The sustained growth of the project bond market in Europe over the last few years has done more than diversify funding sources for projects themselves. It has also brought to the fore a feature which, increasingly, no project bond in Europe can be without ? a monoline wrap.

Monoline involvement is now routine across the spectrum of deals, from some pure project risk to quasi project/infrastructure type deals and, of course, PPP and PFI bonds. But while a monoline wrap can tidily take care of investor concerns for issues which otherwise might only just scrape an investment grade rating, are sections of the market becoming entirely dependent on monoline involvement? If it is becoming the case that a large percentage of project bonds going forward need to be wrapped, what are the implications for investor appetite for such paper and monoline appetite for such risk?

Monoline insurers have embraced project bonds in Europe with gusto as a natural progression from their traditional business in the US. According to recent research by Dresdner Kleinwort Wasserstein, of the Eu4 billion wrapped European ABS issuance year to date, a full 22.5% (or Eu0.9 billion) is project finance business. ?In the US, essential infrastructure has traditionally been financed through municipal bonds,? says Wynne Morriss, senior managing director of structured single risk at XL Capital Assurance (XLCA) in New York. This has ranged from very low risk general obligation bonds to higher risk revenue bonds that rely on a single central project. ?We have taken the skill sets from our project work in the US and applied them in Europe.?

XLCA only received its authorization from the UK FSA to provide general insurance in the UK in 2002 and thus is a relative newcomer in Europe ? the market so far has been dominated by the triumvirate of MBIA, FSA and AMBAC (see table). But it is one thing wrapping a municipal general obligation bond and quite another wrapping true project risk in the early stages of a project.

?We do not broad brush the entire [project finance] sector ? there are particular areas within it that we find meet our underwriting standards,? explains David Dubin, managing director and co-head of Europe, Middle East and Africa at MBIA in London. And those areas can be summarized by one overwhelming feature: essentiality. All the monolines emphasize that they will only get involved in transactions where there is clear evidence of an essential service and they can be confident of government intervention should things go wrong. ?We don't make a big distinction between project finance and PFI but everything has to be an essential public service. This is one important factor in enabling us to get comfortable with the risk,? says Olivier Garnier, director in the UK PFI department at FSA in London.

The result is that the monolines are providing wraps to the sectors of the market in which the levels of construction and performance risk are already relatively low. ?It is hard for us to even consider insuring any type of projects with greenfield characteristics and/or unproven technology track records,? says Dubin. ?These simply do not fall within monoline insurance parameters, which are quite conservative.?

The decision on whether to get involved in a deal is regulated at the most basic level by the simple fact that monolines are not able to get involved in any financing at below investment grade level. The question of the underlying rating of the bonds that monolines wrap, together with maintenance of their own triple-A rating, reflects the extent to which the monolines' fate is intimately tied up with the rating agencies. ?The monolines' own criteria for involvement are often far more stringent that those of the rating agencies,? explains Henrietta Pod at Royal Bank of Canada, which underwrote the £165 million Exchequer Partnership 2 bond issue in January this year.

Is ratings regulation sufficient?

Exchequer Partnerships 2, which finances the second stage of refurbishment of government offices in Great George Street, was wrapped to triple-A by FSA. ?Investment grade is the condition precedent for involvement but in and of itself it is not sufficient,? says Morriss at XLCA. ?There are many investment grade projects that we would not do.? Each time a triple-A guarantee is issued by a monoline a capital charge is taken against the insurer by the rating agency based on the probability of default and expected loss over the term of the wrap. In this way the industry is directly regulated by the rating agencies ? raising the question of whether this form of regulation is sufficient. ?Since Enron there has been a lot of discussion about the role of rating agencies as regulators,? notes Steve Harris, partner at law firm Ashurst Morris Crisp in London. ?I'm sure this question has been raised. But the rating agencies have been doing this quite successfully for a number of years now.? One bond investor does not see any problems with the rating agencies role: ?Monolines are in many ways a rating agency construct and the rating agencies are going to do everything they can to make sure that the monolines survive.?

But this does not mean that the rating agencies and monolines view risk in the same way. ?Monolines take their own view of the credit, which may be different to ours,? explains Mike Wilkins, head of infrastructure ratings at Standard & Poor's in London. He makes the point that several recent UK PFI deals for which monolines have provided a wrap ? particularly in the road and hospital sectors ? ?have only just scraped investment grade? but the monolines have been happy to take them on.

?There is a different dynamic at play here,? says Wilkins. ?In a default scenario the monoline knows that it will be lead creditor.? Indeed, provided that it is investment grade the actual rating can have remarkably little impact on the monoline's decision. Morriss at XLCA in New York explains that the underlying rating can play a minor part in the decision to underwrite. XLCA wrapped the Eu126.5 million bond issue (together with an EIB loan) to refinance the SCUT do Algarve toll road in July 2001 (the total deal size was Eu256.5 million). ?When the underlying rating was revealed it was triple-B plus but we were going to underwrite the deal whether it was triple-B plus, triple-B or triple-B minus,? he reveals.

