Cat bonds that is and certainly they have been topical this week here on slabbed. Let’s begin by taking a trip back in time to the Bloomberg story we linked on Willow Re, an Allstate SPE (special purpose entity) earlier this week:
The issuer has notified Standard & Poor’s that it will not have sufficient funds to make the scheduled interest payment,” S&P analyst Gary Martucci in New York wrote in the statement.So-called cat bonds have gained popularity as a way for insurers to protect against natural disasters, and buyers demand outsized returns because they risk losing their entire investment to the insurer if the catastrophe is large enough. With Willow Re and other bonds backed by Lehman, investors are on the verge of losing a portion of their stake because of a financial calamity instead of a natural one.“The market was already pricing Willow Re in the area of 50 cents,” said Christophe Fritsch, head of insurance-linked securities at Axa SA in Paris. “New deals will improve dramatically. Investors will make sure that they will only be exposed to insurance risk and won’t take credit risk.”
Willow Re is one of four catastrophe bonds that used contracts sold by Lehman to guarantee returns on collateral backing the notes and to make interest payments. Lehman’s collapse in September nullified the guarantees, leaving the securities open to market value losses on the collateral.
“Since Lehman’s bankruptcy terminated the total-return agreement, a portion of the interest and principle due to noteholders is subject to market risk,” said Maryellen Thielen, a spokeswoman for Allstate. “The default of Willow Re does not create any contractual obligations for Allstate.”
Thielen said Willow Re intends to pay about 95 cents on the dollar for its scheduled February payment. The bonds, due to make an interest payment today, have a five-day grace period until a default is declared, the S&P statement said.
The defaulted bond accounts for less than 5 percent of Allstate’s overall reinsurance program, Thielen said.
S&P grades the other three cat bonds that used Lehman as a swap counterparty at either CC or CCC, its third and fifth- lowest ratings.
This default raised two questions, one mine and one Russell’s:
- What form did the guarantee take within the overall financial instrument?
- What were the securities underlying the Willow Re cat bonds that caused the bonds to drop so much causing the default?
The answer to those questions, in the case of Willow Re, is a bit unnerving.
First let’s back up and refresh everyone on exactly what a Cat bond is and why it should be important to every policyholder in this country. Luckily for our readers we have an entire page devoted to the subject that features the congressional testimony of John Seo, Co-founder of Fermat Capital Management, no doubt named for the famous mathemetician. There is also the layman’s definition at Wiki which I thought very good:
Catastrophe bonds (also known as cat bonds) are risk-linked securities that transfer a specified set of risks from a sponsor to investors. They are often structured as floating rate corporate bonds whose principal is forgiven if specified trigger conditions are met. They are typically used by insurers as an alternative to traditional catastrophe reinsurance.
For example, if an insurer has built up a portfolio of risks by insuring properties in Florida, then it might wish to pass some of this risk on so that it can remain solvent after a large hurricane. It could simply purchase traditional catastrophe reinsurance, which would pass the risk on to reinsurers. Or it could sponsor a cat bond, which would pass the risk on to investors. In consultation with an investment bank, it would create a special purpose entity that would issue the cat bond. Investors would buy the bond, which might pay them a coupon of LIBOR plus a spread, generally (but not always) between 3 and 20%. If no hurricane hit Florida, then the investors would make a healthy return on their investment. But if a hurricane were to hit Florida and trigger the cat bond, then the principal initially paid by the investors would be forgiven, and instead used by the sponsor to pay its claims to policyholders.
I’m not familiar with the Lehman structure for the swap. In early transactions, the bond principal invested by the cat bond buyers was used to purchase government securities, often treasuries, and these were placed in trust for the benefit of the reinsured (and ultimately the bond purchasers if there were no losses). As the cat bond buyers required much higher returns that those provided by treasuries, a swap transaction would be entered into whereby the cat bond structure would exchange the investment return on the treasuries for a higher return, say LIBOR plus 4%. Obviously, someone would have to pay for the cost of that differential and in most cases that cost was wrapped into the “premium” paid by the reinsured for the coverage. The swap party not only provided this higher investment return to the cat bond purchasers, but it also guaranteed that the principal amount of those notes would be at par in the event the bonds were called at a time the principal value might have been reduced by market fluctuation.
