Continued losses for monoline insurers on structured products mean the model may be broken for the foreseeable future. New deals can still be done, but lower leverage will be vital. Writer Philip Alexander.
Amid high-profile bank failures across the world, the travails of monoline insurers have slipped out of the headlines. However, as US housing market delinquencies continue to soar, they translate into defaults on super-senior tranches of mortgage securitisations which were wrapped by the monolines.
The insurers therefore face a rising tide of claims from investors. JPMorgan credit analyst Arun Kumar estimates that the monoline industry received 312 claims totalling more than $2bn in September 2008 alone, compared with 103 claims for about $750m six months earlier. He calculates that the six major players in the market have so far received claims for $6.97bn on residential mortgage-backed securities (RMBS), together with credit impairments on collateralised debt obligations (CDOs) totalling $9.58bn.
Ambac reported net losses of $2.4bn in the third quarter of 2008 alone, triggering further negative actions from credit ratings agencies, with another $807bn loss for MBIA. “A lot of monolines did not model the cash-flows adequately, they sometimes had teams of just three or four people taking on big exposures to complex securities, hoping that charging an average of, say, 15 basis points to provide AAA insurance would be enough to cover payouts,” says Tonko Gast, co-founder of structured credit specialists Dynamic Credit Partners.
His firm has about $5bn of assets under management, but as the widening of bid/offer spreads restricted trading opportunities from the second half of 2007, Mr Gast took a strategic decision to focus on analytical and consultancy work. His team of 25 people now spends a growing amount of their time advising banks, private equity firms and regulators on valuation, risk analysis and structured credit restructuring, and especially on the fate of monoline insurers.
Accounting for failure
Against this backdrop, questions are inevitably growing on whether monolines will have the resources to pay out on all potential structured finance claims. The weakest, such as CIFG, Financial Guaranty Insurance (FGIC) and Syncora (previously Security Capital Assurance – SCA – and XL Capital Assurance), have credit ratings from at least one agency in low speculative grade territory, well below many of the bonds they were insuring. Two others, Assured Guaranty and Financial Security Assurance (FSA) have less CDO exposure, and have so far retained AAA ratings – although both are now on review for downgrade from at least one ratings agency.
Even where structured credit tranches are wrapped by monolines that still have A or AA ratings – such as Ambac and MBIA – auditors are warning their bank clients not to rely on these ratings in assessing the fair value of their securities exposure. “We would encourage management to look at the unenhanced rating of the issue, to gain an insight into what value the monoline is adding. If there is a 30 cents on the dollar price difference between where a BBB unenhanced bond is trading and the A or AA that equates to what the monoline is adding to the rating, the question is how much of that uplift can you take as guaranteed,” says a technical adviser in the financial services division of one of the leading international audit firms.
“A good indicator of that is by reference to the credit default swap (CDS) spread on the monoline itself, the risk of default implied. Credit default swaps are much more responsive than the rating agencies, which cannot give constant daily update,” he adds. The five-year CDS spread on Ambac widened to more than 2000 basis points (bps) as of mid-November, from less than 800 bps six months earlier, while that on MBIA widened by 400 bps to about 1470 bps over the same period, according to derivative pricing provider Markit.
However, the auditor notes that, as long as the monolines remain solvent, there is some technical advantage to a wrapped product even if the wrapper is downgraded. In an event of default on wrapped CDO or RMBS tranches, the cost of seeking recovery from the borrower falls to the monoline rather than the end-investor, who should receive a quicker payout than on an unwrapped tranche.
Difficult choices
Many investment banks, both top-tier and second-tier, have disclosed significant exposure to monoline insurance. According to Standard & Poor’s, as of the first quarter of 2008, disclosed exposures ranged from $24.6bn at UBS to $7.9bn at Canadian Imperial Bank of Commerce (CIBC). Given the scale of the problem, banks have begun undertaking what are known as ‘commutation trades’ – agreeing to cancel the monoline policy altogether, in return for a fee up front. In the first such deal in July 2008, XL Capital paid Merrill Lynch $500m to terminate cover on a portfolio worth $3.7bn.
However, many of the commutation trades imply a substantial net present value loss for the banks, says Mr Gast, because the insurance policies would have repaid the principal at par, and all the missed coupon payments. “For the banks, it is a large loss. The CDOs that they bought protection on usually don’t even have enough collateral cash-flow to keep paying coupons, but it is probably difficult for the banks to get paid for this in commutation trades.”
This might sound like a bad deal for the banks, but they must contemplate some complex game theory scenarios, says Mr Gast. “If you are first in the queue to do the trade, at least you know the capital is there. But if you wait until the back of the queue, maybe the monolines have commuted enough exposure that they escape, they could rebuild their solvency and pay your claim in full. But then, if everyone waits, the downgrades to monolines will continue as the bonds they have insured go to B or CCC.”
Lower leverage
Whether or not the monolines survive, most have stopped writing new structured finance business. In any case, the higher risk premium now attached to the existing players means many of the calculations that underpinned the use of wrapping are no longer valid. Before the boom, CDOs and collateralised loan obligations (CLOs) were originally tools for banks to tidy up their balance sheet. At a time of abundant liquidity, they became a volume business as part of a credit arbitrage strategy.
Those days are over for the time being, says Andrew Godson, head of distribution for CLO manager Babson Capital Europe, and former head of a CDO syndicate at Citi in London. In particular, the “negative basis trade” in which bankers were able to buy default protection from the monolines for less than the spread on the underlying bond – allowing them to earn a return while theoretically taking no credit risk – is unlikely to make a comeback in the foreseeable future.
