A F G I ASSOCIATION OF FINANCIAL GUARANTY INSURERS. Unconditional, Irrevocable Guaranty

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1 A F G I ASSOCIATION OF FINANCIAL GUARANTY INSURERS Unconditional, Irrevocable Guaranty May 24, 2012 European Commission Avenue du Bourget n Evere BELGIUM Markt-consultation-shadow-banking@ec.europa.eu Re: Shadow Banking Green Paper Ladies and Gentlemen: The Association of Financial Guaranty Insurers ( AFGI ) appreciates the opportunity to provide the European Commission (the EC ) with comments on the EC s March 2012 Green Paper on Shadow Banking (the Green Paper ). 1 AFGI is the trade association for financial guaranty insurers, whose members include ten insurers and reinsurers of municipal, infrastructure and asset-backed securities ( ABS ). The Green Paper indicates that possible shadow banking entities and activities [ ] include insurance and reinsurance undertakings which issue or guarantee credit products. AFGI submits that the EC should not include insurance and reinsurance activities which issue or guarantee credit products within the definition of shadow banking activities. Further, AFGI s members should not become subject to an additional prudential regulatory regime established by the European Union to cover the shadow banking system because the activities of AFGI members do not present any of the risks related to shadow banking identified in the Green Paper. Moreover, AFGI members are already regulated appropriately and directly by the applicable sovereign insurance regulators in Europe and the State regulators in the United States. As such, AFGI members will be subject to the requirements of the Solvency II Directive when implemented in Europe and are subject to the applicable State insurance laws in the United States. The Business of Financial Guaranty Insurers The activities of financial guaranty insurers are straightforward, not complex. Financial guaranty insurers generally insure that scheduled payments on specific obligations will be paid when due to the holder of those obligations. The business of financial guaranty insurance consists predominantly of the insurance of securities sold in capital markets. Financial guaranty insurance generally results in a lower interest rate on insured securities than would otherwise apply absent such insurance. Generally, the issuer pays a 1 European Commission, Green Paper: Shadow Banking, COM(2012) 102 final (Mar. 19, 2012).

2 portion of this interest rate savings to the insurer as an insurance premium, while the issuer retains the balance of this savings as its incentive to use the insurance. Since issuers of securities have the option to sell their securities on an uninsured basis, issuers employ financial guaranty insurance when doing so results in material cost savings for the issuer. Insofar as financial guaranty insurance is used predominantly in connection with financing obligations of public issuers and projects serving a substantial public purpose (such as schools, water and other utilities, public hospitals, and roads), financial guaranty insurance itself serves a substantial public purpose. The Financial Guaranty Insurance Industry Is Not Currently Engaged in Material Shadow Banking Activities The composition and business of the financial guaranty insurance industry has changed dramatically since the advent of the financial crisis. It is important to recognize these developments to ensure that any new regulatory measures are targeted, proportionate, forward-looking and adaptable, effective and [subject to] assessment and review. 2 Prior to the crisis, the financial guaranty insurance industry included seven triple-a rated insurers engaged in the business of insuring municipal bonds, ABS and infrastructure financings in various markets, including the United States and Europe. Presently, there is only one financial guaranty insurance group (Assured Guaranty) actively writing new business. Other industry members plan to commence writing new business when they overcome their impediments. Similarly, new participants are seeking to enter the financial guaranty insurance market subject to obtaining satisfactory financial strength ratings from the securities rating agencies. Notably, the new financial guaranty insurance business currently being written and proposed to be written by existing and potential industry participants is comprised predominantly of the insurance of U.S. tax-exempt municipal bonds sold to U.S. investors. Since the advent of the financial crisis, financial guaranty insurance of new business in European markets has not been significant, with future prospects focused primarily on the insurance of infrastructure bonds sold to institutional investors in connection with private finance initiative and public private partnership financings or refinancings. Financial guaranty insurers previously were significantly engaged in more complex activities such as the business of insuring ABS and providing credit default swaps ( CDS ) through insurance of CDS written by nominally capitalized affiliates. However, the insurance of CDS as previously conducted by financial guaranty insurers is no longer permitted under applicable insurance law requirements 3, the requirements added under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act ) in the United States, and the European Infrastructure Markets Regulation ( EMIR ) 2 Id. at p See e.g., NY Insurance Dept. Circular Letter No. 19, Best Practices for Financial Guaranty Insurers (Sept. 22, 2008). 2

