Guaranty insurance, as a term, may be new to you, but it is an important component of the financial services industry. In financial terms, guaranty insurance makes the capital markets more efficient from a cost and accessibility point of view by allowing debt issuers to lower their overall borrowing costs.
It is credit protection for debt issuers and investors, including those that issue mortgage, auto and student loans. By “wrapping” the insurer’s credit rating with that of the debt obligation, the debt receives a higher credit rating, in turn lowering the interest rate on the debt. It can also open up the capital markets to more issuers.
When this particular niche in the insurance industry began, it focused primarily on municipal bonds, mainly because of their historically low default rates. Then, in the 1980s, the industry expanded into asset-backed securities and subprime loans, or what are called CDOs, subprime collateralized debt obligations. As the niche industry grows and evolves, it becomes more vulnerable as well.
That vulnerability could lead to a downgraded insurer, which would, in turn, downgrade each of the bonds it insures That makes the bond’s rating the same as it would be without the credit “wrapping.” For those investing in the bond, that turns into a lower payout.