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A Guide to

Insured Asset-Backed Securities

Financial Security Assurance Inc. (FSA) is a monoline financial guaranty insurer of asset-backed securities and municipal bonds. FSA was the first insurance company organized to insure asset-backed obligations. Four rating agencies have assigned their highest available ratings to FSA's claims-paying ability: Fitch IBCA, Inc. Moody's Investors Service, Inc. Standard & Poor's Ratings Services (S&P) Japan Rating and Investment Information, Inc. (R&I) AAA Aaa AAA AAA

Headquartered in New York, FSA has additional U.S. offices in San Francisco and Dallas, subsidiaries based in London and Bermuda, and representative offices in Madrid, Paris, Singapore, Sydney and Tokyo. For Japanese assets, FSA provides financial guaranty services through a joint venture with The Tokio Marine and Fire Insurance Co., Ltd.


Asset-backed securities (ABS) have become a fixture of numerous countries' financial markets, and their importance is growing. Financial institutions and other businesses have developed a remarkable array of techniques for asset securitization -- the process of creating securities backed by pools of financial assets. For their sponsors,1 asset-backed securities fulfill a number of important objectives. The primary benefits are: · lower capital costs · access to capital markets · expanded sources of liquidity · off-balance-sheet financing · improved returns on capital · better matching of asset and liability characteristics · more liquid asset portfolios · regulatory compliance at reduced cost For investors, asset-backed securities provide high-quality investments with superior liquidity. However, ABS are complex securities that require specialized expertise and substantial analysis by investors. One means of simplifying ABS is financial guaranty insurance.

1 For

convenience, the term "sponsor" is used throughout this booklet for the entity that derives the main economic benefit from a securitization, which is usually the organization that originates and then sells the assets that back the securities.



Specialized insurance companies that provide guarantees for secured financial obligations play a major role in the ABS markets. These companies are known as "monoline" financial guaranty insurance companies, because their business is limited to providing financial guarantees and related types of insurance. They do not engage in other property/casualty or life insurance lines of business. The major monolines have Aaa/AAA claims-paying ratings. To maintain its Aaa/AAA ratings, a monoline guarantor carefully selects the obligations it insures. Before insurance, transactions must be of investment-grade quality. In other words, the underlying credit quality must be Baa/BBB, A/A, Aa/AA or Aaa/AAA. In many instances, the underlying credit quality is Single-A or higher. The guarantor's financial strength is protected from liquidity problems because its guaranty covers principal and interest payments only as scheduled. A claim does not require payment of insured principal until due. Many types of ABS cannot be marketed successfully unless they carry Triple-A ratings. The market's preference for higher quality has become more pronounced since the global financial crisis of 1998. As a result, demand for Aaa/AAA financial guaranty insurance is increasing. Aaa/AAA insurance is frequently the most cost-effective way to achieve a Triple-A rating and attract the broadest range of investors. Monolines sometimes conduct their business through joint ventures with multiline insurance companies. In Japan, for example, FSA works with The Tokio Marine and Fire Insurance Co. to provide financial guaranty services to issuers of asset-backed securities, municipalities and others, as well as to holders of portfolios of such issuers' bonds. These joint ventures offer expanded capabilities, greater capital strength and deeper knowledge of specific markets.

S&P Ratings of U.S. Public ABS


92.8% 2.7% 2.7% 1.8%

Based on par value of new issues rated by S&P in 1998. Less than 0.1% were rated BB or B. Source: Securities Data Company


Benefits of Financial Guaranty Insurance

Investors rely on financial guarantors for:

· unconditional, irrevocable guarantees of timely payment of principal and interest · credit research · collateral analysis · due diligence · structuring supervision · legal analysis · surveillance · enforcement of rights and remedies

These services simplify securities from the investor's standpoint and create substantial savings in the time and resources required to purchase, monitor and resell insured issues.

