread between triple-A and single-A municipal bonds was roughly 35 basis points, according to Municipal Market Data.
That spread allowed the top-rated bond insurers to charge roughly 20 basis points to the issuer and pass on a savings of around 15 basis points.
In emerging markets, credit spreads are much wider. Even in the most developed of emerging economies, such as Mexico, the local scale spread between triple-A and single-A credits is 150 to 200 basis points.
The wider spreads potentially allow insurers to charge more — say 125 basis points.
If insured bonds were valued near the local scale rating of the sovereign, triple-A level, then single-A borrowers could save 50 to 75 basis points.
“The bond insurer makes good money when there are wider spreads between different rating categories,” Stevens said. “And the spreads in these countries are extraordinarily wide between different rating categories.”
Conventional wisdom says these spreads are wider because of greater default risk. If the risk is artificial, the market should correct itself and spreads should narrow.
“If there is a tendency for emerging market economies to favor domestic bonds rather than external debt, then one should expect an increased incidence of domestic debt restructurings in the future,” said Desmond Lachman, a resident fellow at the American Enterprise Institute, a Washington, D.C.-based think tank.
Stevens contends that credit spreads are wide simply due to the dearth of investors, rather than because of actual or even perceived risk.
In some emerging markets, a borrower with a local-scale double-A or single-A rating might only attract a handful of institutional investors, Stevens said, which means the wider spreads are not necessarily an indication of higher risk.
“This is the part nobody will really believe,” he said. “The loss experience in these markets is minuscule, in local currency. Right now, there is arguably near-zero default history in private-sector local-currency bonds within our asset classes in these markets.”
Stevens concedes that the literature backing up this claim is limited.
“There are no data supporting my business contention — I can’t prove to you that I’m right,” he added. “I’ve never tried to do an exhaustive study because I wanted to run a business, not be an academic.”
Kenneth Rogoff and Carmen Reinhart, economists at the National Bureau of Economic Research, recently tackled the issue of sovereign defaults in emerging markets and concluded that the shortage of data was “stunning.” They called their own research “as much an exercise in archeology as in economics.”
Stevens says his confidence that local-currency debt has a better history than foreign-currency denominated debt is based on his own research and extensive traveling.
Greg Kabance, head of Latin America structured finance at Fitch Ratings, said it’s been pretty well documented among rating agencies that local-currency markets in Latin America “have performed very well.” But, he said the track record only goes back about 10 years.
Kabance, who has followed local markets in the region for 15 years and published reports on them for about a decade, said insuring debt in the markets he knows is a sound idea.
“Emerging markets have gone through a lot of crises,” he said. “That’s the good news, in some way, because these transactions have been stress tested.”
Kabance said he wasn’t familiar with other markets and questions the accuracy of extrapolating the performance of Latin American markets into Africa.
Regardless of location, Stevens said borrowers have greater incentives to fulfill their obligations when dealing with a small base of local investors.
“What I found is that, in instances where there were problems in credits, the issuers often moved heaven and earth to fix it before they defaulted, Stevens said. “Because, if they defaulted, they would never be able to issue another bond.”
Lachman said there could be legal issues hurting the ability of investors to recover when there are defaults.
But Stevens believes governments in the smallest emerging nations have a huge stake in their nascent bond markets, so they could intercede in the case of a looming default.
“If it’s something they might have direct or indirect control over, they will be highly motivated to work with you to save the credit from default,” he said. “Governments hate to see their newborn local bond markets get off on the wrong foot and they are likely to be good partners if you have to do a restructuring.”
AMF promotional material says that once the insurer matures, four to six years after launch, it would limit its single-country exposure to 5% in an effort to minimize potential losses from a single market.
AMF plans to take measures to learn from the downfall of the U.S. monolines.
It proposes operating with a lower leverage ratio and setting aside 35% of annual premiums to absorb potential losses, as opposed to the 5% to 12% reserve typically set by the U.S. monolines. Stevens said this should allow AMF to absorb more than three times the losses.
Additionally, AMF will be structured as a mutual insurance company. That means it would initially be owned by the development aid agencies who fund its launch, but the issuers buying its insurance would gradually become owners over time.
“No owner should be particularly interested in maximizing revenues,” Stevens said. “All owners should have the same overriding interest, which is preservation of the firm’s ability to fulfill its development mission through preservation of its credit quality.”
For now, ownership transition remains a distant concern. The priority is finding investors and securing some deals.
“I don’t think it will be hard for us to be hugely successful — I’m really convinced of that,” Stevens said. “The question I have is whether we’re going to be able to launch.”