Success and Failure Gaming Insurance Company Capital Requirements
As an attorney and banker, Oussama Nasr created securitization structures for 12 years. Here he describes two structures intended to create securities with high expected returns, but also high ratings and low capital requirements. One succeeded and the other failed spectacularly.
I joined Citibank’s emerging market securitization group in 1989 after four years at a Wall Street law firm and left Citi as a managing director in 1997. We created transaction structures to overcome barriers to the flow of capital from US, European, and Japanese investors to capital-seeking entities in developing countries. These barriers might be legal or regulatory, and often they increased the credit risk investors took to entities domiciled in a foreign country. For example, we designed structures to make sure investors had enforceable claims on assets domiciled in foreign jurisdictions. We also created structures to prevent a foreign jurisdiction’s action, such as a currency devaluation, from interrupting or diminishing the value of cross-border payments. Better yet, we designed structures to avoid these issues altogether.
But this story is about two transactions created for a different purpose. The goal was to create high expected-return investments that were also highly rated. So, this story will begin by discussing credit-rating-agency practices. We wanted high ratings to minimize capital requirements for insurance companies investing in these securities, so I’ll also touch on insurance company capital requirements. Finally, because the second transaction was thwarted by an accounting rule, I’ll talk about that rule.
Rating Agency Practices
The place to begin describing the two securitization structures is to think about the scope of a credit rating from an agency like S&P or Moody’s. Everyone accepts that there are certain things a credit rating does not address. No one thinks, for example, that a credit rating addresses market risk. Market interest rates may increase or decrease and, as a result of just that variation, a fixed-rate debt’s value may decrease or increase. Market value volatility will occur even if a debt’s credit quality has not changed.
Similarly, no one thinks a convertible bond rating addresses whether the embedded option will prove valuable. Maybe a corporation sells its straight debt with a 7% coupon, but convertible debt with only a 1% coupon. Clearly, the value of the call option embedded in the convertible bond is very important to the convertible bond purchaser. They wouldn’t buy such a low-yielding bond if it did not embed the option. But no one has trouble understanding that a rating agency’s convertible bond rating solely addresses the bond’s coupon and principal, and accepts that the rating agency is silent on the embedded option’s value.
A rating’s limitation becomes more striking when we consider certain exotic financial instruments. Rating agencies rate the credit quality of interest-only and principal-only mortgage securities. But the value of these securities varies greatly with mortgage prepayments. If mortgage prepayments increase, interest payments decrease, and interest-only securities fall in value. If mortgage prepayments decrease, the principal-only security holder has to wait longer for cashflow, and principal-only securities fall in value. So, when rating agencies assess “IO” and “PO” securities, they are not opining on how much total cashflow the investor will receive or the timing of cashflows. They are narrowly opining on the credit risk of receiving whatever cashflow the investor is supposed to get after the effect of mortgage prepayments.
Clearly, these examples show that a rating often addresses an amount and timing of cash flows less advantageous than what the investor expects. A corporation’s stock price might perform below expectations and the call option embedded in the convertible bond might expire worthless without the bond being deemed in default. Likewise, mortgage prepayments might vary beyond their expected range and interest-only securities receive less cash flow and principal-only mortgage securities receive delayed cash flow. It is understood that a credit rating’s scope is limited.
Restructuring Brady Bonds
Brady bonds were issued from 1989 through the mid-1990s by a number of Latin American and other developing countries. They were named after US Treasury Secretary Nicholas Brady and created to restructure the distressed debt of these countries. A fairly typical example of a Brady bond would be a 30-year bond with a coupon of, say, 6%. But the payment of principal at maturity was credit-enhanced by the pledge of a 30-year, zero-coupon, US Treasury security. The distressed sovereign was responsible for the bond’s coupon and principal payments. But if the country defaulted on the principal payment, the 30-year US Treasury security ensured the return of principal. Note that if the sovereign made the principal payment, the investor didn’t receive a second principal payment from the US Treasury security. So, the investor was US-government triple-A certain of receiving his principal back at maturity, but his coupon was at risk to the distressed sovereign.
