Dinallo's dilemma

Editor's letter


By any standard, the state of New York has a big insurance market. In 2006, $61.5 billion of life insurance premiums were paid in New York, making it the second biggest market in the US. Figures for general and health insurance are similarly impressive. Far more modest was the $1.2 billion of premiums, or 2% of the total, which were paid in New York to insure bonds.

Unlike the diversified multinational insurance groups that receive the lion's share of New York's life, P&C or health premiums, the bond insurers are rather different. The biggest ones - Ambac, MBIA and FGIC - do virtually nothing except insure the credit risk of municipal bonds, asset-backed securities and CDOs. For this reason, they are called 'monolines'.

Until recently, the monolines languished in obscurity. One imagines Eric Dinallo, the New York insurance supervisor confirmed in his post last year, sitting down to plan out his annual calendar. How much time should he allocate to monolines? Based on the percentage of premiums flowing through New York he might have scheduled a couple of days a year.

These days, Dinallo seems to be spending nearly all his time thinking about monolines as he tries to put together a bailout to keep them afloat. For those who don't follow the subject, here is a recap.

The issuers of US municipal bonds (including New York itself) pay rating agencies to rate them, and typically the agencies apply a more conservative standard than they do for corporate bonds, meaning that municipal paper gets a lower rating. There is a long tradition that investors in US municipal bonds (who enjoy substantial tax benefits) will only buy them if they have a triple A rating.

Here's where the monolines step in. In return for a premium, they provide a default insurance policy, or 'wrap' to the issuer. In return for a further fee, the rating agencies stamp a triple A rating on the wrapped bonds, and the investors buy them. For years this seemed like a logical thing to do and no-one questioned it.

Then, perhaps bewitched by the siren call of massive revenues, the monolines and rating agencies decided to branch out. They became increasingly dependent on rating and wrapping CDOs cooked up by Wall Street, a strategy that went horribly wrong when the sub-prime bubble burst in 2007. The rating agencies are now licking their wounds, admitting that their methodology was flawed, while the monolines are fighting for their lives.

This is a headache for Dinallo, more significant than the monolines' minuscule share of annual premiums would indicate, because New York accounts for 28% of the US bond insurance market. Unfortunately, not only are Dinallo's bail-out efforts constantly getting overtaken by the deteriorating credit crunch, but the whole cosy model of municipal bond insurance is being questioned.

Why, US state treasurers are asking, should we be paying discredited rating agencies and collapsing bond insurers for triple A ratings when statistically, our debt is among the safest in the market? Of course it's quite easy to reply that the municipal debt only appears safe because US local government doesn't account for pension liabilities properly.

But in hindsight, Dinallo's life would be much easier if the monolines had been better regulated in the first place, and crucially, not permitted to become contaminated by Wall Street 'innovation'. This has lessons far beyond New York.

In Solvency II, supervisors are wondering what kind of group support can be expected from non-EU groups such as Swiss Re or AIG that like to dabble in CDOs and sub-prime. And in the UK, the Financial Services Authority is bound to mull over a nascent monoline sector in the shape of pension buyout companies that are also heavily dependent on financial innovation.

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