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Bond insurance was a small but sophisticated sector of the broader insurance industry. Conceived and created in the 1970s, bond insurance penetrated more than half of the entire US municipal bond market in the 1990s. This article explains bond insurance, its rise to prominence, and its sudden and shocking collapse. A diversifying foray of the bond insurers into structured finance risk in the years prior to 2007 is a dominant cause of these firms' failures. Yet the larger story is the manner in which business imperatives, rating agencies, and regulators enabled and encouraged all bond insurers to pursue the same catastrophic strategy. The uniformity of strategy and capital and risk assessment created the "systemic risk" of high correlation among bond insurers.
The bond insurance business began life in 1971 with the founding of Ambac.1 By its peak in 2007, there existed ten significant bond insurers with seven of these firms holding triple-? financial strength ratings.2 The Credit Crisis that began in 2007 decimated this sector. Depending on how one defines "survival," only one firm - Assured Guaranty - still stands (S&P, 2010a). The rise and fall of bond insurance is a story of innovation, regulation, and correlation. In this respect, our story shares some common elements with the trajectory of the banking industry. I find that regulation fosters correlation.
I. Bond Insurance Mechanics
Let's begin with some terminology. Another name for "bond insurance" is "financial guaranty insurance." The terms "insured bond" and "wrapped bond" are synonymous. Bond insurance firms are also known as "monolines" or "monoline insurance companies" to distinguish them from "multi-line" insurance companies. A multi-line insurer is generally the more typical insurance company that offers life or property and casualty (P&C) insurance. One of the rating agencies' and regulators' key tenets over the years was that only monoline insurers could be trusted to issue financial guaranty insurance.3
The purpose of bond insurance is to insure the bond investor against the failure of the bond obligor to make required principal and interest payments.4 Imagine an investor purchases an insured bond with the city of Scranton (Pennsylvania) as the obligor. If Scranton cannot make a payment of interest and/or principal, the bond insurer will step in and pay precisely what is due. The...