A number of US institutional investors, primarily insurance companies, became interested in emerging market risk and Latin-American sovereign risk in particular. But the problem insurers had was that from a regulatory capital perspective, they were not allowed to point to the Brady bond’s principal guarantee at maturity and claim it as a triple-A investment. Their regulators said the Brady bond needed to be rated triple-A to get triple-A capital treatment. And the rating agencies would only give Brady bonds double-B or lower ratings based on the credit quality of the distressed sovereign.
The difference in life insurance company capital requirement for a triple-A investment compared to a double-B or lower investment is enormous. Back in the 1990s, a triple-A bond would require 0.4% capital. But a double-B to triple-C-rated bond would require 4.6% to 30% capital. The difference in capital treatment has a massive effect on profitability: return on capital varies 75x depending on whether the capital requirement is 0.4% or 30%!
Structurers at one security firm came up with a plan to change the required capital treatment of the Brady bond from up to 30% to only 0.4%. The first step was to buy the 30-year Brady bond. Using small numbers for illustration, the bond paid $3 every six months for 29-and-a-half years and $103 in 30 years. As I have explained, the semi-annual $3 interest payments were at risk to the distressed sovereign and the $100 principal payment in 30 years was guaranteed by a US Treasury security. The security firm’s second step was to buy a series of zero-coupon Treasury bonds: a $0.50 face-amount zero-coupon bond maturing in six months, another maturing in a year … all the way out to a $0.50 face-amount zero-coupon bond maturing in 30 years.
The Brady bond and the series of zero-coupon Treasury bonds were to go into a trust and the trust would issue 30-year certificates. These trust certificates had a 1% coupon, which only takes into account, in my small-number illustration, the $0.50 semi-annual cash flow and the $100 principal cash flow backed by US Treasury securities. The cashflow from the distressed sovereign was not included in the bond’s coupon. Furthermore, non-payment of the semi-annual $3 from the distressed sovereign would not be an event of default under the terms of the trust certificates. The semi-annual $3 or 6% annual yield was extra.
The trust certificate was similar to the convertible bond I mentioned earlier. Recall that the issuer paid 7% interest to issue straight debt and 1% to issue convertible debt. Investors gave up 6% annual interest in exchange for the bond’s embedded call option. The failure of the option to wind up in-the-money was not a default under the terms of the convertible bond. In comparison, the distressed sovereign trust certificate would yield 1% “sure thing US Treasury triple-A” and another 6% if the sovereign came through. Like the convertible bond, it’s a 1% coupon security with a risky component worth an additional 6% in yield. It should be rated triple-A!
Or so the security firm thought. Before they bought the Brady bond and the zero-coupon Treasury bonds, set up the trust, and sold the trust certificates to insurance companies, they had to convince the rating agencies to see things their way. What would they think? Would the agencies accept the convertible bond analogy?
Low and behold, the rating agencies felt that they could issue a triple-A rating on the trust certificates. The only stipulation that one rating agency made was that their rating be expressed in a private letter to trust certificate buyers making clear that the triple-A rating only applied to the trust certificates’ US Treasury-supported cash flows. The agency didn’t want to print the triple-A rating in their rating manual among all their other ratings where this disclaimer could not be printed.
This agency was sensitive to issues that had arisen from their triple-A ratings of IO and PO mortgage securities. Some unscrupulous boiler-room security firms had marketed those securities to retail investors, neglecting to explain how mortgage prepayment rates would affect the securities’ yield. Instead, the salesmen presented expected yields under optimistic prepayment scenarios and pointed to the triple-A rating as proof that this was a safe investment. Although the security firm was selling the distressed sovereign trust certificates to sophisticated institutional investors, this rating agency still wanted to foreclose the possibility of a similar scenario with these securities.
