Order Code RL34364
Bond Insurers: Issues for the 110th Congress
February 11, 2008
Baird Webel
Analyst in Financial Economics
Government and Finance Division
Darryl E. Getter
Specialist in Financial Economics
Government and Finance Division
Bond Insurers: Issues for the 110th Congress
Summary
Beginning in 2007, higher than expected defaults and delinquencies in
“subprime” mortgages led to a significant slowdown of the housing market. Most
of these mortgages were financed by capital markets through asset- or mortgage-
backed securities, rather than by traditional banks. Thus, rather than being confined
to the institutions that made the now-questionable loans, losses caused by unexpected
mortgage defaults have been felt throughout the financial system by any entity who
bought mortgage-backed securities. In addition, financial guaranty insurance
companies, often known as “monoline” insurers, have also been affected because
they insured the prompt payment of interest and return of principal for various
securities that may now not be able to pay the promised amounts. With most
possible insurance payouts still in the future, these insurers have yet to experience
large real losses. Possible massive future losses, however, have caused financial
turmoil for insurers, downgrades from rating agencies, and fears about further harm
to other institutions, individuals, and municipalities. While the federal government
does not currently oversee any insurers, various proposals for broad federal oversight
have been introduced, including S. 40/H.R. 3200 in the 110th Congress. The House
Financial Services Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises is scheduled to examine “The State of the Bond Insurance
Industry” on February 14, 2008.
The financial guaranty insurance industry began less than four decades ago with
insurance policies being offered on municipal bonds. Bond insurers became known
as monoline insurers because they were limited by the regulators to offering financial
guaranty insurance, and relatively few companies entered the business. While
insuring municipal bonds has remained the majority of their business, bond insurers
also expanded into offering insurance for international bonds and the aforementioned
asset-backed securities. In response to demand from their new customers who were
issuing asset-backed securities, the insurance provided on the securities was offered
through relatively new financial derivatives known as credit default swaps, rather
than through traditional insurance policies. The coverage provided through such
swaps has in most cases been essentially identical to that provided through traditional
insurance policies, but the accounting treatment is different for these tradeable
contracts. As the risk of default for the underlying securities has risen, the value of
the credit default swaps to insurers has fallen, resulting in multi-billion dollar paper
losses for bond insurers.
With the possibility of wider financial damage spilling over from bond insurer
difficulties, various market participants and government regulators have broached the
idea of some sort of rescue for the troubled insurers, similar, perhaps, to the Long
Term Capital Management failure in 1998. Uncertainty about the need for, and size
of, such a rescue, as well as greater complexities in the bond insurer situation have
stymied any such rescue to this point. In addition to the immediate demands of crisis
management, the turmoil surrounding the bond insurers may also bring longer term
regulatory issues to the fore, including questions about future federal oversight
regulation of insurers and future federal oversight of derivatives, many of which are
essentially unregulated. This report will be updated as events warrant.
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Bond Insurance Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Municipal Bonds and Asset-Backed Securities . . . . . . . . . . . . . . . . . . . . . . . 3
Movement into Credit Default Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Current Bond Insurer Situation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
An Optimistic View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
A Pessimistic View . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Spillover Effects from Monoline Difficulties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Individual Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Municipalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Other Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Future Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Bond Insurers:
Issues for the 110th Congress
Introduction
In 2007, much higher than expected defaults and delinquencies in the
“subprime” segment of the mortgage market, led to a significant slowdown of the
housing market. Most of these mortgages were financed not by traditional banks, but
by global capital markets through asset or mortgage-backed securities. Thus, rather
than being confined to the institutions who made the loans initially, the losses caused
by the unexpected volume of mortgage defaults have been felt throughout the
financial system by any person or institution who bought such securities.1 In
addition, financial guaranty insurance companies, often known as “monoline”
insurers, have also been impacted because they provided insurance for various asset-
backed bond issues. These insurers also insure a variety of other bonds.
Consequently, if the ratings of a bond insurer should fall (due to widespread default
problems associated with a particular category of bonds), then the ratings of other
bonds insured by the same firm will also decline. Such spillover and contagion
effects are raising questions regarding the possibility of a government-sponsored
rescue of bond insurers in difficulty.
While the federal government does not currently oversee insurers, various
proposals for broad federal oversight of all insurers have been introduced, including
S. 40/H.R. 3200 in the 110th Congress.2 The House Financial Services Subcommittee
on Capital Markets, Insurance, and Government Sponsored Enterprises is scheduled
to specifically examine “The State of the Bond Insurance Industry” on February 14,
2008, but, at the time of writing, there have been no bills focused on bond insurance
introduced.
