Recent Trends in Bond Insurance

I’ve often thought of bond insurance as a waste of time. Long the mainstay of the muni market, bond insurance has crept into other fixed income markets as well. The reason for this should be obvious, money.

I’m no expert on the topic, but I guess it was easy money putting an insurer’s imprimatur on esoteric products with complex and sometimes indiscernible cash flows (A lot of SAT words in that sentence). While bond insurers have ventured from munis before, it was usually into related areas where they could have a good handle on what the potential risks were.

In my days trading international bonds, it was quite common to see insured tranches of dollar-denominated sovereign issues. There were (and are) several Quebec issue with these tranches, but in the past, there were issues as far afield as Thailand and Italy that were part of this market.

The reason for doing this was to help facilitate a sale of bonds to US individual investors, many of whom were quite familiar with the insured bond concept. It was an easy money maker for broker-dealers (because they could buy bonds at the uninsured spread level, purchase insurance for some nominal amount, and sell them as if they were triple-A rated, which they were thanks to bond insurance) and easy money for the bond insurers (Was Italy really going to default? They could, and have in the past, print more money to pay off the bondholders).

The bond insurers also got involved providing somewhat dubious credit support to some mortgage-backed securities, although it was never really clear help they would provide other than sticking their good name on some bonds.

It shouldn’t be a surprise then that the bond insurers moved into other and more lucrative areas of the fixed income world. However, the sale of complex financial instruments would be different than selling munis to Mr. and Mrs. Smith. In some ways, it would be easier.

After all, the buyers were sophisticated financial entities that had armies of analysts doing their own in-depth research on these products. They looked at the models and developed their own. The bond insurers looked at the models and came up with their own models. Everyone’s models were stressed tested, and performed well. What could possibly go wrong? The bond insurers were only too happy to put their triple-A stamp on these products. There were a lot very smart people that said everything was OK. Those people had developed better and more sophisticated ways of measuring risk and valuing securities. Hedging techniques were more numerous and readily available.

Here’s the problem. Most of the people involved here had a large amount of technical knowledge and access to vast quantities information. Some, but not many, had requisite experience and market savvy to understand what the potential problems were. The game kept going until a fear-driven liquidity crisis forced change on us all.

Many, including myself, were quite surprised that it took as long as it did for the crisis to manifest itself. The bigger question going forward is how long will the investing community learn its lesson. My guess is that it depends on how long the current players stay involved in the market, how good their memories are, and how well they learned the lesson.

The one good thing this market has learned is that when investing in anything, there is risk, some known and some unknown. The market had moved away from that in recent years, focusing on easily definable risks like the political risk of investing in Venezuela or Iran. In the future, bubbles will form and pop. The trick is to avoid them or minimize the exposure when thing turn bad.

The bond insurers were just another piece of this unraveling puzzle. There will be bond insurance in the future, but it can almost be guaranteed that it will look more like the bond insurance of 20 years ago (at least in the short term), will have different, restructured players, and will cost more.

Like the aforementioned Italy, municipalities rarely blow up, and when they do, they usually get bailed out, ultimately by taxpayers. In the insurance game, it was a low risk business. What wasn’t noticed by the market in general was that the risk profile changed, and accordingly adjustments weren’t made.