Canada’s office of the Superintendent of Financial Institutions has moved to reassure stressed credit markets.

With spreads in the credit-default insurance market swelling — an indication of the high price of insurance for bond defaults — OSFI has made it easier for U.S.-based bond insurers to do business in Canada. Based in New York, these companies charge fees to ensure that if a bond fails to be redeemed on time, with full interest, they will make immediate payment. Called “monoline” insurers, companies in this little-known niche of global finance have been a vital part of the market for U.S. municipal bonds.

OSFI has clarified the rules for monolines operating in Canada, probably in hopes of persuading them to add capacity when it comes to bailing out illiquid or defaulting debt in areas such as asset-backed commercial paper. That hope may be slight, however, as bond industry insiders say the monolines have little relevance to Canada. The monolines themselves, which are gushing money to cover defaulting credit instruments in the U.S., appear to be in worse shape than some of the risks they cover.

OSFI’s move amounts to throwing a leaky life jacket to capital markets, say bond industry insiders.

OSFI’s regulatory clarification began on Aug. 15, just as the ABCP crisis boiled over into the stock market. Money was fleeing from credit-sensitive bonds and heading to the safety of treasury bills. OSFI took that moment to clarify its position on the foreign companies, mostly in the U.S., that take on bond default risk. It recommended that risks located in Canada but insured outside of Canada by foreign companies — the monolines — will have an easier time with compliance after Jan. 1, 2009, with lighter reporting rules.

BIG BARRIER FALLS

According to a bulletin from Toronto law firm McMillan Binch Mendelsohn LLP: “Foreign insurers providing this product [monoline coverage of bond defaults] would no longer be subject to Part XIII requirements.”

Those rules served to deter the monolines from operating in Canada. Although the monoline companies may have to satisfy provincial insurance regulators with respect to licensing and regulation, OSFI’s statement means one of the big barriers has come down.

There is some question, however, about what the monoline companies will cover. Any assistance they give to Canadian bond issuers will take time to develop. Bond buyers do not demand default insurance for federal or provincial credits. And Canada’s municipal bond market is tiny and almost default-free, says Neil Murdoch, president and CEO of Connor Clark & Lunn Capital Markets Inc. in Toronto.

Monoline insurers are being courted because their business of providing financial comfort to bond buyers is becoming more important. That’s because of the rising price of default insurance in the credit-default swap market, in which worried bondholders pay a premium to investors who are willing to take bets that the bonds they insure will not default.

The monoline companies, which get paid to take on default risk, do what rating agencies do and more, given that their cash is at risk if their clients cannot come up with money for bond redemption or coupon payments. For bond issuers, more default insurance should have a calming influence that reduces what they have to pay to attract buyers.

That’s the theory. But the mono-line insurers are in trouble. Selling credit insurance hinges on convincing bond issuers and bond buyers of a player’s ability as a counterparty to come up with money to cover bond defaults. The key is the creditworthiness of the insurer, Murdoch says.

The market is not convinced that the monolines are up to the task. Boosts on returns for taking on the monolines’ own debt have widened to as much as 700 basis points, up from 120 bps in late February.

Contrast that with swaps from Citigroup Inc. , the largest U.S.-based financial services company, that have widened their spreads over comparable U.S. treasuries from 20 bps on Oct. 12 to 80 bps as of the second week of November.

UNDER CREDIT REVIEW

An 80-point spread on a corporate bond is still respectable for an investment-grade credit, but a spread of 700 bps is a rating for seriously troubled junk, says Brad Bondy, vice president for fixed-income at Genus Capital Management Inc. in Vancouver. So, it’s not surprising that rating agencies have taken the monoline companies’ finances under review to determine if they are good enough credits in their own right to cover clients’ potential bond default.

@page_break@If the monoline companies’ own credit ratings decline, there would be a cascade effect with the bonds they insure becoming less reliable and, therefore, worth less. The holders of those bonds, especially pension funds and life insurance companies, would then have to reappraise their own exposures, Bondy notes. What’s more, institutional investors that can hold only investment-grade credits would have to dump some bonds backed by monoline coverage, Bondy adds.

So far, the problem is mostly U.S.-based, as monolines have not been active in the Canadian bond market. “That could change,” he says, “but I don’t know how many investors will rely on monoline bond backing, given the state of the monoline companies’ own finances.”

If the market senses backup payment facilities offered by swaps and monoline companies are in trouble, a Pandora’s box of woes will open. Bond prices would fall, risk/asset ratios would change and capitalization would have to be boosted at companies that OSFI supervises.

Whether that scenario plays out may depend less on what OSFI does than on the state of the economy. If the world economy remains robust, defaults should remain low. If the world economy shudders, defaults will rise and bond prices, which should rise, would tend to fall on credit concerns.

“What is essential is to find replacement buyers for distressed debt,” Bondy says.

“If the monolines are downgraded or go under, issuers they have covered and their bonds will be in trouble,” he says. “But the problems will be specific to the bonds that have been insured by the monolines. The swap market will carry on.” IE