Guarantors help design securities tailored to sponsors' specific objectives by providing:

· access to low Aaa/AAA borrowing rates · the ability to securitize assets that are not homogeneous or have special characteristics · a method of introducing new asset types to the market · solutions to tax, regulatory or accounting problems · a means of attracting new funding sources · heightened name recognition and secondary-market liquidity · cross-border market access based on the guarantor's international market acceptance



The chart below illustrates the expansion of the U.S. asset-backed market. As defined here, the market includes ABS backed by consumer and corporate receivables as well as private-label mortgage-backed securities (MBS), which are securities backed by residential first mortgages that are neither issued nor guaranteed by government-related agencies. (Unless otherwise noted, references to "ABS" in this booklet include private-label MBS.) In aggregate, the U.S. ABS market grew from $67 billion issued in 1990 to $360 billion in 1998. As recently as 1985, annual issuance was less than $4 billion. The chart does not show the asset-backed commercial paper (ABCP) market, which grew from $88 billion of outstandings in 1995 to more than $380 billion in 1998.2

U.S. Securitization Market




350 300 250 200 150 100 50 0

278 206 141 100 67 158 139 151

90 91 92 93 94 95 96 97 98

Includes public & private transactions, excludes ABCP and government-agency MBS. Source: Inside MBS & ABS

Use of Insurance

The worldwide annual volume of ABS and related obligations insured by monolines grew from less than $500 thousand in 1985 to $120 billion in 1998.3 Experienced sponsors of regular ABS programs routinely compare the economics of insured and uninsured executions, choosing the structure that works best in current market conditions. Many establish long-term insured securitization programs to take advantage of the cost efficiencies, certainty of execution and structuring flexibility these programs provide. In addition, insurance plays an important role in introducing new assets, new sponsors and structuring innovations to the market, and it simplifies transactions that are complex from an investor's point of view.

2 Sources: 3 Source:

Inside MBS & ABS, Asset Sales Report, Federal Reserve System Association of Financial Guaranty Insurors (AFGI)



Almost any type of asset pool that generates predictable revenues may be converted to marketable securities. Assets that have been securitized include: · residential first mortgage loans · closed-end residential second mortgage and revolving home equity loans · home improvement loans · credit card receivables · consumer automobile loans · wholesale automobile receivables · truck, recreational vehicle and motorcycle loans · manufactured housing loans · trade receivables · bank loans, debt securities and equity securities · franchise loans · equipment leases · student loans · boat loans · concession revenues from infrastructure privatizations Instruments include term issues, revolving facilities and commercial paper. Coupon rates may be fixed or floating. Both prime and sub-prime consumer assets may be securitized. If properly structured, underlying asset pools may combine fixed and floating rate receivables or prime and sub-prime obligors. By incorporating swaps in the structure, fixed rate assets may back floating rate ABS and vice versa, and locally denominated assets may back cross-border ABS denominated in US dollars, euros or other currencies.

U.S. Securitization Market

By Collateral

Residential Mortgages & Home Equity Loans 44% Manufactured Housing 4% Auto Loans 8% Student Loans 3% Other Assets 12% Credit Card Receivables 29%

Sources: The Bond Market Association, Inside MBS & ABS Based on all issues outstanding at 12/31/98



Asset securitization is a natural step in the evolution of financial markets. For banks and other financial services organizations, securitization is an efficient means of managing portfolio risk concentrations, funding operations and divesting assets on a large scale. For finance companies, leasing companies and industrial corporations, securitizing receivables is part of the larger trend toward using securities markets as an alternative or supplement to bank lending. When capacity is constrained in the bank loan market, ABS can be a lifeline of access to liquidity and capital. For a corporation that frequently issues debt, asset-backed issues do not use up the debt market's capacity for the borrower's name, since ABS are usually structured as asset sales rather than as secured debt. The ABS market grew rapidly in the United States, beginning in the late 1980s, and continues to expand in both volume and the range of securitized assets. A growing ABS market is developing for issuers in Japan, where the accelerating pace of reform and the need for financial restructuring have combined to create the potential for an enormous securitization market. Many Japanese borrowers are particularly attracted to securitization because it provides access to new investors, enabling borrowers to reduce their dependence on banks and to lengthen debt maturities. In Europe, securitization has been used in special circumstances for more than a decade, and a broad, more stable market now appears to be developing. The market is expanding for several reasons, including: the improved European legal frameworks for securitization; a broader array of mortgage types and the introduction of new asset classes; the increasing number of repeat issuers of

Worldwide Growth of ABS Issuance




1 2 3 4 5 6

Japan SE Asia Australia Canada Latin America Europe




1 2 3 4 5 6

1 2 3 4 5 6

1 2 3 4 5 6

1 2 3 4 5 6


TOTAL: $17







Source: Moody's Investors Service. Excludes U.S. issues and ABCP . U.S. dollars in billions


