Beyond the AAA Monoline Model for Development of Local Capital Markets

1. Beyond the AAA Monoline Model for Development of Local Capital Markets Presentation by David C. Stevens Inter-American Development Bank Business Seminar on Capital Markets for Development June 4, 2004

2. The AAA Financial Guarantee Insurance Model • Financial Guarantee industry began in 1972 offering credit enhancement to US municipal bonds • Today this financial product dominates the US municipal market and is significant in the global ABS and infrastructure markets • The industry’s fundamental expectation is that only minimal net losses will occur in a normal operating environment • Insurers take on exposures judged to have minimal loss potential – investment grade only • Premium rate is generally ½ to 2/3 of the difference in cost of issuing an uninsured bond (e.g., BBB or A) versus that of an insured AAA transaction; the remaining portion constitutes savings for the debt issuer

3. The Monoline Product • One-product industry: AAA credit enhancement • Unconditional, irrevocable guarantee of scheduled principal and interest • No acceleration of obligation to pay (but insurer can accelerate against a defaulting obligor) • Extensive research backing deal underwriting and credit surveillance/remediation • Banking rather than insurance product -- credit-based rather than actuarial risk underwriting • Unlike P&C insurance, obligation to pay claims as presented is absolute. S&P measures the willingness as well as ability to pay claims by its FER – financial enhancement rating. “Pay first, sue later.”

4. The Benefits of the AAA Product • To Issuers • Lower cost of funds • Easier, stable access to capital markets • Broader investor participation • Single point of contact for documentation issues, waivers, consents, surveillance & workout • To Investors • Credit Protection – “Sleep insurance” • Liquidity • Price Stability – Retention of value in crisis • To Emerging Markets • Easier access to capital markets • Faster pace of infrastructure development • Huge savings potential • Safer pension investments

5. Typical AAA Asset Classes • Asset Backed Products • Consumer Structured Finance – mortgages, credit cards, auto loans, student loans • Commercial Structured Finance – corporate receivables, trade finance, leases • Collateralized Debt Obligations – pools of corporate bonds, bank loans, etc. • Future Flows – Mostly banks and commodity exporters • Single Risk Products • Municipal obligations • International project finance for essential infrastructure

6. What the AAAs Have Done in the Emerging Markets • Future Flows (USD financings) • Banamex electronic remittances • Infrastructure • Chilean toll roads (local currency) • Santiago Airport (mixed dollar & local) • Cross-Border ABS • Costa Rican mortgage-backed securitization

7. What is the Long-Term Potential of AAA Bond Insurance in Latin America? • Promotes fulfillment of development policy objectives, e.g., local capital markets • Promotes issuance of highly-rated, long-term local currency instruments • Allows for recycling of local savings pools in pension funds to safest investments, which also promote local economy • Avoids the FX risk inherent in dollar or Euro financings • Adds depth and liquidity to local capital markets • Provides tenor extension beyond limits of most banks and thus new source of financing for long term assets like infrastructure • Local banks can take leading role in structuring and underwriting insured bonds • Promotes development of local credit rating agencies, more disciplined credit culture, more differentiation based on credit quality

8. Why the AAAs Have not Done More in the Emerging Markets • Generally weaker credit fundamentals • Financial/economic volatility • Weaker political institutions • Still-evolving legal systems • Fiscal and external financing constraints • Weaker banking/financial regulatory framework • Chronic exchange rate pressures • Greater vulnerability to external shocks • Underdeveloped local capital markets • Lower sovereign ratings; therefore, more limited opportunities to meet investment grade threshold

9. Limitations for AAAs in Latin America • Country Limits • XLCA already maxed out in Brazil and close in Mexico; others may have room but all observe country limits • Portfolio Balance Requirements • AAAs must really focus on AAA countries • Investor Pressure • Average muni investor doesn’t like to hear about AAAs’ exposures in Brazil or other EM countries • Rating Agency Pressures • Restricted Asset Classes – future flows, infrastructure • Lack of Familiarity with Local Companies • Limits on Appetite for Cross-Border Financing • E.g., cheaper to finance within Peru than to use future flows • “Excess enhancement”

10. Excess Enhancement B B+ BB- BB BB+ BBB- BBB BBB+ A- A A+ AA- AA AA+ AAA Brazil Peru El Salvador Mexico Chile U.S. AAA Monolines Local investors generally do not ascribe value to instruments which are higher rated than their local treasuries. When a US AAA monoline wraps a Chilean local currency deal, for example, the investor’s yield on its AAA instrument is actually greater than that available on debt of the A rated sovereign. A more efficient mechanism within Chile might be to structure a monoline to the local AAA, equivalent to the international A rating.

11. Alternatives for Emerging Market Financial Guarantee Companies • Global – A-rated EM entity • Discussions with IFC never resulted in execution. Rating agencies reportedly cited correlation risks. • Regional – Asia Limited • A-rated regional guarantor failed – correlation risks. Downgraded out of business – actual losses were low. • National Level – Most promising • Likely prospects: South Africa, Mexico, Chile • Structure monoline companies in these environments to local AAA • Use local rating agencies and local credit expertise

12. The Local Option • Eliminates exchange risk, transfer and convertibility risks • Prevents any risk of currency mismatch • Local currency financing matches revenues and debt service obligations • Dollar-pegged debt service doesn’t work • Indonesian experience at MBIA • Fulfills public policy goal of recycling local pension fund investments into a country’s productive infrastructure (although it does not provide greater level of pensioner protection afforded by US AAAs) • Promotes development of capital markets, stable long-term financing, and overall economic development

13. Would a National-Level Guarantor Work? • Anecdotal evidence that South Africa, Chile and Mexico could benefit – strong and increasing local capital markets flows • Spreads are (probably) there • Mexican Issuance: Hipotecaria Su Casa 2002-1 • MxAAA: 180 day Cetes + 100-120 • Ba2 Tranche: 180 day Cetes + 400-500 • If assume BBB would be 200-225, there is about 100 basis points of available spread • Would meet most aforementioned policy objectives – but not the objective of providing pensioners better credit risk than the sovereign • Setting up a national monoline in an EM environment would require rethinking US-based typical AAA assumptions like the zero loss standard, leverage levels, and reserving practices • Worthy project for multilaterals & promising investment for leading players in these local capital markets to consider. • A functioning entity in one of the above markets or another important EM venue such as Brazil could serve as a model for other national-level monolines in other EM environments.