Bulge bracket dealers are eyeing an extension of traditional trust preferred securities as the next new asset class to be packaged into collateralized debt obligations, according to sell-side and rating agency officials. They say Merrill Lynch and Bear Stearns are among the dealers working on CDOs of insurance trust preferreds and trying to encroach on what has traditionally been the focus of smaller banks. The initiatives come as CDO issuance slows, causing bulge bracket dealers to turn to other asset classes to pick up the slack. UBS Warburg was also working on a trust preferred CDO of insurance paper, but outsiders say it shelved plans earlier this month. As many as five such CDOs are in the pipeline, according to rating agency officials. CDO officials from Merrill, Bear Stearns and UBS either declined to comment or did not return calls.
To date, these deals have only been done by smaller firms such as Sandler O'Neill & Partners and FTN Financial Markets. But, officials at the smaller players insist they don't fear the competition, saying they are well-suited to fend off the big banks because they have always focused on the middle-market arena and are not fair-weather friends.
Insurance-backed deals are an extension of bank trust preferred pools, which have been used in roughly 10 CDOs totaling $20 billion and are gaining popularity. Given the success of this asset class, which has emerged as one of the few growth areas in the CDO market this year, large banks are now said to be looking at pooling paper from insurance companies. "A lot of banks out there feel like they missed the boat on bank TruPs, so they'd like to get in early on the insurance side," says one observer.
Bankers say CDOs represent an attractive funding market for mid-sized insurance companies, particularly property and casualty providers, that are hungry for cash as liabilities have risen since 9/11. "The size of the [CDO] market for banking paper validated that as an efficient way to raise capital" for insurance companies, says Tom Killian, a partner in the investment banking group at Sandler O'Neill. The bank expects to close on a $385 million CDO of insurance trust preferreds, InCapS Funding I, later this month.
Trust preferreds offer mid-sized insurance companies efficient access to the capital markets, says Sajjad Hussain, a director at Fitch Ratings in Chicago. By pooling together into a CDO, insurance companies can offset transaction costs that can run as high as 6%, Killian says, adding a typical deal will include debt from up to 40 separate entities. Hussain stresses while the pipeline for insurance-backed CDOs may be full, the deals are labor-intensive are unlikely to become as popular as bank deals.
Though these deals are similar to bank trust preferreds, investors should recognize that CDOs of insurance paper are inherently riskier, points out Jerry Gluck, managing director of CDOs at Moody's Investors Service. He declines to comment on specific deals but notes that even mid-sized insurance companies tend to be highly correlated, whereas banks offer diverse, localized exposure. "It's not as if car thefts only go up in, say, the Southwest. It's more likely to be a national trend," he explains. A banker adds that since insurance companies are likely to be either P&C or life providers, they do not have as diversified interests as banks do.