«by MICHAEL GUDGER FAO AGRICULTURAL SERVICES BULLETIN 129 The designations employed and the presentation of material in this publication do not imply ...»
In the following section, three case studies of bond insurers are presented both to illustrate the diversity of the industry and to point to several features that make them germane as models for development finance. These companies have both enabled many projects financed with public money, principally tax receipts, to access debt markets on better terms than available without the guarantee. More interestingly for development professionals, these companies have shown a behavior similar to the mortgage guarantee companies. When faced with a saturated market, they have moved “down market” and developed products that meet the guarantee needs of other sectors that formerly could not access credit markets or could do so only on disadvantageous terms. Most recently, the bond insurance industry is beginning to reach into the ranks of the small and medium enterprises for business as its traditional markets saturate and the possibility of sustaining growth diminishes. Like the mortgage insurers, some (although not all) of the bond insurers have shown considerable skill at developing new guarantee products for “low end” markets traditionally neglected. Finally, like the mortgage guarantee companies, they have begun to expand abroad. This expansion has taken some most interesting turns for the development finance community.
Capital Guaranty Insurance Company
Capital Guaranty Insurance Company (CGIC) is the second smallest bond insurer in the U.S.
market, after Connie Lee, a government sponsored enterprise (GSE), now privatized, which initially insured only college dormitory construction bonds. It has only a 1.9-% market share.
In its 8th year of operations, CGIC has an insured portfolio of $12.5 billion. The company’s net premiums were about $26 million for the last year for which data are available, 1993. The company has managed to retain a very tight financial discipline issuing guarantees only to the low risk sectors of the municipal market and has a comprehensive credit surveillance policy in place to detect deterioration and take corrective actions. As a consequence, the company has no payment defaults in its portfolio. However the bonds which it insures have traded at a yield slightly higher than those insured by the larger competitors.
CGIC faces a severe competitive challenge in a market with declining premium rates. For example, between 1992 and 1995, premium rates for tax backed municipal bonds fell 22%.
Its existing business has relatively high imbedded premium rates. However, acquiring additional business is challenging given that the trading value of its insured bonds are somewhat lower (with slightly higher yields) than those insured by its competition. This makes its continuation as a niche bond insurer more difficult and reduces its pricing flexibility. The company is compelled to reduce the charges for the guarantees, given that its bonds trading values are lower. The bond issuer wants lower premium rates to compensate for the higher yields demanded by the market place.
With a very small niche market and its bonds trading at slightly higher yields, it is likely that over time the profitability of the company will continue to be pressured. In fact, the company’s return on average equity is only about 8%, roughly half that of the other companies in the industry. Given the relatively low annual premium income of just over $20 million and the high overhead and especially surveillance costs, it is difficult to see how the company can be very profitable. As a stockholder company with low returns on equity, it may find it difficult to attract additional capital. By way of comparison, Triad had a premium volume of under $20 million and was compelled to spend over half that on overhead, but remained quite profitable producing a return on assets of almost 13% and on capital of 15%.
In general, Triad had a market that was neither saturated nor in which premium volumes were declining. The management of Capital Guaranty found itself severely constrained by these factors plus the fact that it could not raise additional capital to expand into more profitable areas.
MBIA Insurance Corporation
MBIA, like GEMICO, is the giant of its industry. MBIA has 42% market share on its $188 Billion net par portfolio which produces nearly $185 million per year of premium income generated by guarantees issued on public finance, asset backed securities, and international debt. In addition, the company raised $130 million in new capital to take advantage of the economies of scale that characterize its operations. In the face of declining premium rates in the municipal bond market that cripple a small player like Capital Guaranty, MBIA had the ability to raise additional capital and pursue other opportunities. With the increased commoditization of financial guarantees and lower margins, MBIA implemented four strategies to sustain growth and profitability.
• The company diversified into structured corporate debt and asset backed securities.
• MBIA began writing guarantees on international debt issues.
• It formed a strategic alliance with its largest competitor to cooperate in the European market.
MBIA also set up investment management services both for municipalities and to issue the guaranteed investment contracts of other insurance companies in order to generate additional revenues.
These first three were designed to produce additional premium while the fourth generated substantial new fee income. To lower expenses, MBIA brought the risk assessment department on line to provide additional surveillance and risk assessment for the guarantees it issued. MBIA no longer needed visit the companies or municipalities but instead could assess the financial condition on a regular basis via an on-line link. As a result, even in a declining premium rate market, MBIA was able to keep its return on a rapidly growing equity in the 15% range.
What “best practice” lessons may be drawn from the experience of these two companies for development finances professionals interested in providing guarantees in developing countries?
• Economies of scale are very large in the financial services business, especially in competitive markets. MBIA was able to increase capitalization and reach out to new businesses to sustain growth and return; Capital Guaranty was not, as it was too small and suffered from a rate of return that was not attractive. It stagnated, producing inadequate returns on capital while MBIA was able to grow, expand and enter new related businesses.
• Diversification into related markets was able to sustain growth at MBIA while being locked into a niche market cut Capital Guaranty’s return to ½ of the industry average.
MBIA built an international business and a service business for municipalities and other insurers
• Innovation both helped sustain margins and reach formerly unserved markets. MBIA entered two new markets, home equity loan and first mortgage pools (where MBIA issued a guarantee on the securitized products). Capital Guaranty remained a niche player, confined by an inability to raise capital to grow and innovate. As with the mortgage guarantee companies, competitive markets drive diversification and innovation. This time, the bond insurers and the mortgage guarantee insurers began to converge on the margins as MBIA began to enter markets traditionally served by mortgage guarantee companies.
