The Uncertainty of Surety

A pending face-off between bankers and insurers may put an end to a cheap source of credit enhancement.

In a trial guaranteed to embarrass both sides, J.P. Morgan Chase & Co. will square off in court this December against 11 insurance companies to demand payment of almost $1 billion in commercial surety bonds. The insurers have refused to pay, claiming the gas trades they thought they were guaranteeing were actually an elaborate financial sham that allowed J.P. Morgan to provide disguised loans to now-bankrupt Enron Corp.

The case has far-reaching implications, including the peculiar possibility that evidence the bank uses to recoup its losses subsequently may be used against it in a criminal securities case by Manhattan district attorney Robert M. Morgenthau, who is currently investigating the bank’s dealings with Enron, or as evidence in the Enron class-action suit, which names J.P. Morgan as a defendant.

Even before the trial begins, however, it is a blow to the already troubled surety bond market. Since the beginning of 2000, insurers have reported almost $1 billion in direct losses from commercial surety bonds alone. Meanwhile, traditional, plain-vanilla types of sureties widely used by U.S. businesses are already more expensive and harder to come by. If insurers lose the case, “I think certain boards of directors at insurance companies would look hard at their involvement in the surety business,” predicts Brian Driscoll, president of Boston-based J. Barry Driscoll Insurance Agency. “The financial losses could also chase some reinsurers out of the business, and restrict the flow of capital and support into an already restricted market.”

Boom and Bust

The current crisis only adds to commercial sureties’ already checkered past.

Traditional surety bonds, called contract sureties, are widely used in the construction industry to guarantee completion of work. If the contractor (the principal that purchases the bond) fails to finish the bonded work, the surety company pays the property owner (the obligee), and then recoups the money by completing the work itself. By contrast, commercial sureties are typically used to guarantee performance that has a financial component. For example, most states require a company that self-insures for workers’ compensation to post surety bonds to guarantee coverage if it becomes insolvent.

During economic booms, however, insurance companies have often expanded commercial surety bonds into hybrid products that look more like bank offerings. “The traditional surety concept of third-party guarantee moves from performance of contract to payment of debt,” says Mark Reagan, CEO of the construction practice for Willis, a global insurance broker. “That’s not suretyship, that’s financial guaranty.” Lloyd’s of London, he says, has banned financial guaranty sureties since the end of the Boer War in 1902, when speculative ventures fueled by military spending and underwritten by the insurance consortium collapsed.

But insurance companies haven’t learned from history, he says. In the 1970s, when corporate computer use began to soar, Lloyd’s stretched its own rules by writing “insurance” on the residual value of computers after leases expired. “Again, they failed tremendously,” declares Reagan.

Surety companies dabbling in mortgage guarantee bonds in the 1970s also suffered disastrous consequences. And a similar fate befell companies that wrote surety bonds in the 1980s to guarantee the activities of partners involved in real-estate investment trusts. When the real-estate market imploded in the early 1990s, “surety companies took it right on the chin,” recalls Driscoll, who is also president of the National Association of Surety Bond Producers (NASBP).

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