Collateral held within catastrophe bond trust accounts will need to change dramatically if the industry hopes to revive the currently dormant market. New structures, higher rated paper and more transparency are just some demands being made by market participants.
With many caught off guard by the amount of credit exposure in their cat bond portfolios after the Lehman Brothers collapse, issuers and investment banks will need to focus their efforts by allaying the fears of buyers.
“Investors want to see a solution,” says Cameron Heath, a credit analyst for Standard & Poor’s in London. “The market has been bitten, and now they want to know what’s in the underlying the collateral structure.”
Typically funds invested in a catastrophe bond are held in trust. That collateral is then invested by a counterparty as part of a total return swap, usually in return for LIBOR plus interest and the promise to pay 100 percent of the value at maturity.
In September when Lehman Brothers filed for bankruptcy several of the cat bonds where it acted as the counterparty were called into question. After a review it was discovered that some of the collateral was invested in securities that became impaired and the bonds lost significant value, according to published reports.
That caused many in the cat bond market beyond Lehman to review their own collateral programs and the results were not pretty, says Karl Bronmann, Ph.D., managing partner of Solidium Partners in Zurich.
Bronmann explained that several investors discovered that the collateral programsi within their cat bonds held illiquid securities that were of questionable credit quality. “The demise of Lehman focused everyone on the collateral quality of their book,” he says. “And surprise, surprise, not all found what they expected.”
In some cases collateral was invested in mortgage-backed securities that had lost significant value while other discovered the accounts were invested in TripleX securitizations that were not only correlated to the insurance industry but were highly illiquid.
“The small print [in collateral agreements] always said the investments should be U.S. government bonds, short-term paper of higher grade or other Triple A or Double A rated securities,” Bronmann says. “That’s not what many found.”
For the catastrophe bond market to regain it’s footing investors worries need to be addressed. Buyers will be looking for greater transparency regarding what’s in the collateral portfolio and updates on any changes.
“There will be better quality paper and there will be monthly or weekly notifications of what is included and very stringent topping up provisions based on weekly evaluations,” says Bronmann.
Greater transparency around what’s held in collateral programs is the easiest fix because any structural alternative to the total return swap method will be difficult to construct. Industry participants say that some alternative methods are being debated –such as state-guaranteed corporate bonds or bank deposits — but have their own issue sand would be difficult to implement.
In any case, simply replacing one security in the portfolio for another does not fix the problem in an environment where credit it declining across the spectrum.
“When looking at an insurance linked securities what the underlying investment is slightly irrelevant,” says S&P’s Heath. “We look at the strength of the counterparty. Typically, that is significantly higher risk than the a loss from a catastrophic event.”
Once the collateral issue is addressed, cat-bond investors will be able to focus on reentering the market based on fundamentals.
“The biggest hindrance for catastrophe bonds is the general state of the markets,” says Bronmann. “There is a feeling that there is a lot of money on the side waiting to be invested, some will prop up the market with two or three structures and see what comes back.”
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