Guarantee Companies & Development Finance: Products, Business Models & Constraints
Specialist guarantee companies can play a valuable role in financial markets when other intermediaries, such as banks or bond market investors, are unable or unwilling to take on specific risks.
This Risk Control study, commissioned by MOBILIST and the Swiss State Secretariat for Economic Affairs (SECO), examines the role of specialist guarantee companies in boosting investment and growth in developing countries. The report aims to inform donor-country decision makers considering whether to invest in specialist guarantee companies.
Examining the role of monoline insurers in developed markets can offer lessons for specialist guarantee companies in EMDEs
Specialist guarantee companies can play a valuable role in financial markets when other intermediaries, such as banks or bond market investors, are unable or unwilling to take on specific risks. An example is the guarantees that monoline insurers provided for infrastructure debt in the 1990s and early 2000s.
In those years, several developed-economy governments wished to raise funding for public investment without encumbering their balance sheets. Corporates also sought financing for investment purposes, either through their own on-balance-sheet debt issues or via bankruptcy-remote Special Purpose Vehicles (SPVs). Saving institutions, like pension funds, lacked the infrastructure teams needed to evaluate the complex risks involved. The solution was that monoline insurers provided guarantees, raising the ratings of bond issues. They acted as controlling creditors, monitoring project conditions and covenants on behalf of all creditors.
This study examines the experience of monoline insurers to determine whether lessons can be drawn for the use of specialist guarantee companies in EMDEs. Donor countries and Development Banks (multilateral and bilateral) have invested in specialist guarantee companies. It also reviews the activities of these EMDE guarantee companies, commenting on constraints and their potential to drive development financing.
Understanding developed market monolines
The report draws on interviews with more than forty industry practitioners, including past and current staff of developed-market monolines, DFIs and specialist EMDE guarantee funds. It also analyses the financial statements and ratings of a prominent developed market monoline and two EMDE guarantee funds to understand the constraints they face, most notably the assessments they receive from rating agencies and the profitability of their business models.
It emphasises four aspects of developed market monolines to clarify thinking about the role and prospects of EMDE guarantee funds.
Products
Monolines focused on insurance lines through which their expertise in guarantee provision could add value. In the US municipal bond market, particular features of the US state and federal income tax systems created a role for the monolines. In the project finance bond market, opportunities arose when public authorities wished to issue debt without committing their own balance sheets in support of the
issue, and banks and investors lacked the specialist teams to evaluate the credit quality of the debt securities. The monolines played an important role in these transactions by acting as an actual or de facto controlling creditor, trusted by other debt holders to monitor and enforce covenants and operating conditions. In structured finance, the monolines supplied product offerings which other entities would have found hard to replicate.
Business Models
A clear description of its business line is provided in its investor communications by AG, a monoline that survived the crisis and which we examine at some length in this report. AG’s description places emphasis on its specific products, on contractual features of its guarantees that protect its liquidity position, on its underwriting and exposure monitoring approaches, its investment portfolio policies and the barriers to entry that partly shield it from competition. Implicit in this description is a view on how the elements of the firm’s financial statements behave.
Such a perspective may be compared to the view of insurer business models provided by the Bank of England in the latter’s supervisory approach for insurers (which the Bank calls Business Model Analysis (BMA)). Former monoline staff interviewed for this study emphasised other specific features within the monoline business model, such as a focus on strict underwriting standards, close consideration paid to legal contracting, and the monitoring of exposures through such activities as the controlling creditor role (actual or defacto).
Constraints
Guarantee companies must optimise their financial performance subject to a set of constraints, most notably the methodologies employed by the rating agencies in evaluating them and the rules imposed by regulators relating to capital adequacy and other aspects. These constraints may limit the degree of leverage that the guarantee companies can achieve and the value that their guarantees provide to investors in the guaranteed securities. Working within these constraints necessitates a careful financial analysis informed by the rating scorecards employed by the rating agencies.
Culture
Monoline staff we interviewed emphasised their strong and conservative underwriting policies in municipals and infrastructure. The specialist teams build up by the monolines were dispersed to other market participants after the monoline sector franchise value was undercut by the GFC. These other market participants found other ways (primarily through debt fund solutions) to meet the needs of the ultimate borrowers. The negative outcome of the GFC for several monolines reflected weaknesses in the underwriting of structured exposures but monoline staff we interviewed emphasised that all but a few exposures even in that category performed well.
What factors should donor countries consider when investing in specialist gurantee companies?
The monolines built product-focused, expertise-heavy guarantee businesses. Crucial for our purposes, through their infrastructure bond guarantees, the monolines helped public authorities in multiple countries to expand Project Finance borrowing without encumbering public balance sheets. The report aims to inform donor-country decision makers considering whether to invest in specialist guarantee companies. Such companies should:
Choose the right product niches where guarantees add unique value
A narrow focus on products and the appetite that customers may have for them is essential. Products should have features that make them less contestable by competitors so that sustainable businesses can be built.
Design strong, scalable, economically sound business models
Coherent business model that employs capital effectively and offer possibilities of scalability, alleviating but also exploiting market inefficiencies, so that the enterprise is not simply a temporary solution to a short-term market failure. Note that the monolines were organised as insurers rather than guarantee companies, a business model that, although more complex than guarantors organised as funds or companies, offered the advantage of rigorous disciplines and natural channels to the reinsurance market.
Develop and maintain a thoughtful rating strategy
Thoughtful and coherent ratings (and depending on the business model adopted, regulatory) strategies are important. Those demanding guarantees from monolines required a high target rating of AA or higher. But, for purchasers of EMDE debt guarantees, a much lower rating may be perfectly acceptable. In either case, a coherent rating strategy is key to success. Ratings strategies should include consideration of tools to sustain ratings as the business develops. Unlike the monolines, which largely retained risk on their balance sheets, EMDE guarantee companies should find ways of using reinsurance/syndication and the network of brokers and intermediaries that accompany it. These latter contribute a valuable discipline, protecting guarantors from taking ill-advised risks.
Build a strong underwriting culture with rigorous expertise and cost control
Building expertise and controlling costs while suitably remunerating and incentivising key staff are key aspects of the businesses the monolines created. Controlling costs is important since the demand for guarantees is price elastic and businesses are only sustainable if they are prudent in this regard.