Finance 431: Property-Liability Insurance

1
Finance 431Property-Liability Insurance

• Lecture
• Financial Guaranty Insurance

2
Overview

• Financial Guaranty Insurance
• Sub-Prime Crisis
• The Effect on Financial Guaranty Insurers
• Other Effects on the Insurance Industry

3
Financial Guaranty Insurance

• Definition Insurance on a bond or other
  security which guarantees that interest and
  principal will be paid on time and in full in the
  event of default.
• Default when the issuer of the bond or security
  does not pay the principal and interest for the
  bond or security.
• Also known as Bond Insurance

4
Financial Strength

• Financial strength is key due to the insurers
  obligation to pay the principal and interest if
  default occurs.
• Rating Agencies
• AAA, Aaa ratings from SP, Fitch, and Moodys are
  needed in order for financial guaranty insurance
  companies to be able to continue writing coverage
  and stay in business.
• High ratings for the financial guaranty companies
  leads to high ratings for bonds and securities
  insured by these companies.
• Claims-Paying Ability
• Reinsurance

5
Products of Financial Guaranty Insurance

• Asset-Backed Securities
• Municipal Bonds
• International Securities
• Includes securities from asset-backed markets and
  infrastructure finance markets from around the
  world.

6
Asset-Backed Securities

• The combination of similar assets and their cash
  flows to form securities that have interest
  payments and a principal.
• Examples
• Mortgage Backed Securities (MBSs)
• Student Loan Securities
• Credit Card Receivable Securities
• Car Loan Securities
• Collateralized Debt Obligations (CDOs)
• The combination of several asset-backed
  securities.

7
Municipal Bonds

• A bond issued by states, cities, local
  governments, or public agencies.
• Bonds fund public projects, and they fund private
  projects as long as they serve public needs.
• Interest income from funding of public projects
  is tax exempt from federal taxes, as well as
  state and local taxes for most projects in most
  states.
• Examples of projects
• Schools
• Highways and roads
• Utilities

8
Who Benefits from Insurance?

• Asset-Backed Issuers
• Higher ratings on bonds and securities allow for
  lower interest payments and thus lower borrowing
  costs to issuers.
• Municipal Issuers
• Higher ratings leads to a decrease in financing
  costs.
• Small municipal issuers receive ratings of bond
  insurer instead of having to file for expensive
  agency ratings.
• Helps marketability of lesser known issuers
  local town agency.
• Taxpayers
• Tax-exempt features on municipal bonds saves a
  lot of money for taxpayers.
• Investors
• Guaranteed to receive interest payments and
  principal in the event of the issuer defaulting.

9
Industry

• Association of Financial Guaranty Insurers (AFGI)
• Most financial guaranty insurers are members
• Members
• ACA Financial Guaranty Corp.
• Ambac Assurance Corporation
• Assured Guaranty Corp.
• BluePoint Re Limited
• CIFG
• Financial Guaranty Insurance Company
• Financial Security Assurance
• PMI Guaranty Co.
• Radian Asset Assurance Inc.
• RAM Reinsurance Company
• XL Capital Assurance
• Monoline Industry

10
Which financial guaranty insurance products have
tax free interest income?

• A) Asset-Backed Securities
• B) International Securities
• C) Mortgage Backed Securities
• Municipal Bonds
• None of the above

11
Student Loans would fall under which financial
guaranty insurance product?

1. Asset-Backed Securities
2. Mortgage-Backed Securities
3. Municipal Bonds
4. International Securities
5. None of the above

12
Sub-Prime Market

• Sub-prime loans
• Sub-prime mortgages
• Loans or mortgages given to borrowers with low
  credit ratings.
• These loans or mortgages have higher interest
  payments due to the increased risk of the
  borrowers defaulting.

13
Sub-Prime Crisis

• Housing market begins to boom in 2002 due to low
  interest rates.
• Asset-backed securities on mortgages are created
  also known as mortgage backed securities (MBSs).
  At first with normal mortgages.
• As housing boom continues after 2002, new
  asset-backed securities are created, but these
  new securities included sub-prime mortgages.
• Some of these securities with very few sub-prime
  mortgages bundled together with other normal
  mortgages were able to earn AAA ratings.

14
Sub-Prime Crisis

• Other securities with many sub-prime mortgages
  bundled with other normal mortgages were still
  able to receive investment grade ratings of A or
  higher. This was because of the MBSs being a
  bundle of many sub-prime mortgages, the rating
  agencies figured the chance of the majority of
  sub-prime mortgages defaulting was minuscule due
  to the booming housing market.
• Additionally, financial guaranty insurance
  companies insured many of these MBSs, which led
  to higher ratings.

