Bond Insurance Guarantees bond principal in case of a credit event.

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Presentation transcript:

Bond Insurance Guarantees bond principal in case of a credit event. Effectively “swaps” the rating of the bond for that of the insurer. Purchased by bond issuers at time of issue to help sell bond (often done with munis). bond holders interested in protecting themselves from bond default. bond holders interested in upgrading the quality of the bonds they have on their books. Soundness of the insurance only as good as the insurance company.

Credit Default Swaps (CDS) CDS typically quoted in terms of $10 million for 5 years. Ex: Price to insure $10 million of XYZ bonds for 5 years is 150 basis points per annum. But like free money if no credit event. A different type of “insurance” because with a CDS, buyers don’t have to own reference obligation. More like a bet than insurance. But such betting made legal by means of Commodity Futures Modernization Act of 2000. Several things went wrong: Since don’t have to own reference obligation, notional amount of outstanding CDSs can exceed reference obligation’s total face value. CDS coverage grew rapidly on mortgage-backed securities. Made them look, whatever their quality, good on the books of financial institutions.

Notional Amount & Credit Event Notional amount = face value of a bond times the number of times it is insured. CDS writers have to pay when credit event occurs on reference obligation. bankruptcy default repudiation/moratorium restructuring When reference obligations went bad in large numbers, CDS writers (like AIG) unable to pay. As a result of Commodity Futures Modernization Act, there were no regulations about having to put any money aside.