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 FSAs
claims-paying ability:
Fitch IBCA, Inc.
Moodys Investors Service, Inc.
Standard & Poors 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

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.

FINANCIAL
GUARANTY
INSURANCE

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 guarantors 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 markets 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

AAA

92.8%

AA
A
BBB

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 investors 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 guarantors
international market acceptance

GROWING
MARKETS

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

$B

400

360
350
300

278

250

206

200

141

150
100

158

139

151

100
67

50
0

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 investors point of view.

2 Sources:
3 Source:

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

TYPES
OF ABS

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

FUTURE
GROWTH

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 markets capacity for
the borrowers 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

$50

$40

$30

1
2
3
4
5
6

Japan
SE Asia
Australia
Canada
Latin America
Europe

$20

$10

$0

TOTAL:

1 2 3 4 5 6

1 2 3 4 5 6

1 2 3 4 5 6

1 2 3 4 5 6

1995

1996

1997

1998

$17

$49

$70

$76

Source: Moodys 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

CHARACTERISTICS
OF
ASSET-BACKED
SECURITIES

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 sponsors 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.
SPONSOR

Assets
$

SPV

Assets
$

INVESTORS

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 investors analysis centers primarily on the adequacy
of the receivables cash flow or liquidation value, not the credit quality of the sponsor.
Bankruptcy-Remoteness

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 issues credit quality is raised above that of the
sponsors unsecured debt or of the asset pools 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 companys 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.

10

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

CONSUMER
BORROWERS

10% Wtd. Avg.

Interest (Monthly)

Excess Servicing Fee

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

SPONSOR
(originator/seller/
servicer)
Loans Sold

$100MM

TRUST
Spread Account
(captures all
excess interest
until fully funded)

Participation Certificates
(5% Interest; Monthly)

CERTIFICATE
HOLDERS

$100MM

Guaranty
GUARANTOR

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

CONSUMER
BORROWERS

10% Wtd. Avg.

Interest
(Monthly)

SPONSOR
(originator/seller/
servicer)

$100MM

Stock

Loans Sold

SPECIAL
PURPOSE
CORPORATION
(SPV)

Pledge of Collateral & Premium

Pledge of Collateral
Senior Bonds (5%
Interest; semi-annual)

SENIOR
BOND
HOLDERS

Guaranty
GUARANTOR

$90MM Proceeds
Subordinated Bonds (9%
Interest; semi-annual)
$10MM Proceeds

SUBORDINATED
BOND
HOLDERS

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.

11

Growth of Monoline Guarantees for ABS

120

125

$B
100

93
75

75

46

50

21

25

7
0

11

25

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
Investors
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
guarantors 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

12

ultimately received in full. Therefore, the durability of any ABS rating should
be considered carefully.
Credit
Enhancement
from the
Sponsors
Perspective

The sponsors 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 sponsors 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 issuers 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.

13

PERFORMANCE
OF ABS

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.

14

UNDERWRITING
INSURANCE
FOR ABS

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 industrys total losses for each of
the years 1988 to 1998 ranged from 0.003% to 0.011% of the industrys
insured exposure. These losses include amounts set aside regularly in general
loss reserves. Increases to general reserves are based on the size of the insurers 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 guarantors 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.

15

Stress Analysis
15%

Cumulative
Losses as %
of Original
Outstandings

Stress Losses
10%

Base Case

5%

0%

12

24

36

48

60

72

MONTHS

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 pools 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.

16

Evaluating
Structural
Integrity

Evaluating
Third-Party
Risk

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 issuers 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 issues 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.

Country Risk
Requirements

Surveillance

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 guarantors 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.

17

PRESERVATION
OF TRIPLE-A
CAPITAL
STRENGTH

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 guarantors

financial resources, operations and exposures. For example:
The Moodys Approach

One tool used by Moodys in shaping its opinion of financial guarantors is a

bond insurance stress model designed to measure a guarantors ability to meet
its policyholder obligations. Moodys 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.
Moodys assigns probabilities of default frequency and severity to sectors of the
insurers 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 Moodys to test the insurers
performance and capital adequacy under a wide variety of economic stresses.
The S&P Approach

Standard & Poors examines each insured transaction and assigns a capital
charge, reflecting S&Ps assessment of the transactions loss potential in a
simulated depression. One part of S&Ps evaluation subjects the guarantor to
the rating agencys 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 insurers third-party capital supports, such
as reinsurance and letters of credit, weighting the value of each such resource
according to the providers credit quality.
To be rated AAA, the guarantor must survive S&Ps 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.)

18

S&P Capital Charges

Municipal

Asset-Backed

(% of Average Annual Debt Service)

(% of Par)

3.8
12.2

11.9

12.7

3.3
2.7

9.9
1.9

FSA AMBAC FGIC

MBIA

FSA AMBAC FGIC

MBIA

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

140-150%

130-140%

S&P "AAA"
Requirement

120-130%

110-120%

100%

FSA

FGIC

AMBAC MBIA

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 insurers claims-paying resources through S&Ps
capital adequacy model (see page 18). The result is expressed as the S&P Margin of
Safety, shown in the lower graph.

19

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 years results.
High-Quality Investments

Reserves are invested in high-quality, liquid securities to preserve capital

and earn investment income. The industrys 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.

20

REGULATION
OF FINANCIAL
GUARANTY
INSURANCE

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.

VALUE IN
INSURED ABS

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.

21

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 Botie
75008 Paris
33.1.42.56.72.22
Fax 33.1.42.56.72.26
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: info@fsa.com
World Wide Web: www.fsa.com

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