15
Sub-Prime Crisis

• The housing market continued to boom and this led
  to soaring profits for all parties involved
  including investors, brokers, banks, rating
  agencies, and bond insurers.
• Due to the MBSs being so lucrative, CDOs began to
  appear. These packaged medium to low rated MBSs,
  which included mainly sub-prime mortgages,
  together to form CDOs that were able to receive
  AAA ratings for the same reason the other MBSs
  were able to receive AAA ratings in the first
  place.

16
Sub-Prime Crisis

• Since the mortgages were being turned in to ABSs,
  this allowed the mortgage lenders to transfer
  much of the default risk to the investment
  market.
• With mortgage lenders not carrying a lot of the
  default risk, they began to alter their loans to
  get even more people to purchase houses.
• These new loans included even lower interest
  rates for the first or second year of mortgages,
  or they included interest only mortgage loans, in
  which borrowers would not have to pay the larger
  principals until a few years passed.

17
Sub-Prime Crisis

• Many home buyers who could not normally afford
  houses borrowed from these new mortgage loans in
  order to purchase a home.
• The rationality of purchasing houses with the
  newer mortgage loan plans was that the housing
  market would continue to boom. In this scenario
  the purchased homes would increase in value
  substantially enough to be able to refinance the
  home at a profit, and thus be able to afford the
  higher future payments of the mortgage.
• These new mortgages were mainly sub-prime
  mortgages and they were being made into MBSs and
  CDOs as well.

18
Sub-Prime Crisis

• With all of these different asset-backed
  securities trading on the market, and profits
  soaring for the main players in these
  transactions, most people thought that the
  housing market would continue to boom.
• However, this was not the case. By the middle of
  2006 home sales stalled and the value of houses
  stopped climbing. By 2007 many homes values
  began to drop.
• With housing values decreasing, many new
  sub-prime home owners could no longer afford
  their houses by refinancing, and this led many of
  these home owners to default on their mortgages.

19
Sub-Prime Crisis

• Now the housing market began to falter even more,
  and this led to even more defaults for homeowners
  who did not want to invest in a home that was
  losing value.
• With homeowners defaulting on their mortgages,
  all these MBSs and CDOs based on receiving
  mortgage payments from sub-prime mortgages
  defaulted as well.
• With the ABSs defaulting the investment market
  that dealt with these ABSs and all the players
  involved began to lose a lot of money.
• These recent events continue to hurt the housing
  market. Housing prices continue to drop, and
  people who want to currently buy houses who need
  loans are having trouble finding good deals.
• This all leads to even more defaults on mortgages
  today causing even more defaults on ABSs, which
  in turn is causing further losses to the
  investment market, thus the sub-prime crisis.

20
Sub-Prime Crisis
                                                                                                                                   
21
Sub-Prime Crisis
22
Sub-Prime Crisis
                                                                                                                                                      
23
In your opinion who is most at fault for the
sub-prime crisis?

• A) Mortgage Lenders
• B) Investors
• C) Home buyers
• D) Rating Agencies
• E) Bond Insurers

24
Impact on Financial Guaranty Insurance Companies

• Financial Losses
• Rating Cuts
• Little to no new business
• Companies asking to not be rated by certain
  rating agencies
• AFGI loses a member
• New financial guaranty insurance company
• New bond insurance market leaders
• Potential regulation changes

25
Financial Losses

• Two market leading companies had big losses each
  reporting multibillion dollar fourth quarter net
  losses.
• MBIA Insurance Corp.
• Net losses of 2.3 billion.
• 3.4 billion write down due to sub-prime loans
  crisis.
• Predicted losses from sub-prime crisis total
  11.6 billion.
• Ambac Assurance Corporation
• Net losses of 3.2556 billion.
• 5.21 billion write down due to sub-prime loans
  crisis.
• ACA had third quarter losses of 1 billion.
• PMI Group reported a fourth quarter loss of 236
  million due to its U.S. mortgage insurance
  operations.
• Other companies suffered or will suffer
  significant losses as well, this can be seen from
  rating cuts.

26
Rating Cuts

• ACA Financial Guaranty Corp.
• SP cuts rating from A to CCC
• Ambac Assurance Corporation
• Rating cuts by Fitch from AAA to AA with outlook
  negative. SP and Moodys remain AAA/Aaa with
  outlook negative.
• Assured Guaranty Corp.
• Fitch, SP, and Moodys all remain AAA/Aaa with
  stable outlook.
• CIFG
• Fitch cuts rating from AAA to AA- to A- with
  outlook negative. SP cuts rating from AAA to A
  with outlook negative. Moodys cuts
  rating from Aaa to A1 with outlook stable.
• MBIA Insurance Corp.
• Fitch cuts ratings from AAA to AA with negative
  outlook. Moodys and SP remain Aaa/AAA with
  negative outlook.

