SIFMA Conference: Collateral Remains King
Investors who specialize in insurance-linked securities see little chance for growth in the near future but are hopeful market forces will eventually turn.
A key obstacle remains restructuring collateral programs in catastrophe bonds and whether buyers and sellers can come up with a compromise structure.
“Cat bond investors are all about what’s rational,” said John Seo, managing principal of Fermat Capital Management in Stamford, Conn. “At some point we — as a market — will say ‘we don’t want to deal with the issues right now, so we’ll do what is necessary.’”
A consensus is building around three possible longer-term structures for cat bond collateral programs, according to participants at the Securities Industry and Financial Markets Association’s Insurance & Risk-Linked Securities conference in New York last week.
The first option is a move to U.S. Treasury “floaters” to replace traditional collateral programs that were structured as total return swaps indexed to the London Interbank Offered Rate (LIBOR).
The argument is that Treasury floaters would not suffer the same wild swings that were seen in the LIBOR market following the credit collapse of 2008.
Another is the use of so-called “tri-party repos,” in which short-term securities are borrowed like traditional repurchase agreements. In a tri-party repo, a custodian bank facilitates the transaction, adding an extra layer of safety.
The final option is to return to total return swaps tied to LIBOR after the market has calmed.
Seo said although the tri-party repo mechanism would scale to work with larger cat bond issues, it could be difficult and expensive to pair it with smaller bonds.
He added that the industry could easily make the switch to Treasuries if investors demanded their safety, but it would come at a price.
“This market never had a problem being Treasuries-based and moved to a LIBOR index because they thought it was a reasonable thing to do,” Seo explained. “But there is a huge implied insurance agreement when you use them and it’s not alway necessary for these structures.”
Some investors would gladly pay that insurance if the bonds’ collateral was truly creditworthy.
“A big part of the due diligence [for cat bonds] has become figuring out the counterparty risk, which you have to dig deeply into the structures [to reveal],” said Marius Mueller, portfolio manager with Munich Reinsurance. “This is not my job. I’m happy to give up the extra yield not to deal with this.”
Figuring how investors, issuers and counterparties would like their collateral structured to make them comfortable in the new credit environment will take time, said Stefano Sola, managing director with Swiss Re Capital Markets.
“The large percentage of [the] investor base would stay with LIBOR, but that was when it was three or five percent,” Sola added. “There may be a shift and that shift may be happening. We are trying to react to it.”
For the near future the bailout of the large investment banks has bought some time for the catastrophe bond market to come up with a solution.
Several of the new catastrophe bond issues over the past few months are using a stop gap measure: paper generated under the Troubled Asset Relief Program that is backed by the Federal Deposit Insurance Corporation (FDIC).
“The FDIC paper is a welcome temporary solution to a temporary problem,” Seo said.
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