Financial guaranty insurance is a type of credit protection for investors in debt obligations such as municipal bonds, commercial mortgage-backed securities (CMBS), and auto or student loans. It provides financial recourse in the event of a default on the bond or other debt instruments. Banks and other lending institutions require a company that provides them with this type of insurance. The purchase of financial guaranty insurance generally allows the debt issuer to “wrap” the credit rating of the insurer around the debt obligation that is being issued in order to raise the credit rating of the debt and thus qualify the debt for lower interest rates.
Many municipalities use bond insurance to obtain an AAA rating, thereby lowering their borrowing costs, which in turn allows them to save money on the overall transaction. In order for this to occur it’s essential that the financial guaranty insurer maintain a very high credit rating for wrapping the debt obligations it insures. Financial guaranty coverage improves the efficiency of the capital markets from a cost and accessibility perspective. The premium paid for the insurance is less than the amount saved through lower interest rates that can be obtained with a higher credit rating.
Many challenges lie ahead
Despite the growing role of financial guaranty insurance in the securitization process that has come to characterize many financial markets, the entities providing this specific financial service received relatively limited attention until early 2008, when several rating agencies openly discussed the possibility of taking adverse rating actions related to the biggest entities in the sector. This resulted in an intense scrutiny into the role of bond insurers in structured finance.
There is a reasonable amount of public interest in the continued availability of guarantees on payments on municipal bonds. To what extent such concerns justify policy intervention is rather uncertain, however, the business outlook for this sort of activity is reasonably sound. Still, more stringent solutions are in the works and new private capital is entering into that segment.
As to the role of financial guarantors in structured finance, some of the smaller companies may exit the market. It remains to be seen whether or not the remaining financial guarantors will be successful in procuring the necessary capital base to insure such business going forward.