27
Rating Cuts

• Financial Guaranty Insurance Company
• Fitch cuts ratings from AAA to AA to BBB with
  outlook negative. SP cuts ratings from AAA to
  AA to A to BB with outlook negative. Moodys
  cuts ratings from Aaa to A3 to Baa3, rating still
  under review for further downgrade.
• Financial Security Assurance
• Fitch, SP, and Moodys all remain AAA/Aaa with
  stable outlook.
• Radian Asset Assurance Inc.
• SP rating of AA with stable outlook. Moodys
  rating of Aa3 with outlook negative. Fitch
  changes rating from AA to A.
• XL Capital Assurance
• Fitch cuts ratings from AAA to A to BB. SP cuts
  ratings from AAA to A-. Moodys cuts ratings
  from AAA to A3, rating still under review for
  further downgrade.
• PMI Guaranty Co.
• SP rating of A, Moodys rating of Aa3, and
  Fitch rating of AA.

28
Rating Cuts

• Mortgage Guaranty Insurance Corporation (MGIC)
• SP rating of A, Moodys rating of Aa2, and Fitch
  rating of AA.
• RAM Reinsurance Company
• SP rating of AAA, with negative outlook.
  Moodys rating of Aa3 with negative outlook.
• BluePoint Re Limited
• SP rating of AA, and Moodys rating of Aa3.
• Channel Reinsurance Ltd.
• Moodys cut rating from Aaa to Aa3
• Assured Guaranty Re Ltd.
• SP and Fitch ratings of AA, and Moodys rating
  of Aa2
• CMG Mortgage Insurance Company
• SP rating of AA-, and Fitch rating of AA

29
Slowing of Business

• Insured municipal bond issuance decreased by
  about half in the first quarter of 2008.
• The issuance of insured debt in the first quarter
  from last year to this year fell from 55.1
  billion to 21.7 billion.
• Ambac Assurance Corporations first quarter
  market share dropped from 24.7 a year a go to 1
  this year.
• MBIA Insurance Corp. first quarter market share
  went from 19.4 a year ago to 2.1 this year.
• Financial Guaranty Insurance Company did not
  insure any new municipal bonds during the first
  quarter of 2008.

30
Withdrawals

• MBIA Insurance Corp. withdrew from the
  Association of Financial Guaranty Insurers (AFGI)
  on February 21, 2008 due to disagreement on the
  future of bond insurance.
• MBIA believes the industry should split the
  insuring of municipal bonds apart from the
  insuring of the often riskier asset-backed
  securities.
• CIFG has asked Fitch ratings to withdraw its
  ratings on the company due to belief the credit
  agency has a poor rating approach.

31
New Company

• Warren Buffet creates a new municipal bond
  insurance company.
• Berkshire Hathaway Assurance Corporation
• Began insuring municipal bonds in December 2007
• Recently earned its first financial strength
  rating from SP with a rating of AAA.
• Although Moodys has not rated the company yet,
  they are rating municipal bonds insured by the
  company with Aaa ratings.

32
Emergence of Market Leaders

• Financial Security Assurance
• Doubled its market share to 52.7 in the first
  quarter
• Assured Guaranty Corp.
• Increased its first quarter market share to 25.9
  this year from 1 a year ago.
• Berkshire Hathaway Assurance Corporation
• All these companies have AAA ratings.

33
Potential Changes

• Future Regulation Changes For Bond Insurers
• May not be allowed to insure bonds or securities
  pass a certain risk level.
• Future Regulation Changes For Rating System
• May employ independent analyzers to assess the
  risk for the bond insurers.
• Ending Municipal Bond Insurance

34
Other Problems Created

• Rating cuts on financial guaranty companies has
  caused rating cuts on currently insured bonds.
• This has caused interest rates to increase.
• Several municipal issuers now cannot afford to
  pay the significantly higher interest payments,
  and they may default, causing further losses to
  the bond insurers.
• Example
• Alabamas Jefferson Countys Sewer Bond Crisis

35
Impact on Insurance Industry

• Private Mortgage Insurance (PMI)
• Investment Portfolios
• Very little to do with investing in sub-prime
  ABSs, but more with ripple effect on declining
  stock market.
• BPP Insurance
• Workers Compensation
• DO Insurance
• Surety Insurance
• Sales Decline
• Due to sluggish market and building sector.