By Shanker Merchant, managing director at NewOak Capital
Over the past two years, many companies have completed re-REMIC transactions. A re-REMIC is a securitization of a portfolio of downgraded real estate mortgage investment conduit securities into AAA-rated to unrated classes of securities, often referred to as the re-REMIC securities. The objectives are primarily to rebalance the portfolio credit exposure, derive arbitrage profit, or a combination of both.
Banks and insurance companies, however, have not been able to participate in the re-REMIC trend. Insurance companies, which invest a significant portion of their assets in AAA RMBS and CMBS, have been particularly hard hit by the downgrading of the vast majority of investment-grade RMBS to below-investment grade, because they need to allocate additional risk-based capital to support such downgraded securities on their balance sheet. Minimizing the risk-based capital requirement to support assets on the balance sheet is one of their primary objectives. But insurance companies are unable to embrace re-REMICs because it results in the recognition of an upfront accounting loss, which reduces the capital. Therefore, they continue to explore alternatives to re-REMICs to achieve risk-based capital relief.
Capital Strain
The risk-based capital requirement for a security is measured primarily by its "C1" risk factor, which is a constant number for AAA, AA and A classes but increases significantly and nonlinearly for ratings from BBB to C, as shown in Exhibit A. For example, the risk-based capital requirement for an investment-grade A-rated security increases by more than 1,000% if the security is downgraded to a non-investment grade BB-rating. The downgraded securities have been the source of a significant risk-based capital strain for the insurance companies, as illustrated in Exhibit B.
Relief from the risk-based capital strain can be accomplished through a re-REMIC structure if one can avoid the recognition of an accounting loss; a modification of the risk assessment process for the securities; a special approval by the domiciliary regulator to allow risk-based capital reduction depending on the facts and circumstances of the company and its downgraded securities, or a combination thereof.
Re-REMIC Background
In a re-REMIC, the company transfers its portfolio of generally below-investment grade RMBS to its bankruptcy-remote trust, which issues AAA to unrated securities. The company sells some of these securities and retains others, depending upon its accounting, economic and other objectives.
The benefit to a company of a re-REMIC transaction is two-fold: (a) it turns a non-investment grade securities portfolio of into a portfolio comprising investment-grade and non-investment grade securities; and (b) the aggregate market value of the new portfolio is higher than the aggregate value of the downgrades securities in the portfolio.
The drawback of the transaction is, however, that it results in an accounting loss if the aggregate carrying value of the securities portfolio on a company's books is higher than the aggregate market value of the new securities.
Re-REMICing for Insurance Companies
If an insurance company attempts to seek risk-based capital relief through a re-REMIC, it would go through the same process of transferring its exposure to a downgraded RMBS portfolio to a trust and then taking back 100% of the exposures to the new securities issued by the trust. In doing so, the company recharacterizes its new securities' exposures on its Schedule D filing and derives capital relief in an amount by which the risk-based capital allocation for the downgraded securities exceeds that of the new securities, provided that the re-REMIC has no adverse GAAP or statutory accounting consequences.
While there is essentially no change in income recognized from a GAAP perspective because the company takes back all the risk, albeit in a different form, the story from the statutory accounting perspective is different. Under statutory accounting, the transaction is subject to the provisions of SSAP 91R and SSAP 25, pursuant to which the portfolio of downgraded securities transferred to the trust must be accounted for at its fair value. This causes an adverse impact on the company's surplus due to the recognition of a loss in an amount by which the carrying value of the portfolio exceeds its fair value. Since insurance companies do not carry the general account securities on a marked-to-market basis, the impact of this loss on surplus is far greater than the risk-based capital relief from re-REMICs.
As a result, re-REMICs do not work for insurance companies because they do not carry the portfolio on a marked-to-market basis and are sensitive to the accounting consequences of the transaction. However, re-REMICs do work for money managers, hedge funds and market arbitragers because they carry the portfolio on a marked-to-market basis; focus on the economic value of the transaction; are not as sensitive to GAAP accounting provisions; and not subject to statutory accounting of any kind.
Potential Capital Relief Solutions
An insurance company can reduce its risk-based capital allocation for a downgraded RMBS portfolio without triggering certain provisions of statutory accounting, so long as there is no transfer of assets. The following are summaries of two potential approaches for an insurance company to achieve risk-based capital relief. The level of the relief would depend on the approach and the portfolio, among other things. Each of these approaches is subject to the approval of the insurance company's regulator, and is not subject to the statutory accounting provisions that trigger fair value accounting of the portfolio.
The Collateral Approach
This approach is based on the correlation of the risk of loss on securities with that on the mortgage collateral underlying the securities. Since the risk-based capital for mortgage collateral is lower than that for below-investment grade securities, the insurance company will benefit from risk-based capital through the application of this approach.
The Reinsurance Approach
This approach is based on the fact that a portfolio of downgraded securities supports the liabilities of a block of business in a reinsurance transaction. The insurance company will benefit from risk-based capital associated with the securities, because the company will no longer be subject to providing risk-based capital for the securities.
Conclusion
An insurance company with a downgraded RMBS portfolio can achieve risk-based capital relief by employing one of the above two approaches as appropriate for a securities portfolio. These approaches for risk-based capital relief are by and large within the existing framework for statutory accounting treatment and risk-based capital allocation requirements.
The National Association of Insurance Commissioners is exploring ways for statutory accounting to accommodate re-REMICs for capital relief purposes. At the same time, the American Council of Life Insurers is exploring new methodologies for risk assessment of the securities to determine capital allocation requirements. While the efforts of both the NAIC and ACLI are important to address the hurdles encountered in the existing statutory accounting and capital allocation process, I believe that we should focus on the approaches suggested above to address the capital issues because these approaches utilize the existing statutory accounting framework, and do not depend on inventing a new process, or fixing the process that is not broken.