The rise of credit derivatives, especially portfolio trades, is providing attractive new opportunities for investors.
Taking credit risk in unfunded form can be highly advantageous, especially for insurance companies, which are used to taking on risk in the form of a liability, rather than an asset.
Increasingly, the synthetic market is channelling credit risk from banks to the insurance sector.
Portfolio swaps recreate the economics of risk tranching, which have served cash securitisation so well, in the unfunded credit derivatives market.
But just as bond market securitisation requires holders of triple-A risk, mezzanine risk and equity exposure to work its magic, so portfolio swaps need a developed market for credit swaps which reaches down the full length of the credit spectrum.
Historically, this breadth of demand has not been available in the credit derivatives market. But in the past year or so, growing appetite for riskier synthetic exposures has made it possible for large numbers of banks to buy portfolio credit swap protection for the first time. So where is this new appetite for credit coming from?
To some extent, the answer is, the same place it has always come from - other banks.
Banks have long sold protection on single name credit swaps to diversify their exposure. By writing credit swaps on the more junior tranches of portfolio swaps, they can gain access to particular types of credit in leveraged form.
For example, some of the biggest buyers of US CLOs have been the New York branches of foreign banks, keen to leaven their portfolios with a taste of the US loan market. Deutsche Bank's CLOs, which provide almost unique access to the small and medium sized businesses that are Germany's industrial core, have proved popular for similar reasons.
Not all the risk transferred in portfolio swaps is bought in unfunded form. Credit derivative bankers are adept at repackaging exposures into securities that can give even risk averse fixed income investors some exposure to highly rated credit.
But some banks are buying credit in unfunded form out of necessity, rather than to improve portfolio diversity. Banks with high funding costs, such as those in Europe's peripheral countries, are important sellers of protection on middle and low rated credits.
The unfunded returns provided by credit swaps can help them to cover their funding costs.
As lower rated banks move into the credit derivative market as protection sellers, the institutions hedging risk are becoming more vigilant about counterparty credit quality. Weaker counterparties are either turned down, or have to pay up on the premium to compensate hedgers for their counterparty risk.
Insurers look for new risks
However, credit structurers agree that insurance companies are the fastest growing source of demand for synthetic credit.
"Insurance companies have become increasingly important players in the portfolio swaps market," says Stephen Stonberg, managing director in Deutsche's global credit derivatives business in London. "Credit derivatives provide an ideal way for them to take unfunded exposure to credit risk."
According to the survey compiled by the British Bankers' Association, banks and securities houses accounted for 63% of protection sellers in 1999, down from 76% in 1997. The big increase in appetite, according to this source, is insurance companies. They represented just 10% of the market in 1997, but 23% in 1999.
Credit swaps are insurance policies in all but form, so they fit naturally into insurance companies' underwriting books. And credit can provide insurance companies with a better return than some of the other risks they underwrite, such as property and casualty.
"One message we hear from insurance company investors is that the capital markets are more generous in compensating for units of credit risk than the property and casualty markets are in compensating for units of P&C risks," says Frank Iacono, vice-president in Chase's structured credit products group in New York.
Other factors which bring insurers to the credit risk market include the lack of correlation between credit risk and their traditional risks, which allows them to diversify their exposure, and the fact that credit risk can be analysed under a traditional actuarial approach using historical data.
A happy accident is that prices have fallen to historical lows in other insurance sectors. "A lot of unfunded CDO tranches are being placed with insurance companies," says Ebo Coleman, senior structured finance analyst at Moody's in London. "There is an excess of capital, especially in the reinsurance market, so there is growing appetite for these credit structures."
The great advantage insurance companies have as holders of credit risk is that they are generally free to allocate capital to an exposure according to their own assessment of its true economic risk, and in many cases this can mean a much lower allocation than the Basle minimum for banks.
