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New mutual model: veterans of public finance Robert P. Cochran and Sean McCarthy formed a mutual insurer solely devoted to insuring municipal debt.


When Robert R Cochran and Sean McCarthy founded Build America Mutual in 2012, they were determined to follow a different course than the one that doomed many of their municipal bond insurance predecessors.

They had both witnessed firsthand what had happened as a result of the financial crisis, when the lure of insuring residential mortgage-backed securities had disastrous consequences. Industry leaders like Ambac, MBIA Corp. and Financial Guaranty Insurance Co. were stripped of their high ratings. What once was a $2.5 trillion business became a shell of itself and, where eight players vied for business, when BAM came along there was only one: Assured Guaranty Municipal Corp.

"There are a lot of lessons to be learned from that experience," McCarthy said of the turn that the industry took as a result of the crisis. "The first and most important thing to notice is that none of the original eight insurance companies that were writing financial guaranties failed because of their municipal bond exposure. They blew up, as made famous by the book The Big Short, because they got involved in highly levered subprime mortgage transactions," McCarthy said.

So Cochran and McCarthy started BAM with the intent of insuring municipal bonds and municipal bonds only. They decided from the outset to create a mutual structure that sidestepped many of the issues that led to the downfall of their stock company industry peers. Cochran is the company's managing director and chairman of the board and McCarthy is its managing director and CEO.

"We concluded that if we were going to go back into the municipal bond insurance business, we were not going to be able to sustain the highest credit ratings over time and attract the quality and quantity of capital necessary if the company was structured using a classic stock model because the economics simply would not support a 15% after-tax return, even on a projected future basis," McCarthy said.

"You couldn't attract capital without promising those returns and even if you did, you would then put yourself on a treadmill that ultimately would lead back to the same place that we had seen all the other companies come to, which is that you can only get to that by employing risky leverage or getting into other products outside the municipal world," McCarthy said.

The Beginning

The business landscape in which BAM was born is fundamentally different from the heyday of the financial guaranty industry. In the period before the financial crisis, it was common for municipalities to issue debt wrapped in the protection of a municipal bond insurer's guarantee of principal and interest repayment. It was a stable business model for these monoline companies: Receive a constant supply of insurance premiums in return for backing debt obligations that had very little default risk. Until 2007, no monoline insurer had ever been downgraded or failed to make a payment, according to a 2008 Wells Fargo white paper, Deterioration of Monoline Insurance Companies and the Repercussions for Municipal Bonds.

But later, everything changed. New financial innovations introduced by investment banks and hedge funds to hedge against credit risk threatened monolines' business models. In particular, credit default swaps--essentially insurance contracts against the default of a referenced bond--gained significant market share. The CDS market grew from less than $5 trillion in 2003 to more than $55 trillion by the halfway point of 2008, according to the International Swaps and Derivatives Association. Demand for collateralized debt obligations--packages of several types of debt sold in tranches of varying types of credit quality--likewise soared, to approximately $2.5 trillion in 2007. According to the Wells Fargo white paper, the premiums paid to insure CDOs were larger than those in the comparatively thin profit-margin business of municipal bond insurance.

"For the monolines, the lure of the market was too great to ignore. Besides, the higher credit profiles were systemically assessed by the rating agencies and securities firms to be of investment grade," the paper stated.

To varying degrees, all of the monolines were affected by their exposure to these new securitized models, and most problematically to exposures to structured finance credit default swaps in residential mortgages. The ratings of Ambac and MB!A, then the largest monolines, were downgraded, as were smaller monolines such as Security Capital Assurance Ltd., CIFG Guaranty, and Financial Guaranty Insurance Co.

"It was predominantly their exposure to SF CDOs that determined just how much trouble they got themselves into," according to the Wells Fargo white paper. "It was the rapid deterioration in SF CDO asset values that pushed their business models over the brink and into negative excess capital reserves. In other words, they didn't have enough cash to cover potential losses. The actual numbers of mortgage defaults went well beyond what the models projected, and the monolines that participated more heavily in the SF CDO guarantee business were the ones that got burned the most," according to the white paper.

"CDO technology, by creating a diversity of pools across different industries and different geographies had a value because if there was going to be an economic strain on Florida real estate companies, it probably wasn't going to affect pharmaceutical companies in Seattle," said McCarthy, who as then chief operating officer of Financial Security Assurance witnessed firsthand what was going on with the industry.

"But it turns out that applying that technology to subprime mortgages was a mistake because they correlated 100%. First, whether they were in Key West or Los Angeles, subprime mortgage borrowers all behaved similarly. Second, the step that really caused damage in the industry was taking subordinate pieces of a pool of transactions and then re-hypothecating them into new securities. They were trying to squeeze that concentrated risk into a diamond, but what they were really doing is creating a nuclear weapon that had tragic results," McCarthy said.

