As regulators and legislators met in Washington, D.C., this week to discuss the state of the municipal market and potential solutions, the efforts of state insurance officials and the forthcoming regulation changes were held up as a model.
Specifically, New York insurance superintendent Eric Dinallo and Wisconsin insurance commissioner Sean Dilweg have been active in seeking solutions to the current capital shortfalls affecting the financial guarantors. Dinallo provided testimony to the House Financial Services Committee Wednesday in which he outlined potential ideas for changes to the regulations overseeing the bond insurers.
Dilweg, in an interview yesterday, said that he has also been examining regulation changes alongside Dinallo and California officials. In Wisconsin, any state-specific changes would likely take effect next year at the earliest, but in the meantime, the insurance laws for the state and those of most other states would automatically reflect the highest standards, Dilweg said.
In February, Dinallo said he hoped to have more stringent regulations for the bond insurers ready by the middle of this year. In testimony in front of the hearing, and a short interview with The Bond Buyer, he further defined what those regulations might look like.
In his prepared testimony, Dinallo said he is considering rewriting state insurance rules that would prohibit insurers from guaranteeing certain collateralized debt obligation products or from writing credit default swaps, further segregate the different books of business - such as structured, municipal, and project finance - written by the insurers, or require the insurer hold increased levels of capital.
In prohibiting the insurers to insure certain products, regulations would target so-called CDO-squared and CDS contracts. It is these securities that have caused the most trouble for the bond insurers because the difficulty in properly assessing their risk requires the insurers to take large losses against them.
In the fourth quarter of 2007, Ambac took a $1.1 billion credit impairment after mark-to-market adjustments of lower-rated securities in the CDO-squareds were assumed to have defaulted. MBIA Inc., parent of financial guarantor MBIA Insurance Corp., also reported a $200 million credit impairment in the fourth quarter related to three CDO-squared transactions it had insured.
"There is a good question about whether the insurer could ever really adequately do the due diligence once it has been transformed from a BBB to a AAA," Dinallo said. "It is hard to trace back to the original underwriting decisions."
Insurers' CDS contracts provided triple-A ratings to many of the CDOs held by some of Wall Street's biggest banks. The risks involved in CDS are also hard to pin down, because the contracts can be sold to third parties.
Dilweg said he is not considering prohibiting certain securities. MBIA and Ambac have both ceased writing structured finance business for the next six months.
An important consideration in looking at new regulations would be the rating agencies, because ratings are so central to the business prospects and solvency of the insurers, for which regulators like Dilweg and Dinallo have responsibility.
"We have to think about how we factor in the rating agencies," Dilweg said. "[Say] you're downgraded, you go from triple-A to double-A. The struggle we have as regulators is we're still in the same boat we were in for the last two months. How do you get on top of the situation before the downgrade, and that's a much more intensive question."
One way would be to require the bond insurers to have greater amounts of capital than they currently do, another part of potential regulations that Dinallo mentioned. The rating agency models require the bond insurers to have a certain amount of capital, and new regulations could work by asking the rating agency to alter their models or through some other measure.
"Whether I approach it through a business plan change or through a regulatory framework, it's clear that for these monoline insurance cases, the ratings are so vital and capital is definitely a piece of that," Dilweg said.
Regulators are also considering further segregating the books of the bond insurers. Currently, the holding company oversees both the structured finance side of the business and the municipal side of the business, with the ability to draw capital from either area as needed. Many market sources and regulators have said that municipal policy holders and the triple-A ratings they depend on would be protected from losses on the structured finance side if the books were more definitively segregated.
Dinallo and others have advanced this idea to solve the current troubles of the bond insurers. It met with outcry from the Wall Street banks and other structured guarantee policyholders who worried about the outstanding structured finance securities that would see their ratings plummet if muni-related capital was no longer available to those policies.
Current policyholders were not served by a split, but Dinallo said that future regulations may have some potential for segregating the books.
Regardless, the writing of new or amended regulations is still in the early stages, Dilweg said.
"The new regulatory approach is still under discussion," said a spokesperson with Dinallo's office. "There are no firm proposals yet."