This approach shows the level of analysis that the monolines undertake on an investment that is in many ways very different to the bulk of the rest of their portfolio. The Dresdner Kleinwort Wasserstein research shows that the majority of wrapped ABS issuance so far this year ? Eu1.9 billion ? has been in the sub-prime mortgage sector and Eu1.2 billion has been written for whole business securitisations. So how does the analysis for project and PFI wraps differ from that for a more traditional CDO-type risk? ?A CDO investment is a much more passive type of investment,? explains one monoline executive. ?You can have exposure to several hundred different names and have little control over whether they pay or not. With a project deal you can lever yourself into the deal and have far more control over the situation if problems arise,? he says.

Monoline CDO exposure concerns

The monolines' exposure to the CDO market has been a source of concern given the sharp deterioration in credit quality that that market has experienced. ?There has been concern in the structured finance market at the level of exposure monolines have to corporate CDOs,? says one bond investor. ?In general the monoline mantra is that monolines do not take corporate risk and people have been surprised at the extent to which they have taken corporate CDO risk.? Concerns such as this reinforce the monolines' policy of removing themselves as far as possible from any corporate risk in their project underwriting. Thus, for example, when considering toll road investments the monoline will usually try to avoid any tolling agreements that lead through to corporate rather than utility risk.

Investor unease at the extent of the monolines' exposure to the CDO market was triggered initially by a critical report published by New York-based hedge fund Gotham Partners in December 2002. The report suggested that ?Dramatically increased liquidity investment, underwriting and correlation risks? in the portfolio of one monoline ? MBIA ? ?do not justify its triple-A rating?. The report caused a furor and was immediately rebuffed by MBIA as a ?negative advocacy piece.? And project bond investors report no concerns over the issues raised by this report. ?The monolines ? particularly FSA ? have taken very quick action to provide write-downs on the corporate CDO side which is very good news,? says Pod at RBC. But could the necessity of such moves be an impetus for the monolines to further diversify their portfolios into areas such as project finance?

According to XLCA a full 53% of municipal bonds issued in the US in 2002 were wrapped by monolines. There is still a long way to go before they reach similar levels of market penetration in Europe. ?The monolines' exposure to UK PFI is minute,? says Henrietta Pod at Royal Bank of Canada. ?It represents minute percentages of write-down risk.? She therefore confirms that there is plenty of demand for monoline paper in the sterling bond market. This is good news for the monolines themselves who all have aggressive predictions for growth in their European project finance business going forward. ?2003 will be a very strong year for monoline-wrapped essential projects in Europe,? says Morris at XLCA. ?This business will increase as a percentage of our portfolio.? According to Dubin at MBIA project finance, including PFI, accounts for 10% to 15% of the insurer's European business but this is set to grow.

It's a cost thing

Given the monolines' desire to write this type of insurance as the market's increasing dependence on it, is there a risk that investors could get full on monoline paper? ?This is an interesting question,? observes Olivier Garnier at FSA. But ? although indicating that there is a possibility that some investors could reach their limits on certain names ? he believes that this will not become a problem. ?Although investors like the bonds to be wrapped they are increasingly looking at the underlying asset,? he explains. ?This will enable them to extend their capacity.? Morriss at XLCA sees the number of players in the market as a protection against any appetite concerns. ?I believe that investors should hold a diverse group of guarantors,? he says. ?I don't see much danger of there being a concentration issue.? There is clearly a pricing distinction between the more established names in this market and the more recent entrants but that differential should reduce going forward.

The demand for monoline insurance is a simple consequence of the arbitrage between the cost of an unwrapped deal and the cost of the monoline premium. As project bond investors become more comfortable with the risks inherent, the differential between the two will decrease. ?There is demand for unwrapped paper out there,? says Pod. ?But we would not advise our clients to tap it as it is clearly more expensive.? While this remains the case the increasing role of the monolines in project finance is assured.

And as more PFI/PPP deals move into their operational phases the prospects for the monolines are again improved. ?Although we are seeing the same level of project finance deals, we find that more of these projects are seasoned or mature,? says David Dubin at MBIA. ?With these kinds of established issuers approaching the capital markets, it is natural that financial guarantee insurance could be an important component of these transactions.? One example of this is the recent securitisation activity in the UK water sector. But there is also plenty of activity at the early stages of many projects. Although monolines are acutely aware of the risks inherent in the early stages of many projects ? one executive at a large monoline claims that ?the majority of pure project finance does not fit in with monoline activity? ? Mike Wilkins at Standard & Poor's emphasizes that monolines do provide financial guarantees to projects that are pre-completion and simply make sure that they mitigate the risk to a third party. ?The larger a deal is the more likely we are to reinsure risk,? explains Morriss at XLCA. ?The guarantor will generally hold on to at least 50% of the risk and very often substantially more than that,? he says.

Monoline appetite for early stage deals is demonstrated by the Metronet Rail transaction in the UK, which will finance the long-delayed upgrade to part of the London Underground system. The deal sees both FSA and Ambac providing wraps to £515 million bonds apiece. Clearly the part-privatisation of the underground system incorporates a number of transitional risks, but the monolines have been happy to take the deal on. Garnier at FSA, one of the monolines involved, comments, however, that this deal is ?at the edge? of what the guarantor is prepared to do. But that edge may yet be extended.