By Bob Meyer There has been a great deal of misinformation reported in the financial media in recent months predicting the demise of the bond insurance industry. Although the insurers and rating agencies have made a valiant effort at explaining the risk exposures in their mortgage-backed security (MBS) and collateralized debt obligation (CDO) portfolios, the unrelenting bashing has blurred the industry’s fundamental strengths. This has resulted in exaggerated and unjustified investor fears of a widespread liquidity crisis and credit rating downgrades. The guarantors will be affected by the current turmoil in varying degrees, and a small number may be placed on ratings watch lists for possible downgrades. But the majority — and in particular, Ambac Assurance Corp., Assured Guaranty Corp., Financial Security Assurance Inc., and MBIA Insurance Corp. — should emerge from the current crisis with their triple-A ratings intact. Furthermore, new business volume, premium rates, and profitability at these companies can be expected to be at or approaching historically high levels. Here are the reasons why:First and foremost, the historical underwriting record of the triple-A financial guarantors has been exceptional and paid losses few and far between — approximately $2 billion in losses of total insured debt of $5.8 trillion in the industry’s 36-year history. This record attests to the rigorous credit, structuring, and risk-management principles that are the foundation of the insurers’ business models and franchise-critical triple-A ratings. Taking recent assurances from the guarantors at face value, there is strong reason to believe that residential mortgage-backed securities (RMBS) and CDO transactions insured in recent years were underwritten to the same high standard. While it is difficult to estimate size or probability of occurrence, some level of losses will undoubtedly materialize. However a majority of the triple-A insurers are expected to side-step ratings-crippling losses on these remote-risk exposures.In the event that major losses materialize, however, a majority of the triple-A insurers are well-prepared to handle the crisis. The credit default swap (CDS) contracts sold by the financial guarantors are structured to replicate traditional financial guaranty insurance policies, and specifically structured to avoid liquidity risk. Unlike most CDS contracts written by commercial and investment banks, the triple-A insurers are not subject to collateral posting requirements under any circumstance, including mark-to-market declines in value, and they are not required to make cash settlements as defaults happen, regardless of their size and regardless of the insurer’s own credit rating. Furthermore, in the event of a claim, the insurer’s obligation is to pay interest and principal on a pay-as-you-go basis, on the earlier of the originally scheduled legal maturity of the collateral or the liquidation of that collateral, and not on any accelerated basis. This feature of predictability of payment timing, together with the guarantor’s surveillance and remediation efforts, enables the guarantors to have sufficient cash reserves and liquid investments in place to cover losses. It also substantially lowers the concern that large, sudden losses could result in an immediate and substantial drain on liquidity and claims-paying resources. The absence of acceleration risk is the most significant liquidity safeguard the guarantors have, and together with stringent underwriting and risk-management standards and substantial claims-paying strength, forms the foundation of their business models and extremely high ratings.The insurers’ books of existing risk exposures are cash-generating engines. For the more established insurers, 90%-plus of their earned premium is locked in before the new year even begins. The combination of this annuity-like revenue stream flowing from previously written multiyear contracts; available credit lines and other highly liquid claims-paying resources; premiums from new business written and refundings; after-tax investment earnings; and the freeing up of capital as existing insured exposures runoff, provide substantial sources of liquidity for the insurers that is available to pay claims. While the prospects for triple-A-crippling losses may be low for a majority of the insurers, it is probable that one or more will be required to make up deficiencies in the claims-paying resources required by the rating agencies to meet minimum triple-A-rating standards (“rating agency capital”). This is likely to be the result of additional rating agency downgrades of RMBS and CDO collateral. While the specific method of calculating rating agency capital varies, one commonality is the comparison of assumed losses in a worst-case claims-paying environment to worst-case total claims-paying resources. Standard & Poor’s, for example, refers to this ratio as the “margin of safety.” From its standpoint, a margin of safety of 1.25x — which is the minimum margin of safety