This report begins with a description of the bond insurance industry and its
business model, including the relatively recent move into providing insurance for
asset-backed securities. An analysis of the current market difficulties follows along
with the various possibilities of spillover effects. Finally, a number of broader policy
questions are briefly discussed. This report will be updated as events warrant,
particularly if and when Congress takes action on the issue.
1 See CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, by
Darryl E. Getter, Edward Vincent Murphy, Marc Labonte, and Mark Jickling.
2 See CRS Report RL34286, Insurance Regulation: Optional Federal Charter Legislation,
by Baird Webel.
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The Bond Insurance Industry
The bond insurance industry is small relative to the entire industry as a whole.
According to the Association of Financial Guaranty Insurers (AFGI), total premiums
collected in 2006 by the 12 insurers and reinsurers3 that represent nearly all the
industry were $3.2 billion.4 In comparison, the total direct premium collected by
U.S. property/casualty insurers in 2006 was $447.8 billion,5 and that collected by life
and health insurers was $619.7 billion.6 While the total premium volume is fairly
low, the total net par value of the bonds insured by its members is much higher,
namely $2.3 trillion with four companies, Ambac, FGIC, FSA, and MBIA, insuring
approximately $2.0 trillion of that $2.3 trillion. The oldest of the insurers, Ambac
Assurance Corporation, was established less than 40 years ago. The bond insurance
sector is relatively small because the companies are restricted, under the state
chartering laws, to providing only one kind of insurance, financial guaranty
insurance, which is why they are often referred to as monolines. While this restriction
applies to the business activity of providing financial guarantees to securities, it does
not limit the types of securities that can be insured.
Bond insurance basically guarantees bond purchasers that interest payments will
be made on time, and if the issuers default, that principal will eventually be returned.
This insurance is typically purchased by the issuer of the bond for a one-time
payment. The purpose of this insurance, therefore, is to “credit enhance” or raise the
credit rating that would have been assigned based upon the financial strength of the
original issuer to that of the insurance company guaranteeing the bond. A higher
credit rating may be useful for issuers wanting to attract more investors, in particular
smaller bond issuers or those unfamiliar to most investors. Many institutions also
prefer highly rated “AAA”7 securities either because risk-based capital requirements
are less for institutions holding such securities or, in the case of mutual funds,
because of specific investment requirements. Issuers without the necessary capital
reserves can still obtain higher ratings for their securities by purchasing bond
insurance.
3 The 12 AFGI insurers and reinsurers are ACA Financial Guaranty Corp, Ambac Assurance
Corp., Assured Guaranty Corp. (AGO), BluePoint Re, Ltd., CIFG Holding Corp., Financial
Guaranty Insurance Company (FGIC), Financial Security Assurance (FSA), MBIA
Insurance Corp., PMI Guranty Co., Radian Asset Assurance, RAM Reinsurance Co., and
XL Capital Assurance. Another smaller bond insurer that is not a member is Security
Capital Assurance (SCA). In response to the crisis, Berkshire Hathaway recently created
a new bond insurer domiciled in New York. Given Berkshire’s financial strength, it could
become a major player in this market, but has yet to do so.
4 See [http://www.afgi.org/fin-annualrept06.html].
5 From the Insurance Information Institute’s website at [http://www.iii.org/financial2/
insurance/pcpbl].
6 From the Insurance Information Institute’s website at [http://www.iii.org/financial2/
insurance/lhpbl].
7 Different rating agencies have different precise ranking systems. This report generally
follows the rankings put out by Fitch and S&P, which has AAA as the highest, followed by
AA, A, BBB, BB, B, and CCC.
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Municipal Bonds and Asset-Backed Securities
Monoline insurers began writing insurance for municipal bonds, and this
insurance remains their primary business (60% of their total according to AFGI).
Over the past 10 years, the annual share of municipal bonds that are issued with bond
insurance has varied from approximately 40% to more thanr 55%8 with the current
total being approximately 50% of the outstanding municipal bonds. Municipal bonds
are typically purchased for their tax advantages, often by individual investors who are
not seeking risky securities. Individual households held $911 billion in municipal
debt at the end of the third quarter of 2007, 35.4% of the total. Other large holders
of municipal debt include various types of mutual funds ($895.6 billion or 34.8%)
and property/casualty insurance companies ($346.8 billion or 13.5%).9
Insuring municipal bonds historically been a low-risk line of business.
