FINANCIAL GUARANTY INSURANCE
Financial guaranty insurance, also known as bond insurance, helps expand the financial markets by increasing borrower and lender leverage. Starting in the 1970s, surety bonds began to be used to guarantee the principal and interest payments on municipal obligations. This made the bonds more attractive to investors and at the same time benefited bond issuers because having the insurance lowered their borrowing costs. Initially, financial guaranty insurance was considered a special category of surety. It became a separate line of insurance in 1986.
Financial guaranty insurers are specialized, highly capitalized companies that traditionally have had the highest rating. The insurer’s high rating attaches to the bonds, lowering the riskiness of the bonds to investors. With their credit rating thus enhanced, municipalities can issue bonds that pay a lower interest rate, enabling them to borrow more for the same outlay of funds.
Over the years financial guaranty insurers have expanded their reach beyond municipal bonds and now insure a wide array of products, including mortgage-backed securities, pools of credit default swaps and other structured transactions. Recent problems in the credit markets have taken a toll on financial guaranty insurers, as they confront heavy losses related to these structured instruments.
TOP TEN WRITERS OF FINANCIAL GUARANTY INSURANCE BY DIRECT PREMIUMS WRITTEN, 2012
CREDIT DEFAULT SWAPS
Credit derivatives are contracts that lenders, large bondholders and other investors can purchase to protect against credit risks. One such derivative, credit default swaps (CDSs), protects lenders when companies do not pay their debt. The swaps are contracts between two parties: the buyer of the credit protection and the seller, i.e., the firm offering protection. Their workings are similar to insurance. Under the contract the buyer makes payments to the seller over an arranged period of time. The seller pays only if there is a default or other credit problem. Either the buyer or the seller can sell the contract to a third party. These instruments are often valued based on computer models; the actual value at settlement might be quite different from the modeled value. Banks, insurance companies and hedge funds create and trade the CDSs, which are largely unregulated and experienced enormous growth from 2004 to 2007 but declined sharply in the three subsequent years.
CREDIT DEFAULT SWAPS MARKET, 2004-2011 (1)
($ billions, end of year)