The Bond Insurance is Really a Put Option; Who’s Ever Heard of a Risk-Free Put Option?

We can clear away one layer of confusion surrounding the 38 Studios reckoning by doing away with the euphemistic use of the term “bond insurance” in conjunction with Assured Guaranty’s role in the transaction. In an insurance relationship, an insurer commits to paying out agreed-upon amounts of money to an insured party, in return for receiving a premium from the insured, if certain conditions are met (and a claim is filed). If a valid claim is filed, the insurer doesn’t receive anything additional for paying it.

That doesn’t describe the relationship between Assured Guaranty and either the state of Rhode Island or the 38 Studios bondholders. Assured Guaranty has agreed, in return for an up-front premium, to pay a certain amount of money to the bondholders if certain conditions are met, receiving in return the right to do whatever the original bondholders could have done with the bonds.  In other words, they will buy the bonds from the bondholders at a previously agreed upon price, regardless of their actual value.

In any objective sense, this doesn’t describe true insurance protection sold by Assured Guaranty, it describes a put option. In the textbook description of a put, the option seller agrees to buy an asset of fluctuating value at a pre-determined price, if its value falls below a certain “strike price” within a specified time-frame, in return for an up-front premium from the option buyer. The only difference between a basic put and the financial product sold by Assured Guaranty to the 38 Studios bondholders (that they paid for with money given to them by the state of Rhode Island) is that the condition-to-buy is not triggered by a price threshold, but by a missed bond payment.

No matter what term-of-art is used to describe it, what Assured Guaranty sold was a put option — and expecting the sale of puts to be risk-free is even crazier than expecting investing in start-ups or selling garden-variety insurance to be risk-free.

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