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Finance 431: Property-Liability Insurance

Finance 431: Property-Liability Insurance. Lecture : Financial Guaranty Insurance. Overview. Financial Guaranty Insurance Sub-Prime Crisis The Effect on Financial Guaranty Insurers Other Effects on the Insurance Industry. Financial Guaranty Insurance.

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Finance 431: Property-Liability Insurance

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  1. Finance 431:Property-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 S&P, Fitch, and Moody’s 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? • Asset-Backed Securities • Mortgage-Backed Securities • Municipal Bonds • International Securities • 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. • S&P cuts rating from A to CCC • Ambac Assurance Corporation • Rating cuts by Fitch from AAA to AA with outlook negative. S&P and Moody’s remain AAA/Aaa with outlook negative. • Assured Guaranty Corp. • Fitch, S&P, and Moody’s all remain AAA/Aaa with stable outlook. • CIFG • Fitch cuts rating from AAA to AA- to A- with outlook negative. S&P cuts rating from AAA to A+ with outlook negative. Moody’s cuts rating from Aaa to A1 with outlook stable. • MBIA Insurance Corp. • Fitch cuts ratings from AAA to AA with negative outlook. Moody’s and S&P 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. S&P cuts ratings from AAA to AA to A to BB with outlook negative. Moody’s cuts ratings from Aaa to A3 to Baa3, rating still under review for further downgrade. • Financial Security Assurance • Fitch, S&P, and Moody’s all remain AAA/Aaa with stable outlook. • Radian Asset Assurance Inc. • S&P rating of AA with stable outlook. Moody’s 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. S&P cuts ratings from AAA to A-. Moody’s cuts ratings from AAA to A3, rating still under review for further downgrade. • PMI Guaranty Co. • S&P rating of A+, Moody’s rating of Aa3, and Fitch rating of AA.

  28. Rating Cuts • Mortgage Guaranty Insurance Corporation (MGIC) • S&P rating of A, Moody’s rating of Aa2, and Fitch rating of AA. • RAM Reinsurance Company • S&P rating of AAA, with negative outlook. Moody’s rating of Aa3 with negative outlook. • BluePoint Re Limited • S&P rating of AA, and Moody’s rating of Aa3. • Channel Reinsurance Ltd. • Moody’s cut rating from Aaa to Aa3 • Assured Guaranty Re Ltd. • S&P and Fitch ratings of AA, and Moody’s rating of Aa2 • CMG Mortgage Insurance Company • S&P 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 Corporation’s 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 S&P with a rating of AAA. • Although Moody’s 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 • Alabama’s Jefferson County’s 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 • D&O Insurance • Surety Insurance • Sales Decline • Due to sluggish market and building sector.

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