The end of the monoline? Monoline insurers contemplating bleak future

But as any student who has blown his overdraft on too much high living knows, there is a chance that at some stage there will need to be a call home to ask for some much-needed credit enhancement. And as far as the over-leveraged and over-extended credit market is concerned, the monolines are standing by the phone, tapping their feet, just waiting to take that "I told you so" call.

So far the phone is not ringing. And maybe the credit market now has so many options open to it that – even if the cycle does turn – it never will. This is the unspoken worry among the insurers as they anxiously wait for things to turn in their favour.

"In the past, if you had told me that Ford and GM could default, short rates could go up, there could be war in the Middle East and Amaranth could go under with a $6.5 billion loss, and still the credit markets would not move, I would have told you that you were mad," muses a monoline veteran. "The thing that keeps me awake at night is the thought that maybe the credit markets have really changed. Maybe there is now so much dispersion of risk that the dynamics of this industry are simply not the same."

Investors’ attitudes towards fixed income have changed beyond recognition in the past decade. What was once a largely defensive allocation of assets is now a way of enhancing yield, and in ever more sophisticated ways. Issuers know that there is excess demand for higher-yielding product, and are therefore unwilling to submit to the cost of a wrap.

The CDS market has transformed risk management in credit, and a wrap now has to compete with a long menu of options available to issuers, and buyers, of bonds. When investors are nervous about a particular credit they will hedge the risk by buying CDS protection – as the recent wave of volatility in the triple-B home equity ABX index has shown. "There are certain instances where a monoline can offer value," says Neil Sutherland, investment manager at Axa Investment Managers in London. "But as the sophistication of the credit investor base increases there is less and less reason for people to use a wrap."

All this is preying on the minds of those who run the monoline insurers – names that used to be synonymous with the fixed-income markets, such as MBIA, Ambac, FSA and FGIC, but now seem little more than an afterthought. "There is an internal struggle going on inside all the firms between the veterans who say that the cycle will turn, don’t do anything foolish, and others who think that this time the cycle is different," says a monoline veteran. The credit market has undergone such fundamental and rapid change in recent years that institutions have a multitude of options available to them by which they can offset risk. "It is likely that we will see a turn in the credit cycle but the question is whether or not the business will come back to the same degree," agrees Jack Dorer at rating agency Moody’s in New York. "This is a legitimate concern. Credit has become a liquid commodity."

In this kind of environment, adverse publicity is the last thing the industry needs, but the reputation of the largest monoline is being questioned by a growing number of investors. MBIA recently agreed to pay $75 million in fines and compensation arising from reinsurance contracts it wrote to cover losses it incurred in 1998 [see The worm of doubt: credit-worthiness of monoline insurers, Euromoney June 2005].  And the protracted negotiations between bondholders in Eurotunnel and the monoline – which ended at the beginning of this year with the wrapped bonds being redeemed at par – has left a bad taste in investors’ mouths. Some accuse MBIA of handling the situation wrongly, and that its attitude was "prejudicial" [see Investors rap MBIA over Eurotunnel payout].

Sutherland at Axa sums up the challenge facing the monolines today. "Our preference is to buy bonds that haven’t been wrapped," he says. "We prefer to hold structurally enhanced triple-A – we invest in deals where we have done the homework."

Going big on small risks

The modus operandi for these firms has been to take on tiny amounts of risk in very large amounts – a comfortably lucrative proposition that has seen them maintain their triple-A ratings despite (in some cases) significant losses and even an SEC investigation. But all good things must come to an end, and the predictable flows of municipal and structured finance business on which this industry has traditionally built itself are looking worryingly uncertain.

"Writing a wrap on structured finance can be like writing aggressive hurricane insurance – you can be sure that every hurricane will find you. It is a structural assessment" Sean McCarthy, FSA