Municipalities rarely default on their bond offerings, so the losses required to be paid
by insurers have been very low. While they rarely default, municipalities often do
not maintain the capital reserves or other requirements rating agencies look for in
awarding AAA ratings. Bond insurers sought a AAA rating so the bonds they insure
would also share this status, making the insurance attractive to many municipalities.
If a bond insurer were to lose its AAA rating, it would become very difficult, if not
impossible, for the firm to write new business. If a monoline is unable to attract new
business, they would be forced to pay any existing claims with existing resources,
rather than being able to rely upon the cash flow from new business. The bond
insurer would essentially be in what is known as “run off” in the insurance industry
unless the AAA rating could be re-established. Hence, protection of a AAA rating
is essential for such insurers to remain ongoing concerns.
Over time, bond insurers expanded the types of products that they insured,
branching out into public and infrastructure bonds originated by issuers from other
countries (14% of their business according to AFGI), and into other classes of asset-
backed securities also known as structured finance or securitization (26% of the
business). Structured finance is the process of pooling similar types of financial
assets (typically loans) and transforming them into bonds or debt securities.
Investors typically purchase these asset-backed securities by paying an initial lump
sum, and they are repaid the principal and interest over time with the cash flows
generated from the underlying assets. Monolines begin to guarantee asset-backed
securities in the 1990s. Ambac, for example, created a specific division to focus on
these securities in 1993.10
8 “Bond Insurance Totals and Market Share 1997-2006,” The Bond Buyer/Thompson
Financial 2007 Yearbook, p. 94.
9 Dollar amounts from Federal Reserve Board, Flow of Funds Accounts of the United States,
“L.211 Municipal Securities and Loans,” December 6, 2007, p 89. Available at
[http://www.federalreserve.gov/releases/z1/Current/z1r-4.pdf]. Percentages calculated by
CRS.
10 See”About Us” on Ambac’s website at [http://ambac.com/aboutus.html].
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Movement into Credit Default Swaps
A traditional insurance policy is a long-standing method of protecting oneself
from financial loss. As financial markets have become more sophisticated, however,
other financial instruments have been developed that may offer similar protection in
a different form. Derivatives known as credit default swaps (CDS) are one of these
newer instruments. A CDS is an agreement between two parties where the seller
agrees to provide payment to the buyer in the event of a third party credit event, such
as default on a security. In return, the buyer typically makes periodic payment to the
seller. From an economic point of view, a CDS can be identical to an insurance
policy. Unlike a traditional insurance policy, however, CDS are not regulated by
state insurance departments and are tradeable assets that can be easily bought and
sold on the open market. The CDS contract terms can be whatever the two parties
agree to, and there is no general requirement that any capital be held by the seller to
back the promise made in the contract.
When monoline insurers expanded into offering guarantees for asset-backed
securities, they apparently did so as protection sellers on CDSs rather than through
selling more traditional insurance products. The move to CDS, however, did require
the creation of separate subsidiaries to offer the CDS, because state insurance
regulators generally would not allow insurance companies to offer them. The
insurers, however, were allowed to write insurance policies to their subsidiaries
guaranteeing the CDS entered into by the subsidiaries.
According to AFGI, the movement toward CDS contracting was initiated by its
customers due to more favorable accounting treatment and regulatory reasons. As
long as the CDS contract is on the same terms as the traditional insurance policies,
the switch to CDS contracting would not alter capital requirements for the financial
guarantor wanting to maintain a very high credit rating. Both AGFI11 and the
individual bond insurer MBIA12 indicate that the vast majority of the CDS offered by
bond insurers mirrored the guaranty of the traditional products — namely, prompt
interest payments and ultimate return of principle under the original terms of the
security. (In response to CRS questions, AFGI also indicated that one insurer, ACA,
which already has been severely downgraded, had entered into some swaps that
required payment if the insurer were downgraded, which likely contributed to its
difficulties.)
One important difference between CDS and traditional insurance is the
accounting treatment. As a tradeable instrument, a CDS must be assigned a current
value, or “marked to market,” on a company’s financial statements under standards
11 Email exchange between the author and representatives of the Association of Financial
Guaranty Insurers, January 26, 2008.
