Standard & Poor's said in a report issued yesterday that bond insurers' exposures to residential mortgage-backed securities have far-reaching implications that will continue to weigh on the industry for many years.
Exposures to 2005 to 2007 vintage direct and indirect RMBS transactions have "significantly impaired" the industry through actual losses and reserves, striking a blow to investor confidence, the report said.
"We won't know the full extent of structured finance losses for some time, but they will affect the capital and financial flexibility of the insurers because many have already exhausted most of their near-term capital raising opportunities or because the cost of raising capital has become too expensive," the report said.
The industry turmoil has led to a decrease in insurance penetration, which Standard & Poor's expects will continue for "some time". But the market will present opportunities to insurers with top ratings, stable capital bases, and solid risk-management policies in the future, the rating agency said.
Triple-A rated Assured Guaranty Corp. and Financial Security Assurance Inc. have wrapped nearly all the insured bonds that have come to market this year.
"We do think there is an opportunity out there for financial guarantee," Standard & Poor's director David Veno said in an interview. "From the discussions we've had with the buy-side investors out there, there is demand for this product, so that's a positive sign of the industry."
Demand for other types of credit enhancement have increased with insurance capacity limited. The use of letters of credit has jumped more than 350% from last year, although "the high volume is likely unsustainable, as LOC pricing has increased due to banks' much higher cost of capital," Standard & Poor's said.
This means there could be room for downgraded insurers to capitalize muni-only subsidiaries and for other participants to enter the market, although both ideas face hurdles. The subsidiary of a downgraded insurer would need to prove it is isolated from any problems at the parent company and regain the confidence of the market, Standard & Poor's said. A new market participant would need to find capable senior management from a "finite" pool of experienced talent in the bond insurance industry and may have difficulty charging premiums in line with established competitors, the rating agency said.
In addition, the added competition could put pressure on pricing. As the only two triple-A insurers active in the primary market, Assured and FSA have charged historically high premiums this year.
"As you get more players in the mix, pricing comes down," Veno said. "But the question will be how disciplined can they remain in their pricing and their risk management so that they're taking on risks at the appropriate price to produce good returns for this business."
In the report, Standard & Poor's divided the bond insurers into three categories based on their exposure to residential mortgage-backed securities, with AAA-rated Assured Guaranty in a class of its own, "generally unaffected by the current RMBS stress."
MBIA Insurance Corp., Ambac, and FSA are all "impaired to a moderate degree," although FSA - rated AAA with a negative outlook - is less so than the two others, according to the report. The insurers that have already seen significant downgrades - Financial Guaranty Insurance Co., Syncora Guaranty Inc., CIFG Cos., ACA Financial Guaranty Corp., and Radian Asset Assurance Inc. - are "seriously damaged by the current situation."
Standard & Poor's said that even if the stress-case scenario occurs it would "not necessarily view this as a liquidity crisis," because claims are paid out over time. Most of the industry has "relatively substantial liquidity," because balance sheets assets are typically mostly fixed-income investments with AA weighted average ratings.
However, companies with guaranteed investment contract businesses may face strains on their balance sheet if they get downgraded and need to post collateral, Standard & Poor's said. Ambac, MBIA, and FSA would all be affected, although they have taken steps to "mitigate this risk," Standard & Poor's said.