Credit insurance is not a new concept. "Insurance companies have a long history of involvement in credit transfer - credit guarantee and export credit insurance are two examples of this," says Jeremy Vice, head of the portfolio credit structuring group at Dresdner Kleinwort Benson in London. "But because of the increased demand for non-funded credit protection, which standardised documentation has helped to foster, the credit derivative market has allowed insurance companies to participate in the credit business in a much more meaningful way than in the past."
Still, insurance companies and banks come to the credit derivatives market from quite different angles. "Insurance companies tend to be very expert credit investors," says Mark Moffat, director in the global asset securitisation group at ABN Amro in London. "For many of them, ratings are less important than they are for many other bond investors. They tend to do their own analysis of the risks."
Monolines and multilines
Insurance sellers of credit protection fall into two broad categories.
For the monoline bond insurers such as Ambac, FSA and MBIA, entering this new market was like coming home. Alongside guaranteeing municipal bonds, their core business is insuring securitisations, so they are highly adept at both underwriting structured credit risk, and managing it on their books.
Their triple-A ratings gave them the key to the door, since OECD banks taking on super-senior swaps wanted to pass the risk on to counterparties of unimpeachable credit quality.
The monoline insurers and the companies that reinsure them have absorbed tens of billions of super-senior swaps since 1998. However, these companies' need to maintain their triple-A ratings by capitalising themselves conservatively can make them less competitive as holders of lower tranches of risk.
To put it another way, if an institution uses the services of a monoline, it has to pay for a triple-A rating, and there may be no need to do this.
The second category of insurers is mainstream companies. Many of these have embraced the market only recently, but others are experienced and very enthusiastic. Highly rated firms such as Pacific Life have set up special subsidiaries to gather portfolios of very highly rated credit liabilities, almost on a zero loss underwriting basis.
"Portfolio swaps usually consist of an equity tranche, one or two mezzanine tranches and a senior tranche," says Stonberg at Deutsche. "Insurance companies usually prefer to take the most senior piece. However, as they become more familiar with the market, some are starting to move down the credit curve."
There is a recent trend for insurance companies in areas such as surety and catastrophe insurance to move into the credit derivatives market.
Many of these companies have lower ratings than the monolines and therefore have little interest in the tiny spreads available on super-senior swaps. They are usually looking for higher returns than those on offer in their traditional insurance markets and are, as a result, willing to sell protection on lower rated exposures.
"We are now seeing insurers going down the capital structure," says Iacono at Chase. "Maybe a year or 18 months ago they would have been interested primarily in super-triple-A risk. But that business has become so competitive that some find it unappealing. For a very small premium they are writing a very large deep-out-of-the-money put option. Some insurers see a better risk/reward trade off lower in the capital structure."
This development has helped to create a liquid market for the first time in riskier credit swaps, making it possible to transfer whole portfolios in unfunded form.
The lack of willing sellers of high yield credit protection has been a perennial weakness of the credit derivatives market. By and large, this continues to be the case for single names. There is a limited market for high yield credit swaps in the US but in Europe volumes are practically non-existent. Emerging market sovereigns are the only single name high yield assets in which there has been any sort of two way credit swaps market.
This fear of writing protection on high yield assets is mainly a reflection of how easy it is to short a credit using a credit swap. Sellers are unwilling to put themselves on the other side of that trade, particularly in an environment of generally widening credit spreads.
The mezzanine and junior tranches of portfolio swaps, however, do not suffer from this problem. A protection seller can often take reassurance from the fact that the originator of the assets retains some equity interest in the portfolio.
In some cases insurance companies have been willing to take exposure to even the first loss piece of a portfolio. The recent Castle Harbor transaction, in which Centre Re wrote a policy on the $50m first loss tranche of a portfolio of Bank of America loans, is one example. However, deals of this kind require a close relationship of trust between the two parties.
Insurance companies worry about being landed with the risks that no one else wants. As a result, they usually prefer the originator of a portfolio of loans to have a strong incentive to keep the portfolio performing. *