ABS; the growth of infrastructure financings under the Private Finance Initiative in the U.K., which are becoming a model for such transactions in other European countries; and the appeal of European ABS to nonEuropean investors. Looking ahead, there are additional trends likely to stimulate the market. First, the introduction of the euro will eliminate currency hurdles and create a more homogeneous pan-European investor base. Second, adoption of the Basel 99 proposals for bank regulation is expected to promote the use of capital markets to finance certain types of assets and projects that have historically been financed by bank loans held on balance sheet. One developing area across all world markets is collateralized debt obligations (CDOs), a type of ABS that helps lending institutions achieve more efficient use of their equity capital, increase returns on equity and make regulatory compliance less costly. By transferring risk to third parties through CDOs or credit default swaps (sometimes called synthetic CDOs), banks can reduce the amount of capital they must hold in reserve. CDOs can make capital available for additional loan originations and allow the bank to price its loan originations more competitively, while still achieving appropriate risk-adjusted rates of return. CDOs are also used by portfolio managers seeking to increase assets under management and by securities firms that wish to profit from market inefficiencies.

Securitization Outside North America

By Collateral

Mortgages 31% Auto Loans 4% Consumer & Personal Loans 6% Lease Receivables 5% Other Assets 13%

Credit Card Receivables 8% Future Receivable Flows 12% Corporate Loans 21%

Source: ING Barings Based on issuance from 1/1/87-12/31/98



One of the strengths of asset-backed obligations is that they can be structured in a variety of ways to satisfy the diverse needs of sponsors and investors. Proper structuring can create specific prepayment, credit risk, interest rate and currency characteristics in order to attract investors with differing appetites and thereby achieve the sponsor's objectives for proceeds and cost of funds. Typically, the assets backing an ABS are transferred from the sponsor to a special purpose vehicle (SPV), which is generally either a corporation or a trust. In most cases, the SPV issues securities and uses the proceeds to acquire the assets from the sponsor, thereby insulating the assets from a bankruptcy of the sponsor. The SPV has no other material income-producing assets and is the legal issuer of the obligation.


Assets $


Assets $


Asset-backed securities have 3 defining features: Collateral

Receivables with predictable cash flow or liquidation value are segregated to support the obligation. As a result, the investor's analysis centers primarily on the adequacy of the receivables' cash flow or liquidation value, not the credit quality of the sponsor.


There are several ways to immunize an ABS issue from a sponsor bankruptcy. In most cases, the assets supporting the ABS are contributed or sold in a "true sale" from the sponsor to an SPV, which would not be "consolidated" with the sponsor in the event of a sponsor bankruptcy. In addition, a precautionary security interest in the contributed or sold assets is typically obtained, as a further disincentive against challenges from other creditors to the contribution, sale or non-consolidation. If bankruptcy-remoteness is not achieved and bankruptcy occurs, investors may have to endure delays in payment or compete with other creditors for the revenues generated by the securitized assets. Bankruptcy-remoteness is usually necessary if the credit rating of the ABS issue is to be independent of the credit rating of the sponsor. The bankruptcy laws and business practices of the country of origin affect whether and how a true sale can be obtained. Recent regulatory changes in Japan, for example, have simplified obtaining a true sale for certain monetary claims and receivables and thereby encourage greater use of securitization.

Credit Enhancement

Credit enhancement occurs when an issue's credit quality is raised above that of the sponsor's unsecured debt or of the asset pool's credit quality. It results in lower all-in funding costs by dividing the risk profile of an asset pool into components suited to various parties' risk appetites, thus increasing market efficiency. Every issue may involve one or more credit enhancement techniques, such as those listed on page 10. The credit enhancement may be partial, covering defaults in the asset pool up to a defined level, or may be a "full wrap," covering 100% of principal and interest.


Risks in ABS

There are two types of risk in ABS, asset risk and structure risk. Asset risk is present because some losses are expected to occur in any large pool of receivables. Such losses occur when an obligor defaults on a payment obligation and any property or collateral pledged to secure the payment obligation is insufficient to satisfy the debt. ABS are structured with mechanisms designed to absorb some or all of the losses related to performance of the underlying assets. Structure risk is the risk that a legal or structural element of the securitization will fail. This includes not only a failure of bankruptcy-remoteness but also fraud by the asset originator or a downgrade or performance failure of any party to the transaction. Securitizations involve a host of parties -- loan originators, custodians, primary and backup servicers, performance guarantors, liquidity providers, mortgage and special hazard insurers, first-loss providers, counterparties for interest-rate and currency swaps, and providers of caps, collars, guaranteed investment contracts and so forth. The credit rating of uninsured transactions may decline if certain transaction participants are downgraded. The investor can address structure risks by evaluating the credit quality and performance of each individual component of a transaction or by requiring a full-wrap financial guaranty insurance policy, leaving the evaluation of such risks to the insurer.


