The Wall Street Journal-20080130-The Bond -Transformers-- Regulators Revisit A Loophole Allowing Insurers to Do Swaps

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The Bond 'Transformers'; Regulators Revisit A Loophole Allowing Insurers to Do Swaps

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Troubles at U.S. bond insurers are forcing industry regulators to rethink a decade-old legal loophole that allowed insurers to venture into the obscure world of derivatives.

The housing downturn is threatening to cripple some bond insurers that wrote billions of dollars of guarantees in the past few years on securities backed by risky subprime-mortgage debt. They entered into contracts known as credit-default swaps, which are derivative instruments that require firms to pay out money when a bond defaults. The ability of bond insurers to make good on their guarantees is in question.

Their problems have led New York state Insurance Superintendent Eric Dinallo in recent days to attempt a rescue plan to save bond insurers that could involve financial help from Wall Street firms.

Some of the Street firms already have reported losses tied to the contracts with bond insurers because the insurers may not be able to make good on them.

It also is forcing insurance regulators, including Mr. Dinallo's office, to reconsider the 1998 legal loophole that allowed bond insurers to issue credit-default swaps through shell companies called "transformers."

Their activity in derivatives has exploded in recent years. With a credit-default swap, one party, for a fee, assumes the risk that a bond or loan will go bad. The bond insurers wrote such swaps on around $100 billion in complex mortgage securities during the past few years, according to ratings-company estimates.

Previously, the bond insurers' business was mostly limited to providing guarantees, based on their triple-A ratings, on bonds issued by municipalities. As margins in the municipal-bond insurance business fell in the 1990s, bond insurers began looking for other profit engines. In 1998, they asked that New York insurance regulators allow them to sell credit-default swaps on asset-backed and mortgage securities.

In a letter to the New York insurance department in 1998, an insurer, Financial Security Assurance Inc., argued that such swaps deals were similar to FSA's existing business of providing guarantees on other types of bonds, albeit through insurance contracts.

"From bond insurers' vantage point, this was identical to their core business," although it involved a different type of contract, said Bruce Stern, FSA's general counsel, who wrote the 1998 letter. "A demand was emerging for guarantees of bond portfolios and it seemed natural for bond insurers to want to do that," he said. FSA has avoided big losses that have hit other bond insurers because it didn't enter the riskiest parts of the business, he said. FSA is a unit of Dexia SA of Brussels.

An insurance examiner working for Paul M. De Robertis, a supervisor in the department's property-casualty bureau, responded in April 1999 that the insurance regulator concurred "with your interpretation of the insurance law."

"Other insurers saw this FSA letter and that is how the 'transformer' business got a boost," said Joseph Buonanno, whose law firm, Hunton & Williams LLP, represented a number of bond insurers in recent years that set up such entities. After New York insurance regulators gave bond insurers their blessing, other state insurance regulators followed suit and the business of writing credit-default swaps on packages of mortgage securities took off.

Following the regulatory green light, bond insurers set up shell companies under Delaware state law. They were known in the industry as transformers because they transformed a traditional bond-insurance contract into a credit-default swap.

Among the transformers used by the bond insurers were LaCrosse Financial Products LLC, which was the transformer for MBIA Inc.; Ambac Financial Group Inc.'s transformer was called Ambac Credit Products LLC.

The transformers, which in many cases were private companies incorporated in Delaware, issued credit-default swaps to banks and Wall Street firms on corporate and mortgage securities, including many pools of debt known as collateralized debt obligations.

The bond insurers, in turn, guaranteed the transformers' obligations, which required them to pay the interest and principal on the bonds if the securities defaulted. The liabilities of the transformers were consolidated with the financial statements of the bond insurers.

From the perspective of the bond insurers, their obligations under the credit-default swaps business were similar to traditional municipal bond insurance. In both cases, the insurer had to make interest and principal payouts to customers if a bond defaulted.

The bond insurers "always looked at what they were doing as substance over form," said Michael Satz, a former chief executive officer of ACA Financial Guaranty Corp. who left the bond insurer in 2004. The bond insurers "needed to create a structural mechanism that would allow them to participate in [the swaps] market and not violate applicable laws." ACA Financial is a unit of ACA Capital Holdings Inc.

A report in 2003 from the Bank for International Settlements said that in some countries bond insurers are prohibited from directly entering into derivative transactions. It said these firms have "found ways to circumvent this restriction" by setting up transformers.

In 2005, the business began to boom. Wall Street firms had won a battle with bond insurers that forced them to adopt the Street's preferred form of documentation for such transactions -- counting them essentially as derivative contracts, rather than insurance contracts. That allowed Street firms to profit from the transactions.

After the housing market started slowing, bond insurers dove deeper into the business in 2006 and 2007, bond insurance officials and lawyers said.

For Wall Street firms, the bond insurers' willingness to sell credit-default swaps was a potential bonanza. The swings in the market values of the swaps these transformers sold to Wall Street helped the banks offset fluctuations in the value of the bonds underlying their own transactions. The swaps also benefited the banks by freeing capital, because it allowed the banks to move commitments off their balance sheets. In many cases, the deals enabled the banks to book sizable profits upfront.

Banks used a trading strategy known as the "negative basis trade," according to industry participants. This involved buying, say, a highly rated security issued by a collateralized debt obligation -- or a pool of packaged bonds -- and simultaneously purchasing a credit- default swap that served as insurance on the same security. They often purchased these swaps through the transformers set up by bond insurers.

Banks profited on the interest-rate differences between the CDOs they bought and the payments they made to transformers. For instance, they might be paid an annual interest rate of 0.3 percentage point above a benchmark rate on the CDO, and in turn pay 0.15 percentage point of that to a bond insurer annually as an insurance premium.

The difference between the two payments was called the "negative basis," and the banks sometimes booked profits upfront on the streams of income they expected to receive.

Now, regulators are looking at whether to change the rules that led to the creation of transformers.

"Obviously, there is a careful line we need to walk. We don't want to stop financial innovation. But on the other hand, crisis and scandals aren't good for the financial markets," said David Neustadt, a spokesman for the New York insurance department.

"It's too early to say we're going to ban all these products," said Guenther Ruch, administrator for Wisconsin's insurance regulation and enforcement division. The Wisconsin insurance commissioner regulates Ambac Assurance Corp., the bond insurance unit of Ambac Financial. Mr. Ruch said that in April 1998, the state concurred with Ambac's view that certain credit derivatives issued by an affiliate of Ambac could be considered insurance contracts that were part of the financial guaranty business.