12 “MBIA’s Selective Approach to Subprime RMBS and Multi-Sector CDOs,” Presentation
dated August 2, 2007, p. 21, available on MBIA’s website at
[http://library.corporate-ir.net/library/88/880/88095/items/256631/MBI080207pres1.pdf].
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put forth by the Financial Accounting Standards Board (FASB).13 Changes in the
value of the contract must generally be reported as current income during each
reporting period. An insurance policy, however, is not marked to market in a similar
manner. Thus, if there is significant increase in a default risk that is being covered
by a CDS, the market value of the CDS to the buyer would rise significantly, (the
value to the seller would, of course, drop significantly) and this rise (or drop) would
have to be reflected on the income statement. This would not be the case if the
identical risk were covered by an insurance policy. This accounting difference
between traditional insurance policies and CDS holds even if the economic substance
and legal commitment of the insurance policy and the CDS are identical.
Current Bond Insurer Situation
As noted above, the current difficulty in the bond insurance market is rooted in
the unexpected rise in mortgage defaults and foreclosures, which caused an increase
in defaults on a number of mortgage-backed securities, including many that had
previously been thought to be essentially risk-free. This crisis affects bond insurers
in a number of ways. The most straightforward is that, if they insure any securities
that default due to the non-performance of the underlying mortgages, the bond
insurer would be responsible for paying off these securities, which would mean an
increase in future payments to be made by the insurer. A second, more immediate
impact would be on the insurer’s balance sheet, particularly if the insurance
protection is provided in the form of CDS, rather than a traditional policy. Even if
default has not occurred, as the probability of default on a security covered by a CDS
increases, the insurers offering the protection must show a loss on their books, even
if the immediate cash flow has not changed. Finally, the bond insurers may be
affected by generally increased skepticism on the part of investors and the ratings
agencies.
Over the past months, market sentiment on bond insurers has turned
substantially negative. Stock prices for bond insurers are down substantially, nearly
90% in the last year for Ambac, which has been downgraded to AA by one rating
agency (Fitch), while the other two primary rating agencies are reevaluating its rating.
Other downgrades have included FGIC to AA by Fitch and Standard & Poor’s, and
SCA to A by Fitch. One insurer, ACA, has been downgraded all the way to junk
levels by Standard and Poor’s. Several insurers have scrambled to raise capital to
avoid being downgraded. Multi-billion dollar paper losses have been reported,
primarily from the value of the insurers’ CDS contracts. New York State Insurance
Superintendent Eric Dinallo has held meetings with various banks and other financial
institutions attempting to arrange some kind of rescue package to prevent further
downgrades. Losses in the hundreds of billions of dollars throughout the financial
system have been foreseen by some analysts.
Different market participants have come up with dramatically different views
on the future of the bond industry. Two competing views are summarized below, the
13 FASB Statement FAS 133 covers accounting for swaps and other derivative financial
instruments. It can be found at [http://www.fasb.org/st/summary/stsum133.shtml].
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first promoted, unsurprisingly, by many in the bond industry, while the second is
voiced more by outside skeptics.
An Optimistic View. According to this view, the bond insurers are not in
trouble for the following reasons: First, when bonds go into default, the insurer pays
only the interest and principal at the time the payments are scheduled. The firms
generally do not have to accelerate the payment schedule if the insured bond defaults,
if the insured bond’s credit rating falls, or if the guarantor’s rating falls. As a result,
the concern over monolines being unable to meet their payment obligations has been
somewhat exaggerated. Second, it is argued that, because a credible reputation is
extremely valuable to attracting future business, financial monolines only insure
highly-rated bonds. Based on this assumption, it is unlikely that they would have
insured the riskier bonds backed by subprime mortgages. Third, turmoil in the
mortgage-backed security market associated with the subprime crisis may effect the
liquidity and value of all such securities, even those that do not contain subprime
loans. While investors trying to sell these securities are likely to absorb losses
associated with falling mark-to-market values, it is maintained that insurers would
only be affected if the underlying mortgage holders failed to make payments. As
long as cash payments are still being made, the declining market value of the
securities would not trigger any losses from the guarantor, since the market value of
the security is not being insured. Hence, optimists maintain that insurers, while
buffeted by a skeptical market, are not headed for long-term financial trouble.