FSA and Assured Guaranty Ltd. limited their exposure to the structured finance CDO business and subprime residential mortgage-backed securities, and thus survived the industry's restructuring in relatively good shape, according to Wells Fargo. Assured Guaranty acquired FSA in 2009.

Getting Started

In the aftermath of the financial crisis, Cochran and McCarthy joined together and contemplated their next move. Veterans in public finance, they first met in the late '70s when Cochran was a public finance lawyer at Kutak Rock and McCarthy was an investment banker at E.F. Hutton's public finance group.

"I was at FSA at the beginning and Sean joined us very quickly after we formed the company," Cochran said. "The founder of FSA, Jim Lopp, died tragically and unexpectedly of a heart attack at age 51 in 1990. At that point, I became CEO of FSA and Sean very quickly became the number two guy in the company and we ran FSA together for nearly 20 years," Cochran said.

In 2011, the two formed Hudson-Greenwich Partners LLC, named after the two streets each lived on in the Tribeca section of New York City. After months of extensive research, they created a business model that's embodied in Build America Mutual.

"We weren't initially committed to the idea of creating a new financial guaranty company. We just knew that between us we had 40-50 years of experience in municipal finance and insurance and we wanted to figure out whether there was something we could do that would be new and interesting and unique to our skills and something that we felt was worth putting the next stage of our lives into," Cochran said.

Eventually, their analysis led them to the conclusion that creating a mutual bond insurance company 100% owned by policyholders was a financial model that would enable a monoline company to sustain itself without relying on insuring nonmunicipal debt.

"In New York, there hadn't been a new mutual insurance company formed in 40 years, so to make BAM a reality we had to satisfy two different regimes: the mutual insurance regime and the financial guaranty regime, which is more technical in the way it was regulated, and combine the two together," Cochran said. "We had to do that for our home state regulator here in New York, and then the other 49 states and the District of Columbia. There was a tremendous amount to be done and our team was building it from whole cloth," Cochran said.

"The activity of raising money to build public infrastructure, which is something we desperately need to do in this country, is a positive synergy here," Cochran said. "If we could create something that is essentially collectively owned by the municipalities of America and therefore is able to deliver its product at the lowest possible cost with the highest possible level of safety for investors who buy the bonds that we guarantee, that's a mission worth spending the rest of our careers to accomplish," he said.

The new company received its initial $600 million of startup capital from White Mountains Insurance Group, a financial services holding company. HG Re Ltd., a Bermuda special purpose insurer provides first loss reinsurance protection for policies underwritten by BAM.

They attracted a board of directors consisting of themselves: Raymond Barrett, chairman and CEO of White Mountains Insurance Group; Richard Ravitch, the former lieutenant governor of New York and co-chair of the New York State Budget Crisis Task Force; Edward G. Rendell, former governor of Pennsylvania; Robert A. Vanosky, private investor and former head of the public finance division of RBC; and Allen Waters, director, president and CEO of Sirius International Insurance Group.

Relatively quickly after opening its doors, BAM closed its first deal, insuring the York Suburban School District's $10 million debt offering. They also obtained the sponsorship of the National League of Cities, which made BAM its preferred provider of financial guaranty insurance on debt for its member municipalities. NLC is an advocacy organization that represents 19,000 cities, towns, and villages, and encompasses 49 state municipal leagues.

In addition to its municipal model, BAM made transparency a fundamental building block of the company. The company publishes three-page credit summaries for every transaction it insures, known as Obligor Disclosure Briefs or ODBs, and makes them freely available on its website. These disclosures are meant to "assist broker dealers in meeting disclosure rules for secondary market transactions," according to a press release accompanying the company's formation. They also help investors monitor the underlying credit quality of their investments and help BAM's issuer-members because well-informed investors typically pay up for bonds that are backed by transparent financial disclosures.

"The role we're playing helps the underlying issuer meet their obligations to put timely financial disclosure into the market in a clear, standardized form, and it helps the regional dealer be able to easily pull a report that he or she can deliver to their investors that summarizes the issuer's financial position and provides a summary of the nature of the demographic and economic environment," McCarthy said.

According to The Bond Buyer, the century-old daily that covers the municipal bond industry, BAM in its first year took 39% of the total insured market by par amount. Today, the competition is tougher with National Public Finance Guarantee Corp. and the two Assured Guaranty companies (Assured Guaranty Municipal Corp. and Municipal Assurance Corp.) competing for business.

"I think that if you had asked us three years ago where we would be today, we would have thought we might have insured more volume. But I don't think we could have imagined that we would have created the great company that we feel we have today in terms of the people, the systems and the market acceptance," Cochran said.
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Title Annotation:Risk Takers: Build America Mutual
Comment:New mutual model: veterans of public finance Robert P.
Author:Lewis, Angelo John
Publication:Best's Review
Geographic Code:7IRAN
Date:Dec 1, 2015
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