The structure Mr Sposato describes appears very reasonable. There is little risk of losing the principal of the bond because the quality of the assets backing it were so good and except in the unlikely event a covered peril triggers the bonds principal forgiveness provisions the investor could sleep easy at night. Plus the related embedded derivative helps insure smooth cash flow and value should there be a triggering event requiring the assets to be monetized.
But what would happen if a misguided but enterprising young Wall Street MBA figured a way the insurer could reduce the payment on “the premium” by backing the bonds with higher yielding securities? Say a high yield corporate bond, otherwise known in the 1980’s as junk bonds. “Nope”, Russell said to me as he gave me a PHD level explanation of the intracacies of the bond world. So what do you use? He said it as I was thinking it, “A CDO” or collateralized debt obligation aka mortgage backed securities aka subprime aka toxic paper.
But that would be too risky and the interest rate swap that was traditionally embedded in the transaction would not cut the risk of default of the underlying assets backing the cat bond. What was needed was another derivative, one that not only guaranteed the principal but the stream of interest the Cat bonds paid too. The marketplace had such a financial instrument, the total return swap. And with this total return swap embedded in the transaction promoters were able to bill these very high yielding new fangled cat bonds as having a guaranteed return.
Change the derivative from a Total Return Swap to a Credit Default Swap, subtract the twists of nature from the bond and hear the word subprime screaming in the Hurricane force winds. Why did Willow Re default on it’s Cat Bonds? Check this out from the google cache of a November 2008 Insurance Risk and Capital story on Willow Re:
The big turning point was the bankruptcy of Lehman Brothers on 15 September, which led to the downgrade of all four catastrophe bonds that used Lehman Brothers Special Financing as the total return swap (TRS) counterparty.
The role of swap counterparty is an important structural feature, as this entity is responsible for making scheduled coupon and interest payments on bonds and ultimately paying the principal at maturity.
On 30 September Standard & Poor’s (S&P) cut ratings on tranches of Allstate’s Willow Re, Catlin’s Newton Re, Aspen Re’s Ajax Re and Munich Re’s Carillon transactions. Ratings on Ajax Re’s $100 million and Carillon’s $51 million Series-1 Class A1 notes fell to CC on CreditWatch negative from BB, while Newton Re’s $150 million 2008-1 Class A and Willow Re’s $250 million 2007-1 Class B bonds dropped to CCC on CreditWatch developing, from BB and BB+ respectively.
Sponsors are understood to be exploring various courses of action to try to find a workable solution for all parties involved and mitigate any reputational risk. Allstate’s assistant treasurer Karen Duffy outlined three options open to the firm on an investor conference call last month.
One option would be to find a new TRS counterparty. Another would be not to replace the TRS and have Willow Re manage the investments internally or hire an investment advisor. The final option would be to accelerate the maturity of the notes in absence of any default event. Allstate has solicited quotes from eight TRS providers, adds Duffy, but these firms are reluctant to accept the current assets or commit to providing the full principal amount at maturity, given the current uncertain market value of the portfolio.
Mark Gibson of BNP Paribas: “It has been a shock to the market that a transaction structure which was supposed to be all about diversification…appears to have failed in these cases.”
The assets comprise a diversified pool of mortgage-backed securities except for two assets, Long Beach Mortgage Loan Trust series 2006-7 and series 2006-8, which were recently downgraded. Under the guidelines, Lehman should have substituted these securities with assets of equal or greater market value, but failed to do so. Also, pursuant to the swap agreement, when Lehman was downgraded 15 September, the bank was required to post additional collateral to the amount of $78.6 million but did not.
Given the current state of financial markets, Duffy notes that an active market in mortgage-backed securities (MBS) does not exist and therefore the current market value of the portfolio is unclear. She adds this fact is also complicating Willow Re’s efforts to dispose of the two non-conforming investments and substitute them with conforming investments.