• Mechanization, computerization and on-line surveillance are essential to manage a large and diverse portfolio and as a cost savings measure when margins are pressured by competition.
Asian Securitization & Infrastructure Assurance (pte) Ltd.
A new company, Asian Securitization and Infrastructure Assurance, Ltd. (ASIA) has recently been established in Singapore. Its shareholders are CapMAX Asia, Ltd., an affiliate of Capital Markets Assurance Corporation; Apcac Investment Pte. Ltd., a subsidiary of the Government of Singapore Investment Corporation; Asian Development Bank; Employees Provident Fund of Malaysia; American International Assurance Company; Korea Long Term Credit Bank; Deutsche Investitions-und-Entwicklungsgesellschaft; and the Netherlands Development Finance Co. ASIA will be capitalized with $100 million in policyholders surplus with an additional $50 million of callable capital and an additional $50 million in soft capital from an excess of loss reinsurance from the Aachener Reinsurance Company of Germany.
The company’s principle business will be financial guarantees on asset-backed securities and infrastructure debt to be placed in primary and secondary Asian fixed-income capital markets.
OECD estimates that Asian countries are already spending about 5% of GNP on infrastructure. The infrastructure project finance market in Asia is estimated to grow at from about $78 billion in 1996 to excess of $90 billion in 1999 while the asset backed securities market will grow from $5.5 billion to almost $11 billion over the same period. ASIA Ltd.
estimates that it can achieve a low single digit penetration of both of these markets.
The management of ASIA Ltd. has announced that they will underwrite to a zero default standard. This will be difficult in present circumstances. The condition on which Asian Development Bank, with its focus on the development of financial markets, agreed to participate in the capital structure of ASIA Ltd. is that not more than 20% of the guarantees be issued in “strong” countries such as Singapore, Korea, Hong Kong and Taiwan. The remaining 80% of the guarantees will have to be placed in the Philippines (BB), India (BB+), Indonesia (BBB) and China (BBB) as well as unrated countries which have substantial political and currency risks. ASIA Ltd. will not accept the risk of impairment of collateral or cash flow arising from fluctuations of the guaranteed security’s currency and that of the collateral. As a result, it will be necessary to use currency swaps, hedges, reserve funds, indexing and even over-collateralizations to control this risk. The fact that the guarantees go to relatively high-risk projects implies a substantial cash flow from premiums as well as a much greater volatility and risk of losses.
The chief technical partner, Cap MAC, a subsidiary of U.S. based bond insurer, Capital Markets, has an 8 year track record in Asia and has had only one bond default. On larger risks where the commitment of ASIA would exceed 30% of its capital,28 Cap MAC will counderwrite the guarantee as well as provide the technical expertise to the new company as it tries to find a profitable Asian market for its guarantees.
The Singapore regulatory authorities have adopted prudential regulation modeled on New York State. The minimum capital requirement is U.S. $75 million and the net par exposure for guarantees cannot exceed total qualified capital (paid up capital, capital on call and reserves).
The initial business written in 1996 was a mix of asset types spread across several countries.
Infrastructure is one of the more promising areas for selling credit enhancements. A total of 5 transactions were approved or closed in China and Indonesia during 1996. Additional deals are likely to develop in 1997 as some international banks seek to reduce Asian infrastructure exposures. Over the next 5 years or so, Asia Ltd. expects to develop a risk to capital ratio of about 40-to-1 for the infrastructure component of the portfolio and between 75 to 100-to-1 for the bond component of the portfolio.
30% is the usual U.S. regulatory limit on the amount of capital that may be exposed to a single risk.
ASIA will be regulated by the authorities of Singapore who permit up to a 75% exposure to a single risk.
However, ASIA has adopted the 30% exposure on a voluntary basis as part of a deal with Standard and Poor’s to obtain an “ A” (Good) financial rating. Without at least an “A” rating, its guarantees would be of little use to buyers and its market would contract significantly.
PRIVATE MORTGAGE AND BOND GUARANTEE INSURERS AND
LENDERS, BORROWERS AND GUARANTEES
Essential to the development of third party credit guarantees is a fundamental change in the behavior of lenders. Only when lenders are prepared to originate a loan (or let someone originate it for them) is the entire chain of events set in motion. Why then would lenders prefer a third party guarantee to simply charging a higher rate and in effect keeping the risk
premium for themselves? There appear to be several reasons:
• First, foreclosure or realization of collateral is very time consuming and costly in case of a default. Lenders also do not like to foreclose or take collateral due the bad publicity; the guarantee companies are both more adept at it and are less concerned with the consequences. In the U.S., there is an additional constraint. U.S. law does not permit mortgages to be called by the lender if the mortgagee is not delinquent. This is a legacy of the Great Depression when cash strapped banks called loans even when the mortgagee was current.
• Second, banks can generate a large volume of these loans but cannot sell relatively poorly collateralized home mortgages without the guarantee. Few banks would want to keep all of this class of loans that they can originate. The capital used to back these weakly collateralized loans would be quite large due to the adjustments applied to the risk weighted assets. The return to capital would be commensurately lower. The debt market can take more risks than can prudently managed banks. Furthermore, most of the participants in debt markets are not banks and do not have to meet capital adequacy ratios.
However, the debt market demands the guarantee to insure that the lender is not acting opportunistically.29