Forms of Credit Enhancement

The major forms of credit enhancement are: Subordination/Overcollateralization

A pool of assets can be divided into a senior and one or more subordinated interests. The senior securities typically have first claim on assets in the pool as well as cash flows, thus creating overcollateralization to protect against expected losses and some level of deterioration beyond expected performance. The subordinated investors absorb the first losses in exchange for a higher yield. If assets do not perform as well as expected, cash flow may be diverted from subordinated to senior investors.

Cash/Reserve Account

There are two basic methods for setting aside cash to protect investors. A cash collateral account may be established at the outset of a transaction. Additionally or alternatively, a reserve called a spread account may be funded over time through the capture of the spread between the interest rate on the underlying receivables and the lower rate paid to ABS investors. The cash in these accounts may be used to cover shortfalls in payments from the receivables.

Sponsor Limited Recourse

The sponsor may provide recourse for defaulted receivables up to a specified level of underlying losses. This may take the form of a limited repurchase obligation covering defaulted assets. This structure is similar in risk profile to the sponsor retaining a subordinated interest, or residual.

Bank Letter of Credit

A bank may provide a letter of credit to be drawn upon when needed to cover shortfalls.

Financial Guaranty Insurance

ABS insured by financial guaranty insurance companies typically have one or more levels of credit enhancement ahead of the insurance policy. In other words, the guarantor will require that its exposure to the risk of defaults in the underlying receivables be limited to a satisfactory investment-grade level (frequently Single-A or better) by other means of credit enhancement. Investors are protected by the insurance company's guaranty as well as the credit enhancements the guarantor has required to protect itself. Typically, the guarantor provides an unconditional and irrevocable 100% guaranty of ABS principal and interest, as scheduled. Such a policy typically covers both asset risk and structure risk. In other cases, the guaranty may be for less than 100% of principal and interest, and thus covers only asset risk and only up to a specified limit of underlying losses.


Examples of Insured ABS Structures

Financial guaranty insurance can be applied to a wide range of structures. Two hypothetical examples are diagrammed below.

$100 Million Insured Pass-Through Certificates with Spread Account

$100 Million loaned 10% Wtd. Avg. Interest (Monthly)


SPONSOR (originator/seller/ servicer) Loans Sold TRUST Spread Account (captures all excess interest until fully funded) Participation Certificates (5% Interest; Monthly) $100MM

Excess Servicing Fee (excess interest received but not needed to fund spread account)



Pledge of Assets & Premium

In this pass-through structure, receivables are sold to a trust, which issues certificates that represent equity interests in the trust and entitle holders to a pro rata share of cash flows generated by the receivables. Cash flows are passed through to investors as received. In this example, the interest-rate spread is captured in a spread account. A financial guaranty insurer, protected by the spread account, provides a 100% guaranty.

$100 Million Insured Pay-Through Bonds with $10 Million Subordinated Class

$100 Million loaned 10% Wtd. Avg. Interest (Monthly)


SPONSOR (originator/seller/ servicer)

Stock Loans Sold


Pledge of Collateral & Premium


Pledge of Collateral Senior Bonds (5% Interest; semi-annual) $90MM Proceeds Subordinated Bonds (9% Interest; semi-annual) $10MM Proceeds SUBORDINATED BOND HOLDERS SENIOR BOND HOLDERS Guaranty GUARANTOR

Pledge of Collateral

In this pay-through structure, receivables are transferred to a special purpose corporation that issues debt secured by the assets' cash flows. In general, pay-throughs allow greater flexibility to pay principal and interest to investors on a schedule that does not match the timing of the incoming cash flows. They can thus be tailored more readily to investor preferences. In this simplified example, a pay-through structure allows consumer loans with monthly payment schedules to back bonds with semi-annual coupon payments. The guarantor is protected by 10% subordination.


Growth of Monoline Guarantees for ABS





93 75



46 25


21 7 11 11 12


89 90 91 92 93 94 95 96 97 98

Annual aggregate gross par amounts of ABS and related insured transactions by monoline financial guaranty insurers. Source: AFGI

Four Aaa/AAA guarantors insure the bulk of monoline-guaranteed ABS. The first to do so was FSA, which entered the market in 1985. AMBAC, FGIC and MBIA, which were originally municipal bond insurers, are more recent entrants.