Duffy says Willow Re is unable to predict or give any reassurances on whether sufficient cash will be available to meet interest payments on notes after October 31 or the obligation to pay principal at maturity. The next scheduled interest payment date for the Ajax Re, Newton and Carillon transactions is December 15. Once either issuer misses a scheduled payment S&P says it would lower the ratings to D and force the bonds to be unwound.
So the next question in my mind is simple. Are subprime mortgages backing more Cat bonds than the limited number mentioned in the story? It is important to remember what made Willow special was the loss of it’s swap counterparty when Lehman took BK. But if you scroll the list of Cat bond issues here and read the general descriptions of the transactions there appears to be a good many “B” rated securities, the same investment grade as those CDO’s held by Willow Re that backed their Cat bonds.
Are these CDO’s backing the cat bonds sporting investment grade ratings due to financial guarantees of concerns like AIG, Morgan Stanley or Goldman Sachs? If so is Uncle Sam funding these guarantees with TARP? Something tells me if we could peek under the hood the answer would be HELL YEAH! How am I so sure? Easy, stories like the one Sam Friedman’s boys at the National Underwriter posted today:
Swiss Re Group said today that to preserve its “AA” rating it is beefing up its capital with an infusion of three billion Swiss francs—$2.6 billion at current exchange rates—from billionaire investor Warren Buffett, after sustaining an estimated 2008 loss of one billion Swiss franc, translating into $860 million………..
In reaction, Standard & Poor’s said it was putting the firm’s ratings on CreditWatch with negative implications. It said the magnitude of additional write-downs, much of it on credit default swaps, by the company “and the resulting need to raise capital are outside of our expectations.”……..
Swiss Re said it is “de-risking” its portfolio. Mr. Aigrain noted the company “has taken steps to protect our capital strength to ensure the continued trust of our clients, and we continue to manage our business in a disciplined, conservative manner. Warren Buffett’s agreement to invest in Swiss Re is a testament to the strength of our franchise.”
The preliminary one billion Swiss franc loss estimate was attributed to negative investment results, primarily due to mark-to-market losses seen in income and impairments on its investment portfolio. The company said its losses were partly counterbalanced by a hedging program.
Swiss Re said a decline in shareholders’ equity in the fourth quarter are primarily due to unrealized losses on investments and the impact of exchange rate fluctuations.
The million dollar question on my mind is should we take Swiss Re at their word as to the causes of it’s losses? I’m not so sure and this insurance journal story is the reason:
The catastrophe risk field was created after Hurricane Andrew wreaked havoc on southern Florida’s coastline in 1992, generatingclaims that dealt a significant blow to the insurance industry. Despite the risk, it has generally produced secure bets for traders, according to Isom.
“Money managers can choose the risk area that meets their appetite. By and large, they haven’t had to pay out too often,” Isom, who is also a senior vice president at Willis Re, a reinsurance broker, said in reference to cat bonds.
The potential calamities covered by bonds have typically been limited to a few, including Atlantic hurricanes in the U.S., windstorms in Europe and earthquakes in Japan. But the field has grown as insurers look to offload their exposure to disasters such as terrorist attacks or a bird flu pandemic.
Swiss Re, the world’s largest reinsurance company, has become an industry leader in issuing cat bonds for such “extreme mortality” events.
“In the last couple of years we have seen new perils being securitized and that has been a step in the right direction for potential investors,” Araya said.
I’ll end this post with a frightening thought. With the collapse of Willow Re, Allstate’s reinsurance program took a hit and in doing so it’s capital to support it’s policies in the newly created void has been diminished. Who will make good on these guarantees when these bonds mature and the toxic paper backing the bonds pays 50 cents on the dollar? Companies like AIG that exist outside of bankruptcy only because Uncle Sam is bankrolling them? I’m afraid the answer is yes.
In the end the moneychangers took our money for wind policies, made up excuse after excuse why they would not pay after katrina and now they stick us with the bill for their failed investment strategies. As Stan from South Park would say, “Dude, this is pretty fucked up right here.”