TRS collateral mechanisms falling out of favour

The Total Return Swap (TRS) collateral mechanism has fallen out of favour with investors whoare looking for more conservative ways of limiting risk following the bankruptcy of Lehman Bros, according to Standardand Poor's Ratings Services.

Lehman Brothers, which played a counterparty role in several cat bonds, highlighted the potential weaknesses of TRS collateral solutions after its collapse in September 2008.

Lehman was the TRS counterparty for four cat bonds; Willow, Ajax , Newton's class A 2008-1, and Carillon's class A-1. Since its downgrade in September 2008, Willow defaulted on its interest payment and Ajax defaulted on its principle repayment on May 8 2009. Both Newton and Carillion remain vulnerable to default, according to S&P.

Investors no longer appear to be comfortable relying solely on a single financial institution to address credit and market risk, and have looked for alternative mechanisms for risk protection, the ratings agency said in a report on Friday.

Gary Martucci, director at Standard & Poor's Insurance Ratings, told Reuters that before Lehman collapsed, there was a significant reliance on the TRS counter party to take on all the risk related to the assets in the trust account. "It was not atypical to have a three year bond which was supported by assets that might have had a 20 (or greater) year maturity.

"When there was a dislocation in the credit markets combined with the bankruptcy of the TRS counterparty as happened in Sept.2008, the assets in the trust account did not generate enough cash flow to either make its share of the scheduled interest payment, or fully redeem the cat bonds at maturity" he added.

S&P rated 15 of the 18 natural cat bond transactions that were closed in 2009. Even though TRS now include restrictions on the types of assets that could be purchased, only four cat bondsused a TRS and all of those transactions closed in the first quarter.

Seven bonds invested the note proceeds in either money market funds with 'AAA' ratings, either backed by a government entity or issued by the International Bank of Reconstruction and Development, the report said. 

Four other transaction used repurchase agreements instead of TRS, where the counterparty sells a pool of collateral to the issuer in exchange for a cash payment.

Increasing liquidity and the post-Lehman "retooling of catbond transaction structures" helped to spur new rated issuance of approximately $2.9 million in 2009 in the 15 bonds rated by S&P. The cat bond sector closed the year 19 transactions, which totalled nearly $3.5 billion in issuance.

Martucci said the evolution in collateral structure mechanisms has helped the cat bond sector to grow versus 2008 because they have structured as much of the credit risk and the market risk as possible. "This takes the transaction back to traditional reinsurance risk, which is what the sponsors and investors have signed up for" he said.