A Pessimistic View. The pessimistic view holds that monoline insurers are
in serious trouble. Pessimists observe that past ratings of monolines not only fail to
reflect the increase in default associated with the increase of the share of asset-backed
bonds they guarantee, but that these bonds are backed by assets highly susceptible to
default, such as subprime mortgages. From this perspective, the guaranty industry
did, in fact, agree to provide insurance to the riskier securities backed by subprime
mortgages, and their ratings should be revised to reflect a high level of financial risk.
Those making this argument assert that the industry is currently not fully disclosing
all information that will eventually emerge as the financial market turmoil continues.
It is possible as well that the situation falls somewhat between the two. As was
noted above, monoline insurers expanded their business from providing insurance to
municipal bonds to providing insurance to asset-backed securities/bonds, some of
which were backed by mortgage loans. Even in the absence of a mortgage default
crisis, mortgage loans generally have a greater probability of default than municipal
bonds. Previous ratings of financial monolines, therefore, may not have reflected the
increase in default risk solely resulting from a shift in the ratio of bonds backed by
municipals relative to bonds backed by other types of financial assets. Hence, the
current ratings pressures may be the market accurately reassessing the prospects of
the insurers in their expanded line of business. If this is correct, the monoline
industry may need increased capital to back the riskier bonds and retain a AAA
rating, but it may not be in risk of default or bankruptcy.
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Important considerations going forward include the following:
! Will a large portion of the bond insurance market be downgraded?
! Would downgrades lead to fewer customers and put the insurers in
serious jeopardy?
! What percentage of securities backed by monolines eventually go to
claim, thus requiring the insurers to make substantial real payments?
! Are there other surprises in the insurers’ books? Did the insurers in
fact insure more risky securities than is currently indicated?
! Are any of the insurers, like ACA, counterparty to derivatives that
might require immediate payment upon a downgrade?
Spillover Effects from Monoline Difficulties
The direct impact of a monoline insurer being downgraded from AAA is critical
for that company. What may not be obvious, however, are the effects on other actors
in the financial system, some of whom may never have even heard of the asset-
backed securities and credit default swaps that are the catalyst for the current
problems. These participants and possible impacts are discussed below.
Individual Investors. The crucial question for individuals holding municipal
bonds is whether they are “buy and hold” investors who are using the bond for
ongoing income and then the return of principle at maturity, or whether they are
intending to sell the bonds before maturity. For the buy-and-hold investor, the
downgrade makes no difference, unless the bond issuer defaults in the future. Since
municipal bond defaults are exceedingly rare, the downgrade will likely have no
impact on this investor. For someone intending to sell the municipal bonds before
maturity, the downgrade cuts the value of the bond. How much of a loss in value
would depend on how low the insurer was downgraded and the rating on the
underlying bond. In addition to holding individual municipal bonds, many
individuals hold the bonds indirectly through mutual funds. These individuals are
facing losses in the value of the funds just as the individual who was planning on
trading the bonds that he or she owned.
Municipalities. For insured bonds that have already been sold, it makes
essentially no difference to the issuing municipality whether or not the insurer is
downgraded. The municipalities commitment to pay off the terms of the bond is
unchanged. In the future, however, municipalities will likely face a choice between
paying a higher premium on insurance from one of the remaining AAA-rated bond
insurers, assuming that AAA-rated bond insurers remain, or paying a higher interest
rate for their bonds if they offer them either without insurance or with lower rated
insurance. In 2007, a AAA-rated bond’s average yield was 4.07%, compared to
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4.17% for AA, 4.43% for A, and 4.78% for BAA.14 Depending on the comparison
between future insurance premiums and interest rates on differently rated bonds,
significant numbers of municipalities might choose to forgo bond insurance
altogether. The possible damage to future municipal bond offerings was reportedly
a significant factor in Superintendent Dinallo’s encouragement of the newly created
Berkshire-Hathaway bond insurer.15
Other Financial Institutions. Financial and institutional investors holding
insured securities that lose AAA ratings may find they are no longer in regulatory
compliance after these downgrades. Banks and insurers face regulatory requirements
concerning the amount of capital they must hold against their outstanding loans and
written insurance policies. Some pension funds are required to hold AAA investment
grade securities. Downgrades will subsequently reduce the value of holdings, and
these investors must hold more capital and/or rebalance their portfolios with higher
quality assets. Estimates of the magnitude of this effect are obviously highly
speculative at this point in time, and the range of estimates is very wide. One
Barclays Capital analysis puts the additional capital needed by global banks to be as
high as $143 billion.16 This $143 billion figure includes both U.S. and European
banks, and takes into account the market value losses as well as the increased capital
required by regulators since the banks would be holding lower-rated securities. A
Morgan Stanley analyst, however, reportedly indicated on a conference call that they
found total bank exposures in the United States to be in the $20 billion to $25 billion
range with likely losses being $5 billion to $7 billion.17
Future Policy Issues
The future of the individual bond insurers revolve around the actual extent of
their losses on asset-backed securities and whether or not they are able to retain their
AAA ratings. While the answer to these questions are largely unknowable at the
moment, the situation does seem to raise three significant policy questions:
! Is an immediate federal government response necessary to address
the situation and avert possible widespread losses and systemic risk?