Interestingly, the rating agencies didn’t care whether insurance company regulators appreciated them providing insurance companies with a regulatory capital workaround. As one rating agency analyst said, “We do our job and they do theirs.” This was all happening at a unique time in the relationship between rating agencies and insurance regulators. The National Association of Insurance Commissioners had a special unit called the Security Valuation Office. Insurance companies could ask the SVO to rate an investment, and the SVO’s rating would trump any rating agency’s rating. In practice, the SVO became a much more lenient credit rater than the actual rating agencies. A few years before these trust certificates were rated, Salvatore Curiale, New York’s insurance commissioner, led a successful effort to require insurance companies to use rating agency ratings in their capital calculations if those ratings were lower than SVO ratings. After the financial crisis of 2007-09 and the perceived short-comings of credit rating agencies, insurance regulators have tried to move away from credit rating agency dependence.
The Hedge Fund Insurance Company
We had a hedge fund client I’ll call HF. HF was very successful, very reputable, and had achieved annual returns well into the twenties and sometimes thirties. HF also owned a Bermuda-based insurance company, I’ll call BBIC.
Like any insurance company, BBIC wanted to invest its money in high yielding assets, but ones whose credit ratings were also as high as possible. As we’ve discussed, this is how insurance companies achieve a high return on capital. The managers of HF and BBIC thought it would be great if BBIC could invest in shares of HF. But shares of HF would attract a 15% capital charge. BBIC knew about triple-A rated restructured Brady bond securitizations and asked us if we could do something similar with HF shares. We certainly could.
Again, using small numbers for illustration, we bought a 30-year series of $0.50 zero-coupon Treasury securities due every six months and a $100 zero-coupon Treasury due in 30 years. We put the Treasurys into a trust along with HF shares. In terms of market value at origination, $25 of the trust’s assets were US Treasurys and $75 were HF shares. The trust issued a certificate with similar terms to the distressed sovereign trust structure. The trust certificate was a 30-year 1% coupon instrument. The stated coupon did not include any expected performance from the HF shares. Disappointing or even negative HF share performance was not an event of default under the terms of the trust certificate.
The rating agencies, by now used to the Brady bond structure, put a triple-A on the trust certificate and the insurance regulator, aware or not and happy or not, accepted the rating agency assessment in the insurer’s capital adequacy calculation.
So, everyone is happy. For a while. One day BBIC’s auditors came in and went through the various investments in BBIC’s portfolio. They discovered the trust certificates and said, “We don’t know what these are. Can you give us some documentation that explains where they came from?”
After struggling to understand the trust structure, the accountants realize that the trust certificates paid out 100% of cash flows generated by the trust’s assets. They conclude that the certificates represent an equity interest in the trust and that BBIC owns 100% of the trust’s equity. So now the very famous old rule of accounting kicks in: if you own more than half of any entity, you have to consolidate the assets of that entity on your balance sheet. In effect, the accountants looked through the trust certificate and put the trust’s Treasurys and HF shares on BBIC’s balance sheet. So instead of $100 of triple-A trust certificates attracting a 0.4% capital charge, BBIC had $25 of Treasurys attracting that capital charge and $75 of HF equity attracting a 15% capital charge!
Meanwhile, over at the rating agencies, the guys who rated insurance companies looked at the trust certificates their colleagues in the structured finance group had rated. Just because the structured guys had rated them triple-A didn’t mean the insurance guys were going to accept them as a safe investment. The insurance company raters downgraded BBIC to low double-A from triple-A.
BBIC might have been able to market itself to insurees as a double-A insurer, but the capital charge would have been devastating. One solution would have been to find a partner to buy half the trust certificates. Then neither entity would have to consolidate the trust. But this was impractical and BBIC and HF unwound the transaction. BBIC went back to investing in plain-vanilla, highly rated securities, accepting their lower yield.
Oussama Nasr is a founder and Managing Director of DNA Training & Consulting. Focusing primarily on international financial services, he provides consulting and executive education in the areas of derivatives, capital markets, risk management, and asset/liability management for major banks, securities firms, and institutional investors around the world. He posts an extensive and useful collection of video tutorials at dnatrainingconsulting.com.
Copyright © 2022 Oussama Nasr. All rights reserved. Used here by permission. Short excerpts may be republished if Stories.Finance is credited or linked.
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Copyright © 2022 Oussama Nasr. All rights reserved. Used here with permission. Short excerpts may be republished if Stories.Finance is credited or linked.