What Is Appropriate Exposure?

The financial guarantors, such as MBI, receive a premium from borrowers in order to lower their borrowing costs. For an example, consider a company which wants to borrow $10 million. Also, in this example, let's assume the company is considered investment grade. Such a company may find that by "wrapping" its bond with a financial guarantee provided by a guarantor, the interest rate may be reduced by more than than cost of the guarantee.

This "free lunch" is a result of asymmetry of information, that is, the financial guarantor may have a greater understanding of the risk than the investor. The principle here is similar to the father who cosigns an auto loan for a child. Not only does the lender receive the additional comfort of the father's financial statement, but the father also, ("theoretically" as my partner Joel says), knows better the likelihood of the child's repayment.

By providing a guarantee, the financial guarantor exposes a portion of its portfolio to risk. For example, the financial guarantor may have a multi-billion dollar capital base. By guaranteeing the bond of the company above, how much of the capital base of the guarantor should be "set aside" to fund the risk that the company may have a problem?

The first answer is $10 million. Intuitively, this simple answer seems too conservative. If the company is investment grade, then some rating agency discovered enough ability to repay its IOU so that a complete loss, while possible, would be highly unlikely.

The second answer would be to simply fund a "gap" number by understanding the difference between the current investment grade rating and a AAA rating. A AAA rating is a result of what's backing up the IOU. If Company XYZ has $10 million in cash backing up a $10 million IOU, then it wouldn't need the guarantor. But the company may have some real estate assets or receivables which could be used as collateral. The more collateral, the higher the rating.

If a company needs, for example, 12% overcollateralization to achieve AAA rating, then a $10 million loan would need $11.2 million in collateral. If the company has only put up a 5% overcollateralization to achieve the investment grade rating, then the "gap" number would be $700,000.

The third answer is a statistical modeling approach. This approach takes historical default rates of investment grade bonds and simply applies the loss rate as an average. So, for example, if investment grade bonds have failed 1% of the time, then $100,000 would be set aside as the appropriate exposure.

You can see a wide variety of choices. These model in a real way the challenges faced by the current situation for financial guarantors.