for triple-A insurers — indicates that a guarantor’s worst-case claims paying resources plus worst-case losses exceeds worst-case losses by 25%. Stated another way, losses could have been 25% larger before claims-paying resources were reduced to zero. It is noteworthy that reductions in capital resulting from mark-to-market losses are not considered by any of the rating agencies in determining rating agency capital. This is entirely appropriate because the market value of an insured CDS portfolio is not necessarily indicative of future losses, especially for an industry that holds its liabilities until maturity.There is a widely reported misconception that insurers whose rating agency capital falls below the minimum triple-A standard will be required to raise additional capital. This simply is not the case, especially for the stronger guarantors. In fact, the guarantors have a variety of other options available to them. The use of reinsurance is one such option. Although reinsurers would hardly be expected to provide capacity for distressed issues, it is quite plausible that they would step up and do so for a well-performing and attractively priced portfolio. Overall, reinsurance transactions of this type would be a highly capital efficient means of addressing deficiencies in rating agency capital, as it reduces the amount of capital required under the rating agency “safety margin tests.” Other, presumably stronger and less capital-constrained competitors, could be one source of this reinsurance capacity. There not only is historical precedent for such inter-company reinsurance arrangements, but one can imagine that the industry would regard the “bailing out” of one or more competitors as the lesser of two evils, since the downgrading of any one of the triple-A rated companies might possibly compromise investor confidence in the entire industry. In addition to using reinsurance, a capital-constrained insurer could change the mix of its business (i.e., more domestic municipal business and less structured finance and international public finance) and/or slow down the growth rate of new business writings to the extent that the market has not already done this for them. This is to say that the market share of a triple-A insurer that is on credit watch is likely to decline quite significantly. The silver lining here is that as new business volume declines, less available capital is being consumed, and therefore more is available to meet liquidity requirements.Some of the guarantors could privately place debt, equity, or hybrid securities that could be used to supplement capital. In fact, depending on future developments in the economy, one of the stronger guarantors could consider taking further steps to bolster its capital position to provide an additional cushion over minimum rating agency capital requirements, and/or to take advantage of potential new business or strategic opportunities in the marketplace, including the acquisition of a competitor. Some insurers may have attractive subsidiaries that could be spun off to raise capital.Finally, if all else fails, the extraordinary could happen again. Turn back the calendar to the fall of 1998 when Long Term Capital Management was on the brink of failure following the Russian debt default and the Federal Reserve Bank of New York brought the lenders together and brokered a bailout. At the time, the portfolio under LTCM’s control was in excess of $100 billion and its swaps position was valued at $1.25 trillion. Fourteen or so banks contributed $250 million to $300 million each to raise a $3.65 billion loan fund, because of the fear that LTCM’s liquidation of collateral and possible bankruptcy would result in substantial investor losses and create serious market disruptions. That fund together with LTCM’s remaining equity enabled it to survive. At year end 2006, there was more than $3.2 trillion(!) in guaranteed principal and interest on triple-A rated insured bonds outstanding. Of this amount MBIA had insured $900 billion, Ambac $800 billion, and FSA $550 billion — collectively representing 70% of the total. Although industry consolidation may be one result of current market stress, and no guarantor has publicly advocated the need for an industry bailout, a question remains whether any one of these companies, or others, would be allowed by the financial markets to be downgraded to double-A. Aren’t they too big to fail?Bob Meyer is the principal of Meyer Consulting Group Inc., a private practice providing consulting services to companies and private equity investors on matters relating to investments in the financial guaranty industry. He is the founder and former chairman and CEO of RAM Re, Bermuda, and president of Bond Investors Guaranty (formed in 1984 by AIG, Salomon Bros. et.al., and sold to MBIA in 1990). Mr. Meyer indicates that he owns no financial guaranty insurance company stock and is not being paid by any interested party to publish this article. He can be reached at firstname.lastname@example.org.