What form of structured finance protection have the monolines written?

This is a valid question as we go into any restructuring of the bond insurers, and the answer is more complicated than it appears at first sight. Here are some of the issues.

Many corporate bonds pay interest and final principal - you get coupons for some period, then a return of principal.

A standard CDS on a corporate bond uses a notion of credit event which typically includes default, failure to pay and bankruptcy. If the bond displays a credit event, then the CDS protection buyer stops paying the premium on the CDS and has the right to receive recompense in a short period, perhaps 3 or 5 days. This recompense is either through the right to deliver a bond and receive par (physical settlement) or through the right to receive an estimate of par minus recovery as a cash payment (cash settlement). Some key features include rapid payment, the ability to go short - by purchasing cash settled CDS without owning the bond - and the derivatives (i.e. mark to market) nature of the instrument. Note too that the premium is risky in a standard CDS: if default happens, you stop paying it.

There are insurance policies which behave much like CDS. These are part of a wider class of insurance known as financial guarantee policies. The difference here is that they are legally insurance (and hence have a different legal, accounting, regulatory and tax framework). In particular this is not a mark to market instrument, and in most jurisdictions you have to be an insurance company to write insurance. Note also that insurance typically requires an insurable interest - I cannot profit from buying fire insurance on your house even if it burns down - so if you purchase a financial guarantee policy directly it might not allow you to go short.

The fact that there are two instruments, CDS and financial guarantee policies, which can act much the same way yet have very different accounting should be a matter of shame to the FASB and the IASC.

Another possibility for obtaining protection is a bond wrap. Bond wraps are part of a wider class of insurance policies known as financial guarantee policies. In a bond wrap the policy runs to maturity of the bond, you have to keep paying premium until that date (so the premium is not risky), and the policy writer agrees to make good the scheduled cashflows of the bond should the original bond issuer suffer a credit event. Thus here you get paid on the original schedule, and if there is a credit event you substitute the risk of the issuer for that of the policy writer. Most of the muni policies the monolines have written are in this form. The advantage from their perspective are not only insurance accounting, but also lack of cashflow stress: unlike a CDS you typically have plenty of time to find the cash to make the principal repayment.

With amortising securities the issues become more complex since there is the possibility of a principal and interest payment at each coupon date. You can write standard CDS on amortising securities, but it is also possible to write a pay as you go CDS. This imports bond wrap technology into derivatives, and gives the protection holder the right to demand payments on the original schedule from the CDS writer.

For corporate bonds, amortising or not, matters are fairly straightforward since the failure to receive any cashflow (or at least a material one) is an event of default. For ABS you might not want that feature though: in a typical credit card deal, for instance, there will be a certain level of delinquencies which all parties expect, and if you have a credit event which triggers cash settlement based on default, then many junior ABS would suffer that event in the first month. Moreover in many ABS the collateral prepays, so you do not know when you will get your principal back. This means that to define a CDS or financial guarantee you need to tease out the cashflows each security should get in a given month given the level of prepayments, see what cashflow it actually gets, and define protection based on the difference.

Matters get even more difficult when you have amortising collateral in a CDO but some of the tranches have bullet maturities. Remember too that in some cases the CDO issuance SPV can be technically unable to pay without the CDO collateral having lost value: this can happen in particular due to liquidity risk. Figuring out exactly who pays whom what when something bad happens in a CDO of ABS is sufficiently complex that standard documentation has not been available until recently. Most transactions historically used bespoke documentation, and figuring out exactly which risks were transferred was not a trivial business.

Finally, note that the legal final maturity of ABS is often well beyond the last cashflow date. For a mortgage deal, for instance, it might be 35 years. So a contract which only gives you the right to claim ultimate principal at legal final maturity is like buying protection on a long dated zero coupon bond.

My guess is that most but not all of the monoline's structured finance business involved taking middle or upper tranche ABS and writing pay as you go style protection on it in the form of a financial guarantee. This has considerable accounting advantages over writing standard bullet CDS, as well as the advantages the monolines enjoy as a result of insurance rather than banking capital. Finally it means that the monolines have relatively little immediate cashflow stress even though their structured finance portfolio would be, on a mark to market basis, highly underwater. None of that means that there is no problem with their business -- just that if this is going to be a train wreck, it will be a slow motion one.

In any event we do need to know the answer to this question as it determines the capital needs. If they have written CDS with collateral agreements then the monolines need enough capital to support the mark to market volatility of the trades. If they have just written insurance then they only need enough to support the ultimate realised losses on the portfolio. Those numbers are very different (and it impacts how right Bill Ackman is).

Some people have suggested that one of the villains of the current crisis is mark to market. I don't agree: mark to market gives one view of the value of a portfolio; insurance accounting another. But certainly having a portfolio of similar risks subject to wildly differing accounting principles in the same legal entity is unhelpful.