Credit Enhancement from the Investor's Perspective

Each form of enhancement must be analyzed differently. When subordination is used alone, senior investors must be satisfied with the amount of excess collateral, recognizing that there is some risk that underlying losses will exceed the subordinated amount and impair the value and cash flow of the senior securities. Even if such accumulated losses do not result in loss of principal or interest, higher-than-expected losses may cause loss of trading value. For similar reasons, a partial guaranty or cash reserves must be of sufficient size to protect investors against significant underlying losses. When sponsor recourse or third-party guarantees are used, the credit quality of the ABS issue will depend on the size of the enhancement and the credit quality of the sponsor or guarantor. The investor may prefer a third-party guaranty in order to avoid correlations between asset performance and the guarantor's ability to honor its obligation. Also, a qualified third party guarantor can provide objective analysis and surveillance. While all types of credit enhancement address asset risk, only a 100% guaranty offers complete protection from structure risk. Although the basic concept of securitization is fairly simple, the structures of actual transactions can be quite complex, and the possibility of a structuring failure cannot be dismissed. Investors, guarantors and rating agencies must evaluate the technical and legal integrity of the structure of each transaction. For the investor, the mere threat of a downgrade or a legal challenge to the structure can lead to illiquidity and loss of market value, even if payment is


ultimately received in full. Therefore, the durability of any ABS rating should be considered carefully.

Credit Enhancement from the Sponsor's Perspective

The sponsor's cost of funding as well as the amount of proceeds received will be affected by the rating achieved and the cost of credit enhancement. Tax, accounting and regulatory factors must also be considered. In instances when Aaa/AAA ratings are desired, the cost of insurance premiums must be compared with the cost of either selling a subordinated tranche or carrying its equivalent on the sponsor's balance sheet. In general, as credit spreads widen and yields on subordinated paper rise, insured executions become more desirable. If costs are comparable, there are additional reasons why a sponsor may prefer insurance. Some sponsors want to diversify their enhancement sources to attract a broader range of investors and accommodate those whose portfolios have reached capacity for the issuer's name. Some sponsors insure all their issues in order to create a standardized structure that saves time and money and, perhaps most important, ensures certainty of execution. When interest rates or other market conditions present windows of opportunity, these sponsors can bring their issues to market quickly. These programs may include benefits unavailable in stand-alone transactions, such as performance-based reductions in required reserves. For first-time sponsors -- and for those securitizing assets that are new to the market, assets with special characteristics, or pools of mixed asset types, financial guaranty insurance improves liquidity and promotes market acceptance. Monoline guarantors also add value by providing structuring assistance and independent, objective feedback about portfolio trends, underwriting quality, servicing performance, rating agency criteria and industry best practices.



The strong track record of the ABS market shows that asset risk has generally been successfully quantified for investment-grade securities. The credit coverage in most ABS issues actually improves over time. However, these are complex transactions involving numerous risks. For example, severe economic conditions may cause unexpectedly high delinquency and loss rates, the originator may have failed to underwrite loans according to the standards on which performance expectations were predicated, the servicer may become insolvent or otherwise lose its ability to perform effectively, or a swap counterparty or other critical party to the transaction may be downgraded. In addition, for asset types that do not have long performance histories, the transaction structure may not adequately allow for unanticipated patterns in borrower behavior. In general, with the proliferation of asset types and transaction structures in the market, investors must exercise caution. When considering ABS performance, there is a danger of generalizing too freely across market sectors. In addition, it is risky to rely exclusively on computer models without the diligence and judgment of experienced professionals. In an insured transaction, the guarantor takes responsibility for both the performance assumptions and the transaction structure that is based on those assumptions. It carries out independent credit analysis and due diligence and performs its own modeling to determine an appropriate structure. In addition, the guarantor is generally in a position to intervene early if performance problems appear. It receives regular performance reports and can work with the servicer to remedy problems before they become serious. It also frequently has specific rights and remedies that would not be available to an ordinary investor. All this makes it less likely that underlying credit quality will deteriorate seriously. In any case, the rating of a 100% guaranteed issue will always be associated with the guarantor's rating, regardless of the underlying portfolio performance. Although the insurer does not guarantee a particular market value for an insured security, the guaranty has been shown to maintain liquidity and protect against a market value decline in the event an issuer is downgraded or its credit quality is called into question. Of course, should an asset portfolio ever fail to produce sufficient cash flow to make a scheduled payment to holders of insured securities, the guarantor would make the payment. The following section describes the steps a guarantor takes to protect itself and insured bondholders before a transaction is insured, as well as the surveillance activities the guarantor undertakes and the protective mechanisms that may be triggered over the life of the transaction.