3 in Europe. Additionally, the asset-backed and CDS obligations previously insured by industry members are running off rapidly. 4 Since the financial crisis, the financial guaranty insurance business has been predominantly comprised of the insurance of U.S. tax-exempt municipal bonds. 5 The insurance of municipal bonds serves a public purpose insofar as the use of insurance lowers the overall borrowing cost of the municipal issuer and/or allows the municipal issuer access to capital markets that may not be otherwise accessible by the issuer. Because of the tax-exempt nature of U.S. municipal bonds, these securities are owned predominantly by U.S. investors that can benefit from the exemption of the bond interest payments from U.S. income tax. Insofar as the investor base for these securities resides primarily in the United States, the interconnectedness with European banking and other financial institutions is negligible. In addition, financial guaranty insurers generally limit their insurance to municipal bonds that have underlying investment grade ratings. In the event of a financial guaranty insurer downgrade, default or insolvency, the quality of the underlying obligations substantially mitigates the impact on those who invest in securities insured by such insurer. For this reason, during the financial crisis, the downgrade, default, or insolvency of bond insurers had an immaterial impact on the municipal bond market. Likewise, insofar as issuers of securities have the alternative of selling their securities on an uninsured basis, the unavailability of financial guaranty insurers does not result in material inability of issuers to access the capital markets. The Green Paper identifies four risk categories related to shadow banking. The insurance of U.S. tax-exempt municipal bonds does not appear to fall into any of these risk categories. Specifically: (i) (ii) (iii) The insurance of tax-exempt municipal bonds does not entail deposit-like funding structures that may lead to runs. Prior to the crisis, auction rate municipal bonds represented a deposit-like funding structure. During the crisis, some auctions failed as a result, in whole or in part, of ratings downgrades of some financial guaranty insurers. The prevalence of auction rate municipal bonds has declined significantly since the financial crisis. AFGI understands that there have been no new issues of auction rate municipal bonds (whether or not insured) since the crisis. The insurance of tax-exempt municipal bonds does not represent a buildup of high, hidden leverage. The insurance of tax-exempt municipal bonds does not entail the circumvention of rules and regulatory arbitrage. 4 Appendix 1 hereto includes information regarding the run-off of non-municipal insured obligations for Assured Guaranty companies, which is representative of the run off business for other industry members. 5 Appendix 1 hereto includes information regarding the obligations insured by the Assured Guaranty companies, the only financial guaranty insurers currently writing material new business. 3

4 (iv) The insurance of tax-exempt municipal bonds would not lead to disorderly failures affecting the banking system. This is because (a) the underlying credit quality of insured municipal bonds is generally investment grade without the guaranty, thus reducing the impact on investors of an insurer s failure; and (b) tax-exempt municipal bonds are generally held by U.S. retail investors, U.S. mutual funds and U.S. insurance companies, and other U.S. tax payers, resulting into de minimis connectedness to the European banking system. While the business of financial guaranty insurers is expected to consist predominantly of the insurance of U.S. municipal bonds, these insurers also expect to insure infrastructure obligations (predominantly under private finance initiatives and public private partnerships) and ABS. As with U.S. municipal bonds, financial guaranty insurance allows the issuers of infrastructure and asset-backed obligations to lower their overall financing costs. The Green Paper indicates that securitizations are under review as shadow banking activities. AFGI submits that the use of credit enhancement to facilitate securitizations should not be a factor in determining whether or not to regulate such activity. While the use of financial guaranty insurance generally lowers the cost of issuance for securitization transactions, it does not alter the character of such transactions. AFGI Members are Subject to Appropriate Direct Regulation by Insurance Regulators Currently, AFGI members are appropriately and directly regulated in Europe by the applicable sovereign insurance regulators (primarily the U.K. Financial Services Authority) and will be subject to the requirements imposed under Solvency II once implemented. Similarly, in the United States, AFGI members are appropriately and directly regulated by the applicable state insurance regulators and are subject to the requirements imposed under State insurance law. AFGI members operate in the European Economic Area through separately capitalized insurance company subsidiaries, licensed in the United Kingdom or another home jurisdiction and permitted to operate in other European Economic Area countries using passports or through licensed branches. The U.K. Financial Services Authority and the Solvency II Directive (once implemented) regulate the insurance company subsidiaries of AFGI members based in the United Kingdom.. Solvency II, which codifies and harmonizes insurance regulation in the European Union, addresses the risk of insolvency in the insurance industry by implementing a holistic approach to risk management. 6 It takes into consideration capital standards as part of its quantitative requirements, and couples this consideration with governance, risk management, and transparency requirements. 7 As stated in the Green Paper, Solvency II addresses a number of shadow banking issues as it provides comprehensive regulation centered on a risk-based and 6 European Commission, Amended Solvency II Proposal (Feb. 2008). 7 Id. 4

