December 16, 2005

It's Crystal Clear . . .STEER CLEAR!

. . . of Crystal Credit Ltd., Swiss Re's Euro 252 Million Bond issue . . .

Summary: The real story here will be if Crystal Credit closes per its current terms and conditions. Will capital market investors buy under-priced credit risk, originated by P&C (re)insurers, except at a big discount? Will Swiss Re shareholders happily accept a "haircut" as the price of a "marquee" for management? Fortunately, potential investors don't have to labor over all this. Crystal Credit is nothing new. If it doesn't stack up to comparable deals already in the market--Steer Clear!

Last Thursday, December 8, 2005, the Wall Street Journal reported in an article titled Swiss Re Steps up Risk Shift that Swiss Re, the world's largest reinsurer, is now in the market with a Euro 252 million bond issue, to securitize its trade credit insurance policies.

Despite the announcement, Swiss Re is being cagey. The reinsurer "has been assessing investor interest in the issue…[and] declined to comment on its plans, but investors [who have been approached, expect the issue]…to be closed by the end of the year". And no mention, whatsoever, about pricing.

Anyway, you have to ask why they seek publicity about a private placement [?] that is still under negotiation [??]. Perhaps, new management is setting the stage for a "marquee deal" announcement [???].

Some observers characterize Crystal Credit as an innovative, insurance-linked securitization (ILS), that expands and breaks new ground in the tiny--mere $6.5 Billion outstandings after nearly 10 years--ILS market. However, the issue has absolutely nothing to do with "conventional" Property & Casualty insurance risks (e.g. earthquake, hurricane, auto) that have been ILS'ed, before.

Pure and simple, Crystal Credit resembles a Collateralized Debt Obligation (CDO) and is but a small speck in the multi-Trillion dollar CDO market, at that. Trade credit insurance policies are "credit risk", notwithstanding that documentation is in insurance policy form. The pool of Swiss Re trade credit policies underlying Crystal Credit will be funded by equity, mezzanine and senior tranches, just like a CDO. When (if) the deal happens, it's NOT a "marquee", just a reinvention of the wheel. Hold the fireworks!

Keep these distinctions--ILS vs CDO, "P&C insurance" vs "capital markets"--in mind as you read through the Offering Memorandum, if you can get a copy. Rating agency capital charges differ for the same credit risk , depending upon its form (e.g. trade credit policy vs loan or guarantee). It so happens that agency capital charges for credit risk documented in P&C insurance policy form are materially lower than capital market forms, nothwithstanding that the underlying obligor is the same. The lower the required capital, the lower the price (i.e. "premium", on the underlying trade credit policies). When there are 2 prices for the same risk, 1 party has 1 big problem. That is why P&C insurers (their "product" guys, NOT their asset managers) are at the bottom of the credit food chain.

That is also why banks and finance companies lay-off their lending portfolios to P&C Insurers, "buying protection", in insurance policy form, to achieve capital relief. It generally makes no sense to move credit risk the other way around, from the P&C industry (lower capital charge) to the capital markets (higher capital charge)--unless they sell the underlying assets at a big discount.

How do Swiss Re shareholders feel about this? Is a "marquee" for management worth the price of the haircut?

It sure will be interesting to see how Moody's handled this. When they rated tranches of Crystal Credit--B, Ba2 and Baa2--were they using their P&C or their capital markets capital charges? They say "an A is an A is an A". However, when "an A is an A . . AND a C", it raises serious questions about Moody's credit rating policies.

Commercially, investors who buy credit risk portfolios originated in P&C (re)insurers' product lines do so at grave risk. P&C companies compete against banks, who understand credit and price it to the capital markets. In contrast, P&C insurers lack "credit culture" and habitually under-price credit risk, when compared to the capital markets. This is one of the reasons why they blow-up and destroy shareholder value, perpetuating the "insurance cycle".

Before you rely on agency ratings to invest in P&C insurance policy-originated credit risk, do the following reality checks:

Check out McKinsey's excellent work, "The Journey", which evidences a 6.5% historical P&C Industry ROE, compared to mid-teens ROE for other financial service sectors going back some 20 years (sorry, no link).

See also Swiss Re's share price [under]performance, halving in value over the last five years.

Finally, recall another Swiss Re "marquee deal" in 2000. Back then, they used insurance form to structure what they said was "a first of its kind" wrap of a natural gas production payment credit facility. (See the October 9. 2000 edition of National underwriter for an article titled Swiss Re New Markets Targets Energy Sector.)

So far, so good--except that money-center bank energy teams have routinely done production payment loans since the mid 1970's.....even so, it took Swiss Re a "good 9 months" to close....and it was for Enron! Ultimately, they lost over $60 million. (See the PR Newswire for 12/19/2001 titled Swiss Re Reports Loss Estimate Resulting from Enron Bankruptcy).

Something tells me Crystal Credit could be in the market a long time, as well. However, if Swiss Re's new management needs a "marquee" to build market presence, they will close "something" at some point ("finite"?). It would be nice to compare the deal(s) terms, before and after, though.

Fortunately, investors don't have to wrestle with issuer motivations or Crystal Credit's ratings in pricing the deal. They can just price to a comparable credit risk, say a middle market bank Collateralized Loan Obligation [CLO], and see if it stacks up. If it doesn't, STEER CLEAR!

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