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Beyond the AAA Monoline Model for Development of Local Capital Markets . Presentation by David C. Stevens Inter-American Development Bank Business Seminar on Capital Markets for Development June 4, 2004. The AAA Financial Guarantee Insurance Model.

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beyond the aaa monoline model for development of local capital markets

Beyond the AAA Monoline Model for Development of Local Capital Markets

Presentation by David C. Stevens

Inter-American Development Bank

Business Seminar on Capital Markets for Development

June 4, 2004

the aaa financial guarantee insurance model
The AAA Financial Guarantee Insurance Model
  • Financial Guarantee industry began in 1972 offering credit enhancement to US municipal bonds
  • Today this financial product dominates the US municipal market and is significant in the global ABS and infrastructure markets
  • The industry’s fundamental expectation is that only minimal net losses will occur in a normal operating environment
  • Insurers take on exposures judged to have minimal loss potential – investment grade only
  • Premium rate is generally ½ to 2/3 of the difference in cost of issuing an uninsured bond (e.g., BBB or A) versus that of an insured AAA transaction; the remaining portion constitutes savings for the debt issuer
the monoline product
The Monoline Product
  • One-product industry: AAA credit enhancement
  • Unconditional, irrevocable guarantee of scheduled principal and interest
    • No acceleration of obligation to pay (but insurer can accelerate against a defaulting obligor)
  • Extensive research backing deal underwriting and credit surveillance/remediation
  • Banking rather than insurance product -- credit-based rather than actuarial risk underwriting
  • Unlike P&C insurance, obligation to pay claims as presented is absolute. S&P measures the willingness as well as ability to pay claims by its FER – financial enhancement rating. “Pay first, sue later.”
the benefits of the aaa product
The Benefits of the AAA Product
  • To Issuers
    • Lower cost of funds
    • Easier, stable access to capital markets
    • Broader investor participation
    • Single point of contact for documentation issues, waivers, consents, surveillance & workout
  • To Investors
    • Credit Protection – “Sleep insurance”
    • Liquidity
    • Price Stability – Retention of value in crisis
  • To Emerging Markets
    • Easier access to capital markets
    • Faster pace of infrastructure development
    • Huge savings potential
    • Safer pension investments
typical aaa asset classes
Typical AAA Asset Classes
  • Asset Backed Products
    • Consumer Structured Finance – mortgages, credit cards, auto loans, student loans
    • Commercial Structured Finance – corporate receivables, trade finance, leases
    • Collateralized Debt Obligations – pools of corporate bonds, bank loans, etc.
    • Future Flows – Mostly banks and commodity exporters
  • Single Risk Products
    • Municipal obligations
    • International project finance for essential infrastructure
what the aaas have done in the emerging markets
What the AAAs Have Done in the Emerging Markets
  • Future Flows (USD financings)
    • Banamex electronic remittances
  • Infrastructure
    • Chilean toll roads (local currency)
    • Santiago Airport (mixed dollar & local)
  • Cross-Border ABS
    • Costa Rican mortgage-backed securitization
what is the long term potential of aaa bond insurance in latin america
What is the Long-Term Potential of AAA Bond Insurance in Latin America?
  • Promotes fulfillment of development policy objectives, e.g., local capital markets
  • Promotes issuance of highly-rated, long-term local currency instruments
  • Allows for recycling of local savings pools in pension funds to safest investments, which also promote local economy
  • Avoids the FX risk inherent in dollar or Euro financings
  • Adds depth and liquidity to local capital markets
  • Provides tenor extension beyond limits of most banks and thus new source of financing for long term assets like infrastructure
  • Local banks can take leading role in structuring and underwriting insured bonds
  • Promotes development of local credit rating agencies, more disciplined credit culture, more differentiation based on credit quality
why the aaas have not done more in the emerging markets
Why the AAAs Have not Done More in the Emerging Markets
  • Generally weaker credit fundamentals
    • Financial/economic volatility
    • Weaker political institutions
    • Still-evolving legal systems
    • Fiscal and external financing constraints
    • Weaker banking/financial regulatory framework
    • Chronic exchange rate pressures
    • Greater vulnerability to external shocks
    • Underdeveloped local capital markets
    • Lower sovereign ratings; therefore, more limited opportunities to meet investment grade threshold
limitations for aaas in latin america
Limitations for AAAs in Latin America
  • Country Limits
    • XLCA already maxed out in Brazil and close in Mexico; others may have room but all observe country limits
  • Portfolio Balance Requirements
    • AAAs must really focus on AAA countries
  • Investor Pressure
    • Average muni investor doesn’t like to hear about AAAs’ exposures in Brazil or other EM countries
  • Rating Agency Pressures
  • Restricted Asset Classes – future flows, infrastructure
  • Lack of Familiarity with Local Companies
  • Limits on Appetite for Cross-Border Financing
    • E.g., cheaper to finance within Peru than to use future flows
  • “Excess enhancement”
excess enhancement
Excess Enhancement

























Local investors generally do not ascribe value to instruments which are higher rated than their local treasuries. When a US AAA monoline wraps a Chilean local currency deal, for example, the investor’s yield on its AAA instrument is actually greater than that available on debt of the A rated sovereign. A more efficient mechanism within Chile might be to structure a monoline to the local AAA, equivalent to the international A rating.

alternatives for emerging market financial guarantee companies
Alternatives for Emerging Market Financial Guarantee Companies
  • Global – A-rated EM entity
    • Discussions with IFC never resulted in execution. Rating agencies reportedly cited correlation risks.
  • Regional – Asia Limited
    • A-rated regional guarantor failed – correlation risks. Downgraded out of business – actual losses were low.
  • National Level – Most promising
    • Likely prospects: South Africa, Mexico, Chile
    • Structure monoline companies in these environments to local AAA
    • Use local rating agencies and local credit expertise
the local option
The Local Option
  • Eliminates exchange risk, transfer and convertibility risks
  • Prevents any risk of currency mismatch
  • Local currency financing matches revenues and debt service obligations
  • Dollar-pegged debt service doesn’t work
    • Indonesian experience at MBIA
  • Fulfills public policy goal of recycling local pension fund investments into a country’s productive infrastructure (although it does not provide greater level of pensioner protection afforded by US AAAs)
  • Promotes development of capital markets, stable long-term financing, and overall economic development
would a national level guarantor work
Would a National-Level Guarantor Work?
  • Anecdotal evidence that South Africa, Chile and Mexico could benefit – strong and increasing local capital markets flows
  • Spreads are (probably) there
    • Mexican Issuance: Hipotecaria Su Casa 2002-1
    • MxAAA: 180 day Cetes + 100-120
    • Ba2 Tranche: 180 day Cetes + 400-500
    • If assume BBB would be 200-225, there is about 100 basis points of available spread
  • Would meet most aforementioned policy objectives – but not the objective of providing pensioners better credit risk than the sovereign
  • Setting up a national monoline in an EM environment would require rethinking US-based typical AAA assumptions like the zero loss standard, leverage levels, and reserving practices
  • Worthy project for multilaterals & promising investment for leading players in these local capital markets to consider.
  • A functioning entity in one of the above markets or another important EM venue such as Brazil could serve as a model for other national-level monolines in other EM environments.