With recent financial guarantor downgrades generating headlines and destabilizing the municipal bond market, now is a propitious moment to remind fixed-income investors about the power of two-name credit support, and in particular, the improbability of joint default.
Financial guarantees provide investors with a way to reduce default risk and tailor their risk/reward profiles in order to better suit their specific risk tolerances. By purchasing a guarantee in the secondary market or as part of a "packaged" offering in the primary market, an investor substitutes the risk of joint default of both the underlying security and the guarantor for the pure credit risk of that security.
The "uplift" in credit quality from a guarantee is a function of the creditworthiness of the guarantor and the default correlation between the guarantor and the underlying insured risk. The higher the credit quality of the two obligors (the guarantor and the underlying credit) and the lower the default correlation, the more improbable is a joint-default event resulting in credit loss to the investor.
While rating agency recognition of the power of joint default improbability goes back at least 10 years, many investors still hold to traditional rating agency concepts of either "credit substitution" or "weakest link."
Credit substitution leads to guaranteed transactions being assigned the higher of the two obligors' ratings, and "weakest link" holds that the obligor with the lower of the two ratings may have "interference" influence that allows it to damage the creditworthiness of the higher-rated obligor. Thus, weakest link arguments lead to assignment of the lower of the two obligor ratings.
The rise of active credit portfolio management on the part of banks and other financial institutions and the systematic downgrades of the financial guarantors makes it all the more important that investors understand that as long as the guarantor's default probability is only moderately correlated with the default probability of an underlying obligation, the rating of the enhanced obligation will generally be higher than the rating of either the guarantor or the unenhanced credit. A recent application of the concept with direct ratings implications follows:
On Oct. 27, Moody's Investors Service assigned a rating of Aaa/ VMIG 1 to New Hanover County, N.C., variable-rate hospital revenue bonds, Series 2008A and Series 2008B. The ratings for both series were based upon: a single letter of credit provided by RBC Bank (USA); the underlying rating on the Series 2008A and Series 2008B bonds; the structure and legal protections of the transaction, which ensures timely payment of debt service and purchase price to bondholders; and Moody's evaluation of the credit quality of the bank issuing the letter of credit.
Moody's explained: "Since a loss to investors will occur only if both the letter of credit provider and the borrower default in payment, Moody's has assigned long-term ratings based upon the joint probability of default by both parties. In determining the joint probability of default, Moody's considers the level of correlation between the letter of credit bank and the borrower and applies the lowest joint default rating. Moody's has determined that there is a low level of correlation between the Bank and the New Hanover Regional Medical Center. Given this correlation, Moody's believes the joint probability of default results in credit risk consistent with a Aaa/VMIG 1 rating for the bonds. Moody's currently rates RBC Bank (USA) Aa3 for its long-term obligations and Prime-1 for its short-term obligations. The underlying long-term rating on the New Hanover Regional Medical Center's Series 2008A and Series 2008B bonds is A1."
Thus, the combination of the A1 underlying credit, the Aa3 support, and relatively low correlation led to a Aaa rating of the enhanced bonds.
Let us suppose that a fully transparent, municipal-only financial guarantor has received Aa2/AA ratings from Moody's and Standard & Poor's. This means that that guarantor's obligation to pay timely principal and interest upon default of an underlying bond is sufficiently secure to merit triple-A ratings for all investment-grade securities that it insures.
To demonstrate, say a municipal bond guarantee book of business demonstrates a 0.20% probability of default over a 10-year horizon. A commonly used credit-scoring table shows that this 10-year cumulative default probability maps to a Aa2 rating. Ten years is roughly consistent with the average life of a guarantor's book of business.
Now, depending upon the default correlation between the security being insured and the guarantor's own portfolio, the joint probability of the guarantor's default and the default of the underlying bond - both must default for the investor to realize a loss - will most often map to a Aaa credit score.
Thus, despite a stand-alone probability of default that maps to a credit score below the highest level, a guarantor can generate a joint default probability with an underlying credit that indeed maps to Aaa. We use standard financial engineering techniques to assess the improbability of the joint default of two obligors, given different levels of default correlation.
The second table (below) illustrates clearly how for a reasonable range of default correlations, an Aa2 guarantor can elevate virtually all investment-grade securities to a Aaa level of creditworthiness.
For the municipal-only business, our studies of the data indicate that average guarantor underlying-security default correlations likely lie in the 10% to 20% range. Note that even if the correlation between the guarantor's book of business and a given security is as high as 30%, a security mapped to a Baa1 credit score would be elevated via a guarantee to a Aaa default probability.The insights that matter most to investors are that a guarantor can pay claims when needed and that the loss potential of the wrapped bonds in which they've invested is a function of two default probabilities and default correlation.
While the rating agencies appear at the moment to be using the old "credit substitution" approach to rating the claims insured by financial guarantors, we believe that this is a temporary phenomenon based largely on the relative suddenness of financial guarantor downgrades.
As credit markets digest the implications of joint default improbability and the rating agencies formally apply joint default analysis to financial guarantees (as they already have to corporate, financial, and government ratings), wrapped bonds will be restored to their rightful place at the top of the ratings spectrum.
Robert D. Selvaggio, Ph.D., is managing director and head of capital planning and risk analysis at Ambac Assurance Corp.