Abridged from "Financial Guaranty Insurance" by Meredith C. Hill,
head of asset-backed research, Banc of America Securities
Though transactions wrapped by monoline insurers undergo rigorous scrutiny that no single investor could replicate, several other benefits of financial guaranty insurance often go unappreciated.
To comply with the no-loss underwriting strategy, a rigorous underwriting and due diligence process is employed for each potential transaction, which may include, among other activities: review of historical financials; comparisons of an issuer to its competitors; extensive discussions with several layers of management; complete review of servicing operations; on-site due diligence with sub-contractors that are experts in a particular field; and statistically significant review of credit files.
The underwriting process also maximizes the availability of knowledge within different areas of the business. For example, when a deal is submitted by a new rather than repeat issuer, other areas of the business likely reviewed that company or industry. Analysts would be called upon for their insights.
In addition, for repeat issuers, representatives from the surveillance group likely will provide feedback on performance of prior deals from that issuer as well as performance on those of the issuer's competitors. The final decision process would also employ the knowledge garnered from several areas. All potential transactions are submitted to a credit committee, which will include members from many different groups and will depend upon their appropriateness for different deals.
We note that the due diligence process takes place for every transaction, including those for repeat issuers. Issuers that securitize every quarter receive a visit from their monoline insurance company on each occasion.
Belts And Suspenders Provided By Shadow Rating
Rating agencies require that all potential transactions be investment grade quality before a wrap is considered. Therefore, each transaction receives a shadow rating by Moody's Investors Service and Standard & Poor's Ratings Service and, thus, a full rating review, similar to that conducted by the monoline as previously discussed. While some may consider the double review (that is, a review by the rating agencies and monoline insurance wrapper) inefficient, we believe it provides added security in knowing that the deal is undergoing scrutiny by various independent entities.
We note that the rating agencies tend to react to a deteriorating situation more quickly than to an improving one; thus, shadow ratings that warrant a downgrade likely will be downgraded before those that warrant an upgrade are upgraded.
Reduced Downgrade Risk
The triple-A ratings are integral to the financial guarantors' ongoing business, as they cannot afford to jeopardize their ratings. The no-loss underwriting standard is an important consideration for the rating agencies. Furthermore, the triple-A ratings are tested (and indirectly affirmed) each time a deal is transacted because of the shadow rating requirement. Shadow ratings are required on all insured obligations, not only for ABS.
Therefore, wrapped ABS deals can withstand severe portfolio deterioration and even bankruptcy of the issuer without being downgraded. In fact, for all wrapped ABS deals in which the issuer has declared bankruptcy to date, investors have suffered no disruptions of cash flows.
Extensive Surveillance Function
Financial guarantors have separate departments dedicated solely to the surveillance of all underwritten deals. The surveillance group is a staff of professionals at all levels of management (among which individuals can spend an entire career). This contrasts with the typical surveillance group at a rating agency, which may serve as a training ground for recent college graduates.
Once a deal is closed, surveillance is responsible for setting up the spreadsheets to monitor pool performance, credit enhancement levels and performance triggers. These statistics are reviewed every month, wherein a monthly performance summary is produced. In addition, an internal risk rating is assessed at closing and the surveillance team updates the rating each month, based upon their assessment of the performance.
Probably the most important role in surveillance is detecting pool deterioration at an early stage. Armed with this early sensor, the guarantor can take remedial action, which may encompass simple actions such as ensuring that a reserve fund is increased to its new required amount, or more complicated procedures such as replacing a servicer.
While all ABS investors seek to avoid deals in which the servicer declares bankruptcy or some other form of substantially deteriorating circumstances, this event happens (albeit rarely). When it occurs, investors are better protected in wrapped deals because of the guarantee as well the fact that the guarantor serves as a single controlling party whose capital is at risk
The guarantor can act quickly and use its expertise based upon the situation. In contrast, an internally credit enhanced deal for which an issuer goes bankrupt is subject to the actions taken by the trustee, which inevitably attempts to protect itself from litigation.
For most wrapped ABS transactions, there is no carve-out for fraudulent activities. Thus, the financial guarantor rather than the investor assumes the fraud risk. Those investors particularly concerned with fraud for any fixed-income security can protect themselves by purchasing only wrapped deals.
Issuer Considerations While below investment grade issuers often bring wrapped deals to market, it by no means should be translated into the perception that only weaker issuers wrap their deals. Two issuers that contradict this false belief are Household Finance Corporation and EquiCredit Corporation, both of which benefit from financially sound parents but frequently employ wraps on their ABS.