You’d be forgiven for thinking that the spectre of the total return swap counterparty vanished from the catastrophe bond and insurance-linked securities market a number of years ago after Lehman Brothers collapse caused the default of a number of cat bonds they were a swap counterparty to. However there are still deals using a total return swap as part of their collateral arrangements and a development on Friday reminds us how total return swaps made the market more correlated with the broader financial markets.
Nathan Ltd., a $100m extreme mortality ILS bond issued in 2008 by reinsurer Munich Re used a total return swap as part of its collateral arrangements. Unusually, this deal was also a five-year transaction and so the notes are still current, with maturity not due until January 2013. The Nathan Ltd. transaction provides Munich Re with a source of protection for catastrophic mortality risks in the U.S., the U.K., Canada, and Germany on an accumulated basis over the five-year period. The transaction uses a combined mortality index with pre-defined trigger attachment and exhaustion points.
As part of the collateral arrangements for the transaction, the issuer Nathan Ltd. entered into a total return swap agreement with the London branch of Deutsche Bank AG. Deutsche Bank are responsible for converting returns earned from the collateral into the rates payable on the notes, they make payments to Nathan Ltd. to allow the issuer to honour its coupon obligations to investors. As a result the swap counterparty in any transaction adds additional risk to the deal and a greater degree of correlation with the wider financial markets as any inability of a swap counterparty to pay could result in default for the transaction.
So a total return swap counterparty has a bearing on the rating of any ILS or catastrophe bond deal. On the 21st June 2012, rating agency Moody’s downgraded Deutsche Bank AG as part of their action on a number of firms with global capital market operations. This was brought on by the wider economic crisis across the Eurozone and the rest of the world. As a result of this, Moody’s have looked at Nathan Ltd. as a capital market transaction using Deutsche Bank as a swap counterparty, revisited and analysed the swap arrangements and reassessed the rating.
In this case they have decided not to downgrade the rating of the notes issued by Nathan Ltd. Moody’s assessed the probability and impact of a default of Deutsche Bank AG, swap counterparty on the ability of Nathan Ltd. to meet its obligations under the transaction and continue to make its schedule coupon payments to investors. At this time they’ve decided that there was no need for a downgrade of Nathan Ltd.’s notes, what with this being a broader downgrade of major financial firms the actual risk to Nathan Ltd. investors has not risen noticeably.
It’s interesting to be reminded why total return swaps became obsolete in the cat bond and ILS market. The market adapted and began to use alternative mechanisms to arrange and manage collateral requirements and the total return swap is slowly dying out. Total return swaps made up approximately 5% of the market in some recent numbers we published here, this should decline quite quickly. This story of Nathan Ltd. serves as a reminder that impacts to or failure of a swap counterparty add additional risk to an ILS or cat bond transaction and can increase the degree of correlation with the broader financial markets.