5 economic approach, along with strong risk management requirements including a prudent person principle for investments. 8 AFGI members operate in the United States through separately capitalized monoline financial guaranty insurance companies. The New York State Department of Financial Services (the DFS ) is the primary prudential regulator for most United States financial guaranty insurance companies, and those domestic insurers that are not domiciled in New York are licensed to issue financial guaranty insurance under New York Insurance Law Article 69 ( Article 69 ) and are therefore also subject to regulation by the DFS. 9 Since its adoption, Article 69 and other provisions of the New York Insurance Law have provided the regulatory standard for the industry, implementing a comprehensive regulatory framework. This framework includes market conduct rules, financial reporting standards, contingency reserves, single and aggregate risk limits, investments requirements, and regulatory examinations. The financial guaranty insurance industry is a monoline insurance industry, participating in financial guaranty insurance and related products only financial guarantors may not write traditional property/casualty insurance or life insurance. As a result, financial guaranty insurance companies are operated as separately capitalized entities, providing guaranties of financial obligations only. This separation ensures that financial guarantors and other insurers cannot affect one another upon an economic downturn, providing an additional level of protection to the marketplace. In addition, financial guaranty insurers do not participate in insurance security funds, such that the insolvency of a financial guaranty insurer will not risk contagion to consumer-oriented insurers such as automobile, home, or life insurers. The financial guaranty industry has undergone significant change because of the credit crisis. As a result of industry losses during the financial crisis arising largely from insurance of securitizations backed in whole in or in part by residential mortgage-backed securities, State insurance regulators have recognized the need to strengthen State regulation and oversight of financial guaranty insurers. State insurance regulators have also responded by appropriately limiting the activities of financial guaranty insurers, including restricting the insurance of collateralized debt obligations of ABS, mezzanine securities, and CDS. 10 These restrictions generally apply directly or indirectly to the European subsidiaries of financial guaranty insurers. * * * * 8 European Commission, Green Paper: Shadow Banking, COM(2012) 102 final (Mar. 19, 2012). 9 N.Y. Code ISC Insurance (2010). 10 See NY Insurance Dept. Circular Letter No. 19, Best Practices for Financial Guaranty Insurers (Sept. 22, 2008). 5

6 We appreciate this opportunity to comment on the EC Green Paper on Shadow Banking. If you have any questions, please do not hesitate to contact the undersigned at or (212) Sincerely, Bruce E. Stern, Chairman 6

7 APPENDIX 1 Assured Guaranty Municipal Corp. Focuses on Public Finance Has Not Insured Structured Finance Since 2009 $140,000 AGM Originations Gross Par ($ in millions) $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $ Q2012 International Structured Finance International Public Finance U.S. Structured Finance U.S. Public Finance 5 Assured Guaranty Municipal Corp. s Legacy Structured Finance Exposure Runs Off Rapidly AGM Structured Finance Gross Par Outstanding 1 ($ in Billions) $160 $140 $120 $100 $80 $60 $40 $20 Actual Q1 Projected (as of March 31, 2012) US and Non-US Pooled Corporate US Residential Mortgages US Consumer Receivables Other Structured Finance We expect AGM s legacy global structured finance insured portfolio ($59.3 billion gross par outstanding as of March 31, 2012 versus $127.1 billion as of September 30, 2008) to run off rapidly 18% by year-end 2012, 42% by year-end 2013, and 74% by year-end $42.6 billion in global pooled corporate obligations expected to be reduced by 44% by year-end 2013 and by 82% by year-end 2015 $11.3 billion in U.S. RMBS expected to be reduced by 31% by year-end 2013 and by 51% by year-end 2015 $0 6 1.Excludes guaranteed investment contracts related to the Financial Products (FP) business that Assured Guaranty did not acquire when it acquired AGM in 2009 from Dexia. As of March 31, 2012, the aggregate accreted balance of the guaranteed investment contracts (GICs) was approximately $4.3 billion. As of the same date, with respect to the assets supporting the GIC business, the aggregate accreted principal balance was approximately $6.0 billion, the aggregate market value was approximately $5.7 billion and the aggregate market value after agreed reductions was approximately $4.6 billion. Cash and net derivative value constituted another $0.3 billion of assets. 7

8 Assured Guaranty Corp. s Structured Finance Business Activity Has Declined Significantly $60,000 AGC Originations Gross Par ($ in millions) $50,000 $40,000 $30,000 $20,000 $10,000 $ Q2012 International Structured Finance International Public Finance U.S. Structured Finance U.S. Public Finance 8 8