Gone are the days when securitization deals were either wrapped or unwrapped. These days securitizers can select deal enhancement from the traditional monolines, international agencies such as the International Financial Corp. (IFC), and the World Bank; multiline insurers, such as Zurich U.S.; and U.S. federal agencies, like Overseas Private Investment Corp. (OPIC).
"With the wide variety of insurance policies out there, investors should be aware of what is being covered and what is not," said Rosario Buendia, director of the structured finance department for Latin America at Standard & Poor's.
Monoline Insurers Total Protection
Monoline insurers are, by definition, companies with a single line of business. They provide full guarantees of principal, interest and timeliness of payments.
Monolines try not only to control the risks on any given transaction but also to control the risk within their entire insured portfolio. "These insurance companies realize that one of their greatest risks is accumulating a portfolio where correlation would be high," said Jack Dorer, senior vice president at Moody's Investor Services. "That's why they focus on establishing a well-diversified portfolio with a low-risk content and stick to the more developed countries, where risks are more contained."
Triple-A rated monoline insurers, such as MBIA Insurance Corp., Ambac Assurance Corp., Financial Security Assurance, Financial Guaranty Insurance Co., normally require that securitizations are backed by a real asset that is being paid for in hard currency and that the underlying deal is rated at investment grade level by Moody's and S&P (others, such as double-A rated Asset Guaranty Insurance Co., are able to write insurance for sub-investment grade deals).
Multilateral Financial Institutions
Undoubtedly, the international standing of multilateral financial institutions adds strength to the transactions they back, yet there are some important distinctions in regards to the coverage they give to investors. The World Bank acts as a loan guarantor and therefore makes payments of principal and interests if the issuer does not meet payments. In contrast, the IFC and the regional multilateral agencies, such as the Inter-American Development Bank (IDB), do not provide a full financial guarantee but rather issue loans under their preferred creditor status.
This preferred creditor status means that even in the event of a national currency crisis governments usually encourage debtors to make good their debts to the multilateral agencies; for instance, exempting them from the imposition of exchange, transfer or convertibility controls. Thus, the rating is not constrained by the sovereign foreign currency rating, but instead can be assigned a foreign currency rating equal to or higher than that of the issuer's local currency rating.
In order to qualify for inclusion under the preferred creditor umbrella the sovereign government has to have a history of non-interference in private sector payments to multilateral institutions, as well as be well integrated into global trade and financial systems.
Deals are structured with the multilateral agency as the lender of record and investors purchase participation (securitized or otherwise) in the debt payments that the issuing company owes to those multilaterals. In a crisis, governments are likely to ensure that debtors have access to the necessary hard currency to ensure repayment.
"We believe that even in cases in which foreign currency is being rationed by the government or the government itself is not paying some of its obligations, foreign currency
will be made available for purchase by the company in order to avoid a default to [for example] IDB or the IFC," explained Buendia.
Despite the advantages granted by the multilaterals' preferred creditor status, any deal is only as good as the issuing company, because investors are taking the commercial risk of the company and counting on its ability to generate enough local currency to buy the dollars from the central bank. Since the IFC and the regional multilaterals are not guaranteeing payments to investors, if the company is unable to purchase dollars the deal will default.
Political Insurance The Wave Of The Future?
In that sense, preferred creditor status transactions are similar to the new arrivals of bond insurance OPIC and multilines such as Zurich U.S. as they rely on the issuing company's ability to generate enough local currency to purchase dollars that will determine whether investors lose out.
"Since the ability of the company to generate enough local currency to buy the dollars depends on the company's operating environment which can include scenarios of devaluation, price controls, inflation, etc, the ratings on both the OPIC and the [preferred creditor status] transactions are [as far as S&P are concerned] constrained by the local currency of the company in the transaction," said S&P's Buendia.
OPIC's political insurance coverage certainly caused a flurry of interest in the second half of last year, in Latin America in particular. Under the federal agency's policy, emerging market investors are covered against inconvertibility and non-transferability of funds only. The price of the coverage is in the 60 basis points to 100 basis points range.
OPIC's policy generally limits the amount of coverage for any one project to $200 million and limits its exposure under each form of coverage in any country to no more than 15% of its total exposure. Therefore, there may be limits on the amount of insurance available for certain risks in certain countries. The policy pays up to 100% of the total amount of the policy cover for valid claims.
In addition, the coverage is backed by the triple-A credit rating of the U.S. government and OPIC's strong track record of payment.
By statute, OPIC can only support investments of
U.S. citizens and U.S. entities in which they have a majority stake (plus wholly owned foreign subsidiaries of such U.S. entities). For a bond transaction, the statute is satisfied if 51% of the value is held by bondholders (at the outset and during the policy period after any secondary trading of the notes) who are U.S. citizens or eligible U.S. entities.
The bond insurance policy from Zurich U.S. is similar. It covers the risks of expropriation, political violence, currency transfer and inconvertibility. The policy ensures timeliness of payments with a period of 180 days. The coverage is for up to $100 million per risk and the indemnity ranges from 90% to 100%. The policy's maximum term is 15 years and the country limits range from $250 million to $1 billion per country. In October, Mexican brewer Femsa Cerveza was the first to make use of Zurich's coverage.
"We developed our political risk insurance product because we saw a swing in the markets," said Dan Riordan, Zurich U.S.'s managing director of insurance. "The capital markets are coming back and investors are more concerned with political risk than before."
The new political risk products have certainly created heated debate among bankers, investors and rating agencies.
Some feel that they leave many unanswered questions. "We went from seeing mostly policies that covered everything, to seeing more partial coverage and plain vanilla bonds with just transfer and convertibility enhancement," said Buendia. "And there is a gap in between full of risks that are not being covered."
Others agreed. "When these policies first started floating around I think investors assumed that they were covering more risks than they really do," said a one asset backed expert. "Transfer and convertibility insurance is nice and good, but I don't know how much credit you can give it. True, the one sentence description sounds great but when you dig deeper you realize that only one piece of the puzzle is protected."
However, Fitch IBCA and Moody's are happy to rate OPIC-backed transactions and those with a policy from Zurich U.S. above the local currency sovereign ceiling. "A country may default on its local currency debt but that doesn't mean that the company will do the same," said an analyst at Fitch. "It might, however, run into short-term difficulties, which are covered by the six-month reserve funds provided by OPIC."
Duff & Phelps Credit Rating Co. and S&P, on the other hand, established local currency ratings as ceilings for these type of transactions. "We don't feel comfortable saying that a default of the local currency would have no, or almost no, effect on the transaction," said Buendia.
In the end of course it all comes down to cost. "I think political insurance is important, and that the products offered by OPIC and Zurich U.S. are good products," said an investor. "But participating in them means giving up yield. From my perspective, they have a price that I might not be willing to pay."