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
MxAAA: 180 day Cetes
Ba2 Tranche: 180 day Cetes
If assume BBB would be , 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.