Financial guaranty insurance companies are highly selective about the issues they will insure. The guarantor seeks opportunities that will support an appropriate return on its capital and that will contribute to diversification of its insured portfolio. Moreover, unlike a life or property/casualty insurer, which operates on the assumption that it will have some losses regularly, a financial guaranty insurer seeks to insure only obligations where the possibility of loss is remote and where the amount of loss will be minimized in the unlikely event a default does occur. In practical terms, this means that monolines have insured only municipal obligations and secured structured financings, like asset-backed securities, that are of at least investment-grade quality. The industry's total losses for each of the years 1988 to 1998 ranged from 0.003% to 0.011% of the industry's insured exposure. These losses include amounts set aside regularly in general loss reserves. Increases to general reserves are based on the size of the insurer's total exposure and are recorded even when there are no losses tied to specific transactions. Also included are losses related to obligations supported by commercial real estate, an area from which the industry has largely withdrawn. Insurers analyze ABS in essentially the same manner as a potential bondholder would, except that a guarantor must take into account that it is irrevocably guaranteeing the issue, and it will not later have the option of reducing its exposure by selling the securities. The guarantor thus dedicates extensive resources to due diligence and surveillance, consolidating these tasks for investors. The guarantor also requires covenants that may allow it, for example, to demand additional or replacement collateral if asset performance deteriorates. In extreme cases, such as servicer insolvency, the guarantor may replace the servicer. The guarantor's underwriting process concentrates on four principal areas: credit protection, structural integrity, third-party risk and country risk.

Evaluating Credit Protection

The guarantor examines the quality of the underlying assets and reviews the procedures for underwriting and servicing them. Analysts visit originators onsite to conduct file reviews and evaluate staffing and operations. After expected delinquency and loss projections are developed, the guarantor "stresses" the pool, as the top graph on page 16 illustrates. Based on this analysis, the guarantor will require that the issue be structured to provide sufficient cash reserves, overcollateralization or guarantees from other creditworthy parties to qualify the issue, without insurance, for an investment-grade rating. Only then will the guarantor add its Aaa/AAA guaranty. In many cases, the quality of the underlying transaction is as high as Single-A or Double-A.


Stress Analysis


Cumulative Losses as % of Original Outstandings

Stress Losses



Base Case









Computer modeling is used to determine the level of losses that would occur in the pool under various highly stressful economic scenarios, involving heightened delinquency and loss rates, market value declines and interest rate movements. Depending on the results of this analysis and the type of asset, first-loss protections are designed to provide a cushion on the day of issuance ranging typically from two-and-a-half to five times the pool's total future expected losses, thus minimizing the probability and magnitude of claims against the guarantor.

% of Original Pool Balance at Issuance

% of Current Pool 25 Months After Issuance

16.93% 13.45%

5.5% 1.75%

Credit Protection Projected Future Losses Credit Protection Projected Remaining Losses

The bar charts illustrate the growth in credit protection available to the guarantor in an actual transaction backed by auto loans. Sources of credit protection include overcollateralization, cash reserves and interest rate spread. If losses match expectations, the credit protection grows from 2.5x to 9.7x future losses in about two years. This buildup in protection is considered normal for such transactions, and losses would typically decline after the 25th month.


Evaluating Structural Integrity

The guarantor applies its experience and expertise to confirm that all transaction elements are designed effectively. The objective is to ensure that there will be no interruption of cash flow for reasons unrelated to the performance of the assets. This requires legal opinions confirming the issuer's insulation from bankruptcy of any related party. The guarantor will also frequently structure issues with self-correcting mechanisms and discretionary remedies that increase its control. A transaction may be designed to correct itself, for example, by shifting cash flows from subordinated to senior bondholders if performance falls below defined trigger points. In addition, a guarantor will normally review the competence and creditworthiness of all parties that could affect transaction performance. For example, the quality of servicing (i.e., collections and foreclosures) may dramatically affect the performance of assets in a particular pool. Moreover, the issue's rating may be linked to that of certain other transaction parties. However, the insurance cannot prevent a downgrade due to credit deterioration of a transaction party unless the insurance policy covers 100% of principal and interest.

