Default swaps could imperil insurers

A new derivative that Wall Street investment houses are peddling to insurance companies – promising fat profits – instead may be exposing insurers to huge financial risks.

Known in the trade as credit default swaps, the derivative contracts serve essentially as insurance against default on corporate loans and bonds.

Banks, thrifts and other financial institutions pay a big premium for default-protection coverage, but default-swap sellers are facing growing liquidity risks because of the declining economy and rising corporate defaults.

“If you have guaranteed a bank loan, you may have to come to the table with hundreds of millions of dollars,” says Robert Riegel, a managing director at Moody’s Investors Service in New York.

“If a life insurance company started doing this, they would need a bank line of credit or some other source of liquidity. That’s a big difference from just owning the bonds and not getting fully paid off,” he adds.

Seductive fees

A February 1997 study by the Federal Reserve Board concluded that the use of credit-default swaps could cause other markets for loan-risk sharing to break down, increasing the risk of bank insolvency.

And the unforeseen risks are real as well.

Last summer, sellers of default protection on loans held by insurer Conseco Inc. suffered big losses when the troubled Indiana company was forced to restructure its bank debt.

The restructuring triggered a so-called credit event under the swap contracts.

Because of the way the contracts were structured, lenders such as Bank of America Corp., Chase Manhattan Corp. and others that had bought default swap protection stepped in and made a killing.

They were reportedly able to buy Conseco bonds in the cash market for as low as 70 cents on the dollar and deliver them to default-swap sellers.

The sellers were forced to pay them face value, even though the banks suffered no real losses and ended up with better loan terms.

Although the sellers of the default-swap protection were not identified, industry observers believe one or more of Wall Street’s major investment banks were involved.

In any event, some of New York’s biggest derivatives dealers – Deutsche Bank, J.P. Morgan Chase Co. and Merrill Lynch & Co. Inc. – have reportedly removed restructuring clauses from their credit-default-swap contracts as a result of the Conseco episode.

Trading activity has been hampered amid debate over the issue, but the International Swaps and Derivatives Association expects to announce a resolution during its general meeting in Washington this week, says Blythe Masters, a managing director of J.P. Morgan Chase & Co. and co-head of the group’s credit derivative market practices committee.

Siren song

Details are scarce on the size of the default swap market. The ISDA, a New York industry trade group, hasn’t started tracking it yet.

In July, the British Bankers’ Association in London predicted the global credit-derivatives market could reach $1.58 trillion in notional value by 2002, a ninefold increase over 1997.

Insurance companies are expected to make up 26% of the sellers of default protection by next year, up from just 10% in 1998, according to a survey by the association.

Banks and other financial institutions, meanwhile, have shown increasing interest in buying default protection over the last year with the slowdown in the U.S. economy.

With investment returns from the stock market dropping and variable-annuity and life insurance sales slowing, the siren song of a fat new revenue stream may be particularly enticing to insurers and others.

For example, if an insurer owns IBM bonds, it could sell default protection on IBM and earn the spread twice on that bond.

To compensate for reduced liquidity and other issues, credit default-swap premiums are usually higher than the return on the underlying cash bond or loan.

Default protection premiums typically range anywhere from 0.10% to 1.0% over comparable-maturity cash bonds, according to market participants.

Marketing blitz

While most states for years have allowed them to purchase default protection as a hedge on their existing assets and liabilities, insurers were banned from selling default protection through swaps.

Then, late last year, the National Association of Insurance Commissioners adopted uniform reporting and disclosure rules.

Anticipation of that regulatory change prompted a marketing blitz by money-center banks and investment houses 3/4 which act as both dealers and users of credit-default swaps 3/4 to convince rating agencies and life insurance companies of the benefits.

Investment banks are targeting life insurers because of their huge corporate bond holdings 3/4 an estimated $1.1 trillion in company general accounts last year, according to the American Council of Life Insurers.

The bonds can be used to back sales of default protection.

“Merrill and others have gone out on a missionary sell basis to a lot of places where they know there are a lot of bond holdings and said, `Here is a little bit of icing you can spray on the cake,”‘ says a senior money management executive who attended a recent Merrill default swap conference.

About 25 states now allow insurers to sell default protection, says Michael Goldman, a lawyer who heads the insurance and financial services practice at Sidley & Austin in Chicago.

Mr. Goldman helped write new regulations that will allow Illinois insurers to sell default protection this month.

Getting in

The expanded authority from state regulators has prompted scores of insurers to begin looking into getting into the business.

New York regulators, for example, have granted authority to some 150 insurers to sell default coverage after the state Legislature passed a law last year that allowed insurers to use derivatives more widely.

Spokesmen for MetLife Inc., New York Life Insurance Co. and the Mony Group Inc. all say their companies are studying the market, but have yet to decide whether to enter.

So far, John Hancock Financial Services Inc. and Pacific Life Insurance Co. are the only life insurers actively selling default protection.

Hancock sold its first default swap last year, says Fran Felcon, a senior managing director in the Boston insurer’s bond and corporate finance group.

Pacific Life of Newport Beach, Calif., bypassed state regulatory oversight by forming a subsidiary in January 1999, capitalized with $386 million worth of affiliate Pimco Advisors’ stock and a $100 million liquidity agreement with the parent.

The subsidiary, Pacific Financial Products Inc., has sold about $3 billion in default protection.

Several reinsurers, including ACE Ltd. of Hamilton, Bermuda, are active sellers of default protection.

But many insurers are waiting for the evolving market to mature.

When bankers from one big New York investment bank pitched fixed-income managers at Western-Southern Life Insurance Cos. in the fall, the executives said they were more inclined to buy default protection then to sell it.