LONDON (Reuters) — After turmoil in the wake of the collapse of Lehman Brothers, the market in catastrophe bonds finally appears to be reaching a consensus on how to structure collateral, paving the way for further growth of the sector.
Lehman’s failure in late 2008 threw the market into chaos, prompting a freeze in new issuance that lasted several months, because the ill-fated bank had played a counterparty role in several cat bonds.
Prospective issuers cast around for new collateral solutions that would avoid the kind of credit risk presented by Lehman, and moved toward more conservative solutions such as government-backed collateral and money market funds. But there was little meeting of minds among sponsors and investors about which solutions were best.
In the last few months, however, market approval has coalesced around two solutions: U.S. Treasury money market funds and structures based on London Interbank Offered Rates.
These two arrangements look likely to become standard for most future issues of cat bonds, increasing predictability in the market and making individual bonds easier to compare. That should draw more investor interest, analysts and investors who are currently active in the market say.
“These solutions help mitigate credit exposure to the assets in the collateral account, provide the protection sponsors and investors want, and are equally beneficial from a credit perspective,” said Gary Martucci, director at Standard & Poor’s Insurance Ratings.
“In addition they allow more flexibility from the structuring side. This brings the primary focus of the cat bond back onto the insurance risk - not the credit risk.”
Before Lehman’s bankruptcy, many cat bonds used banks as “total return swap” (TRS) counterparties in the mistaken belief that the banks were completely safe guarantors for the bonds.
The Lehman debacle proved that assumption spectacularly wrong, and the four cat bonds that used Lehman as a TRS counterparty have either defaulted or remain vulnerable, analysts say.
Lehman showed the cat bond sector needed to resolve problems with credit risk, market-to-market risk and liquidity risk, said Rupert Flatscher, head of Munich Re’s (MUVGn.DE) risk trading unit.
So last year, cat bond issuers cast around for structures to replace TRS, in what may be the sector’s greatest burst of innovation since it was launched in the mid-1990s.
S&P noted that only four of the 19 transactions completed in 2009 used TRS, and all four closed in the first quarter.
Among the 19 cat bonds, three main collateral solutions were used: investments in U.S. Treasury money market funds; AAA-rated government-backed assets, involving institutions such as the International Bank for Reconstruction and Development; and tri-party repurchase agreements.
Tri-party repos use a bank’s portfolio of investment-grade corporate bonds to generate returns based on Libor, with reporting to investors on daily pricing. They were first used last July by BNP Paribas in Hannover Re’s Eurus II cat bond.
“The natural cat bond market today is approximately $12 billion in size with 85 percent of outstanding deals explicitly priced against a Libor benchmark,” said Rishi Naik, head of insurance-linked securities trading at BNP Paribas.
He said the tri-party repo solution was attractive partly because it targetted Libor as its underlying hurdle rate. Also, tri-party repos have tended to provide higher returns than solutions based on U.S. Treasury money market funds.
However, some areas of the market regard tri-party repos with caution because of their complexity, which can involve greater credit risk; only three such deals were done last year.
Bill Dubinsky, director in Swiss Re’s RUKN.VX capital markets team, said tri-party repos added no value in an environment where credit risk was equal to the increased yield.
“Investors prefer a simple solution with minimal credit risk,” he said.
And while the government-backed asset model was used last year, investors and sponsors believe it was partly a response to the financial crisis, and may become less popular as the crisis fades.
“These bonds benefited from a regulatory situation where you had government agencies issuing bonds or guaranteeing bonds on behalf of other organizations, but that was always going to be a short-term phenomenon,” said Naik.
This means U.S. Treasury money market funds, used in eight cat bond transactions last year, may be the most common model used in coming years. They offer relatively low returns, but a minimum of risk.
Flatscher said the cat bond market was fortunate in now having a choice of several safe, robust collateral solutions.
“Now the cat bond community can concentrate on the more important aspects of the sector — such as attempting to bring in a wider range of investors to the space in order to bring down the price of cat bonds to a more reasonable level.”