Evaluating Third-Party Risk

Country Risk Requirements

Monolines confine their business to countries where they believe the economy will sustain sufficient growth to support payments, and the political climate and government policy provide a stable and conducive setting for payments to be made. Each company sets its own standards. FSA requires that the country of origin must have an investment-grade foreign-currency sovereign debt rating. All currency risk must be fully hedged through swaps with investment-grade counterparties. A guarantor's surveillance activities extend over the life of each insured issue. The guarantor typically receives monthly performance reports from the servicer or trustee of each transaction. The guarantor reviews each structured transaction to confirm compliance with transaction covenants and reporting requirements. It also tracks credit developments that could affect key parties or collateral performance. The objective is to detect problems before they become serious and to take whatever steps are available to correct such problems as soon as possible. For example, the guarantor may have the right to replace a downgraded firstloss provider or insolvent servicer. If a serious problem with the transaction develops, the guarantor often has the choice of either continuing to make scheduled payments on the insured obligations or causing its payment obligation to be accelerated. In some cases, transactions may be restructured to protect bondholders and the guarantor.




Guarantors maintain Aaa/AAA ratings to preserve their ability to write new business and to assure the durability of the ratings of issues they insure. Because the Aaa/AAA rating is so important, guarantors strive to stay ahead of rating agency standards concerning capital adequacy, financial performance and risk management matters.

Rating agencies continually evaluate the guarantor's financial resources, operations and exposures. For example: The Moody's Approach

One tool used by Moody's in shaping its opinion of financial guarantors is a bond insurance stress model designed to measure a guarantor's ability to meet its policyholder obligations. Moody's employs simulation methods that allow it to test the interrelationships of many variables and the effectiveness of diversification in the insured portfolio, investment portfolio and group of companies providing reinsurance. Moody's assigns probabilities of default frequency and severity to sectors of the insurer's portfolio on the basis of credit quality, type of insured obligations, seasoning and economic conditions. The model takes into account the tendency of defaults to be concentrated by sector, geographic location and time period; the variability of premium pricing; and other hazards related to interest rates, management and liquidity. This flexible model enables Moody's to test the insurer's performance and capital adequacy under a wide variety of economic stresses.

The S&P Approach

Standard & Poor's examines each insured transaction and assigns a "capital charge," reflecting S&P's assessment of the transaction's loss potential in a simulated depression. One part of S&P's evaluation subjects the guarantor to the rating agency's depression-scenario capital adequacy model, which assumes three years of business growth followed by a four-year worldwide depression in which the guarantor writes no new business. Expected losses are projected over the four years of the depression by multiplying the weighted average capital charge percentage by average annual debt service in the case of municipal bonds and by average par in the case of asset-backed obligations. The model takes into account the portfolio composition as well as projected expenses and losses that occur in the investment portfolio under depression conditions. It also considers the insurer's third-party capital supports, such as reinsurance and letters of credit, weighting the value of each such resource according to the provider's credit quality. To be rated AAA, the guarantor must survive S&P's hypothetical depression with substantial capital remaining to pay additional claims. The remaining capital must be sufficient to withstand immediate additional losses equal to more than 20% of those the guarantor experienced during the depression. (See graphs, page 19.)


S&P Capital Charges Municipal

(% of Average Annual Debt Service)


(% of Par)

3.8 12.2 9.9 1.9 11.9 12.7 2.7 3.3





Weighted average capital charge on all outstanding issues, reported by S&P in June 1999 in its annual review of each company.

S&P Margin of Safety


% of "Depression Losses" covered by Insurer's Claims-Paying Resources



S&P "AAA" Requirement




Source: S&P June 1999 ,



The top pair of graphs compares the average capital charges assigned by S&P to the major Triple-A monolines' insured portfolios. Lower capital charges indicate less risk in the portfolio. The capital charges are used to calculate depression-scenario loss expectations, which are compared with the insurer's claims-paying resources through S&P's capital adequacy model (see page 18). The result is expressed as the S&P Margin of Safety, shown in the lower graph.


Durability of Ratings

A number of important characteristics contribute to the durability of monoline guarantors' Aaa/AAA ratings: Risk Management

The risks monolines assume generally have both low probability of default and high probability of substantial recovery in the rare event of default.