! Was a regulatory failure at least partially responsible for allowing
conditions for a potential crisis situation to exist?
! What regulatory changes, in particular those addressing the use of
derivatives, may prevent future financial instability?
14 Yields are 2007 averages from Moody’s 20-Year Municipal Bond Yields of the various
ratings levels. Data from [http://www.globalfinancialdata.com].
15 “A Regulator Not Stymied by Red Tape,” New York Times, January 9, 2008, p. C1.
16 Monoline Downgrades: Implications for the Financial Sector, Barclays Capital, January
25, 2008, p. 4.
17 “Bank losses from monolines seen up to $7 billion: analyst,” Reuters, February 4, 2008,
available at [http://www.reuters.com/article/ousiv/idUSN0427726020080205].
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If the potential losses are truly so high, it would seem to be in the self-interest
of a wide number of financial institutions to help the insurers retain their AAA rating
with or without direct government intervention. Unless a single, very well
capitalized individual or firm becomes convinced that buying out a large bond insurer
made business sense, the odds of a purely private rescue seem small. This is
primarily due to the collective action problems due to the large number of actors
involved. Even if the overall losses would be huge, for each individual bank or
insurer affected, the most logical course of action may be to sit back and let
somebody else put their money up to solve the problem. In such a case, government
coordination, even if no government money is directly involved, might avert the
larger loss. This was essentially the solution to the 1998 Long Term Capital
Management (LTCM) failure that was brokered by the Federal Reserve.18 The bond
insurer situation, however, is much more complicated than LTCM was. There are
several bond insurers in difficulty and hundreds or thousands of institutions that
could be affected if the insurers fail. To this point, the direct government
intervention has been much less, than in the LTCM rescue. The primary government
official pushing for some sort of solution right now is Superintendent Dinallo, who
is the insurance regulator of the state where most bond insurers are based, but who
does not have the same overall status that the leadership of the Federal Reserve did
in the LTCM crisis.
The current absence of federal involvement at the micro level points to the more
macro questions about regulatory failure. The bond insurers, like all insurers, are
state regulated entities. While most are domiciled in New York, the largest, Ambac
is domiciled in Wisconsin, and the insurer most negatively affected by the current
crisis, ACA, is domiciled in Maryland. Questions by Members of Congress about
whether state insurance regulators have the ability to ensure the solvency of insurers
were raised in earnest in the late 1980s after several large insolvencies and have
continued as the financial services marketplace has become increasingly complex
since then. The current bond insurer difficulties will likely cause such questions to
be raised again due to the central role played by the relatively new and sophisticated
financial instruments, such as credit derivatives and collateralized debt obligations.
In addition to the question of how insurers should be regulated, the crisis also
may raise questions about whether and how financial derivatives, such as the credit
default swaps offered by the bond insurers, should be regulated. Currently, some
derivatives trading is regulated by the Commodity Futures Trading Commission
under the Commodity Exchange Act.19 Other derivative instruments, including CDS,
are traded in over-the-counter (off-exchange) markets that are essentially
unregulated. Congress has repeatedly considered the question of whether unregulated
derivatives markets have the potential to facilitate fraud, price manipulation, or
financial instability; for example, in December 2007, the Senate passed legislation
(H.R. 2419, Title XIII) that would expand the CFTC’s authority over currently
unregulated energy derivatives. Unregulated financial derivatives markets have
increased in size such that a widespread crisis in derivatives could cause substantial
damage to the rest of the financial system and lead to a downturn in the real
18 See CRS Report 94-511, Hedge Funds: Should They Be Regulated?, by Mark Jickling.
19 7 U.S.C. §§ 1-25.
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economy. This sort of systemic risk is seen as a major rationale for regulating other
financial services, such as banks. If derivatives are posing a similar systemic risk,
some may point to this in arguing for their regulation as well.