As a large operator (more than €7.3bn, or $9.3bn, in assets under management in Europe, across seven CLO programmes and other leveraged loan funds), Babson Capital Europe has built a longstanding base of institutional investors among pension and insurance funds. Consequently, it has not made significant use of monoline wrapping aside from its first CLO in 2001. Monolines tended to seek extensive control over the documentation and stratification for a new issue, which might not suit a CDO or CLO manager that has an established strategy of its own. However, newer and smaller managers with one or two CDO programmes found it easier to bring in other investors once a monoline was on board.
Back to fundamentals
Larger CDO and CLO managers with reliable access to real money investors should therefore be better placed to increase market share over time. The liquidity squeeze is also likely to prompt a turn back toward traditional cash-flow CLOs or CDOs referencing a pool of corporate debts that are closely managed for diversification.
“Our approach has always been bottom-up, choosing a loan that is robust from a cash-flow and balance sheet perspective, we need to be comfortable with the underlying economics of the company,” says Mr Godson. “We’ve been through a period when there was a lot of pressure on people taking that fundamental approach, there was a lot of fast money in the market that just wanted supply and was fairly agnostic on credit standards. Today, people are seeing the value of the fundamental approach.”
Without the arbitrage opportunity afforded by monolines, CDOs and CLOs will return to their roots, featuring lower volumes, lower leverage and more careful credit selection. Mr Godson emphasises that while the market rationale must change, the investment case may become more compelling. Illiquidity means the pricing on many corporate loans has overshot any realistic credit deterioration scenario, so that investors can at last be well rewarded while taking on less risk. “To get a 15% return at the height of the boom, you had to be in the equity tranche with 10x leverage. Now we are talking with investors about a fund of senior secured loans that are returning in the mid-teens, on an unleveraged basis,” he says.
Securitisation unwrapped
The banks’ corporate clients are also contemplating life without monolines, as the funding officials for utilities and infrastructure projects rethink their strategies for corporate securitisation. About a decade ago, the most experienced monolines began to expand their business beyond US municipals to take in major project finance deals elsewhere, such as those under the UK’s state-backed private finance initiative (PFI). By the height of the boom, one banker estimates about 70% to 80% of all senior tranches on corporate securitisations were wrapped.
“There was an arbitrage for the monolines for two reasons,” says one senior corporate securitisation banker in London. “They felt they understood the assets in more detail than pension funds or the other ultimate buyers, thanks to their experience with infrastructure assets in the US municipal market. And they also had closer access to information as the controlling investors, instead of being one of 30 or 40 bond investors. They could monitor the deal and step in if a problem arose.”
Their early success encouraged aggressive new entrants such as SCA and XL, driving premiums down by as much as 60% or 70%, making the wrapping process more attractive for issuers and their bankers. As the monoline ratings fall, however, investors are reassessing the model. “We have noticed a lot more enquires from investors wanting more information on underlyings – they were holding this asset but they had not focused on what was in it. And investors who have filled their portfolios with monoline-wrapped paper are facing greater scrutiny even where the underlying assets are still performing well,” says the banker.
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Simon Dudley, managing director in the EMEA fixed income team at Citi in London, believes there could still be a role in the project finance field for what is likely to be a smaller number of surviving monolines, if they have the ratings and investor confidence. “Ultimately, monolines have added value in terms of opening up avenues of distribution and in terms of price arbitrage. |
“If it makes economic sense for them, I do think there is a role for them wrapping the senior tranches of regulated utility securitisations or project bonds. That will be determined by how much capital they have to set aside and what kind of premiums they need to charge. But I think it is logical for them as they draw away from the flow-structured finance arena to focus on utility and infrastructure transactions in EMEA.”
BAA points the way
Citi and RBS worked on the £13.7bn ($20.3bn) refinancing of UK airport operator BAA, completed in August 2008 without the use of a monoline wrap. “We had been intending to access monoline insurers, but it became clear that this would not achieve an economic saving for the issuer. In the end, we got an A- senior bond and a BBB bond further down the capital structure – which is still investment grade – and these were distributable in the structured corporate bond market, so accessing the monolines was not necessary,” says Mr Dudley.
The deal is widely regarded as a sign-post to the shape of corporate securitisation in the foreseeable future. Transactions are still possible, because investors such as pension funds continue to search for assets with longevity, and project bonds fit the bill. But bankers will not be able to structure deals with such an aggressive debt-to-equity ratio that the standalone rating on the bond only just scrapes into investment grade.
Such deals were where the greatest price arbitrage was, but relied on a monoline wrap to draw in regulated investors who cannot hold speculative grade debt in their portfolio, and therefore did not want the risk of a downgrade. And investors will also ask to be rewarded for the additional due diligence they must now undertake on the underlying assets, says Mr Dudley.
As in the CDO market, it seems corporate securitisation will therefore return to its origins from the time before monolines dominated, potentially requiring lower leverage and higher pricing. “The early deals were done without monolines, so the technology that went into putting those deals together is still there, it has just been forgotten about a bit,” says James Miller, head of corporate securitisation at RBS in London. “A lot of the deals that were put together were from corporates such as water utilities and PFIs that are non-cyclical in nature, and the benefit of overlaying a corporate securitisation structure is more robustness for investors through early warning triggers and covenant security, so the track record has held up well versus other parts of the market,” he notes.
Not such good news, perhaps, for the public treasuries already stretched by bank bail-outs, falling tax receipts and rising unemployment. “Structures are naturally going to have to be more conservative, with more equity and better cover ratios, which is going to have a consequential pricing cost to the public sector party who has pursued the PFI route ,” says Mr Dudley.