Capital Strength

Each monoline has abundant capital in relation to its risk exposures. In addition to "hard" capital, monolines have large unearned premium reserves, future contractual premiums and significant sources of reinsurance. Some monolines also have supplementary "soft" capital, such as maintenance agreements from financially strong parents, or letters or lines of credit from highly rated banks. In certain countries and transactions, guarantors work through joint ventures that combine the capital strength of the partners.

Earnings Stability

Premiums for financial guaranty insurance are earned over the life of each commitment. As a result, future revenues from business already written add layers of predictable earnings to each year's results.

High-Quality Investments

Reserves are invested in high-quality, liquid securities to preserve capital and earn investment income. The industry's average investment portfolio rating quality is Aa/AA.

Liquidity Resources

In addition to cash and liquid securities in its investment portfolio, a guarantor can rely on substantial liquidity mechanisms structured into individual transactions. It may also arrange general liquidity vehicles, such as a revolving line of credit from one or more highly rated lenders.

Controlled Timing of Claims Payments

Unlike a bank that has provided a letter of credit, or a multiline insurance company that has written policies that can be surrendered for cash, the guarantor insures payments only as scheduled and is generally not exposed to massive unexpected liquidity demands. On the other hand, the guarantor usually does retain the option of accelerating insurance payments if it believes collateral values are deteriorating.



In addition to meeting demanding rating agency standards, insurers must comply with the insurance regulations of jurisdictions in which they are licensed. The major monolines are based in the United States and subject to Article 69 of the New York State insurance law and similar laws in California and several other states. These laws are designed specifically to prevent erosion of guarantors' financial strength. They require that financial guaranty business be conducted by separately capitalized insurance companies, set forth minimum capital requirements, restrict ancillary lines of business to a narrow range of related activities, mandate contingency reserves and set single-risk and aggregate-risk limits. The risk weightings used to determine capital adequacy create incentives for guarantors to conduct only high-quality businesses. The growth of the asset-backed market reflects investors' demand for secure instruments with predictable cash flows that are independent of single-company operating risk. ABS are an integral part of the robust consumer and corporate credit markets in the United States. Worldwide, they are gaining popularity because they can be tailored to address a vast range of financing challenges. Financial guaranty insurance bridges differences between the needs of issuers and the demands of investors in the ABS market. It provides financial solutions for sponsors and creates securities of the highest quality for investors.



UNITED STATES Corporate Headquarters Financial Security Assurance Inc. 350 Park Avenue New York, NY 10022 1.212.826.0100 Fax 1.212.688.3101 Western Office Financial Security Assurance Inc. Steuart Tower One Market San Francisco, CA 94105 1.415.995.8000 Fax 1.415.995.8008 Southern Office Financial Security Assurance Inc. The Crescent 100 Crescent Court Dallas, TX 75201 1.214.720.2095 Fax 1.214.720.2096 BERMUDA Financial Security Assurance International Ltd. 12 Par-La-Ville Road Richmond House Hamilton HM 08 Bermuda 1.441.292.6863 Fax 1.441.292.4338

UNITED KINGDOM Registered Office Financial Security Assurance (U.K.) Limited 1 Angel Court London EC2R 7AE 44.171.796.4646 Fax 44.171.796.3540 Registered in England and Wales No. 2510099 FRANCE Representative Office Financial Security Assurance (U.K.) Limited 116, rue la Boëtie 75008 Paris Fax Registered in France No. B401651781 SPAIN Representative Office Financial Security Assurance (U.K.) Limited Paseo de la Castellana 36-38 Edificio Castellana 28046 Madrid 34.91.431.35.97 Fax 34.91.431.88.99

AUSTRALIA Representative Office Financial Security Assurance Inc. (ARBN 054 881 284) Hambros House 167 Macquarie Street Sydney NSW 2000 61.2.9221.8537 Fax 61.2.9223.8629 JAPAN Representative Office Financial Security Assurance Inc. WEST 13th Floor Otemachi First Square 5-1, Otemachi 1-Chome Chiyoda-ku, Tokyo 100-0004 81.3.5288.6123 Fax 81.3.5288.6149 SINGAPORE Representative Office Financial Security Assurance Inc. 6 Temasek Boulevard Suntec Tower Four Singapore 038986 65.333.6968 Fax 65.430.5601 INTERNET Electronic Mail: [email protected] World Wide Web:




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