The National Association of Insurance Commissioners (NAIC) released at the end of last year a  list of CUSIP-level breakpoints for insurance firms to use to determine their capital requirements. The NAIC's list has a set of five breakpoints for every insurer-held bond, each with a corresponding NAIC designation. 

A higher designation would likely mean higher capital charges for CMBS holdings, according to a Barclays Capital report. 

In terms of the lower parts of the CMBS structure, this would also mean principal losses for the AJ and AM bonds. Based on the final release, NAIC expects most of the 2006-08 AJs to take some principal loss, according to Barclays. Half of the 2006 and 2008 and about 86% of 2007 AMs should also take principal losses (by bond count). 

Additionally, some of the non-last cash flow super-senior 2007 tranches should take a principal loss as well. Considering the expected benefits of the time tranches, a non-zero loss for shorter dupers could be a result of the 5% weighted most conservative scenario, Barclays analysts said. The A2 and A3 tranches are generally considered credit risk free because they are backed by shorter loans.

A lot of senior bonds can also be taking some loss in this instance, and even with a low 5% weighting, this would mean a nonzero overall loss number, the analysts said.

While a significant percentage of senior bonds from later vintages seem to be taking losses, the
actual loss number seems to be small, they said.

Aside from the expected losses, the regulatory capital is expected to be considerably higher under the new NAIC system for CMBS holdings, based on the new data Barclays analysts said.

This is particularly surprising, Barclays said, since the new system was implemented to, among other reasons, lessen the capital burden and to bring it in line with improving market fundamentals. This was also made to make it less dependent on the rating agencies’ view, analysts said.

However, Barclay analysts said that changes in capital requirement are expected to be minimal for supers, AM and AJ tranches. Most of the need, they said, for more capital should come from the current NAIC 5 tranches that should migrate to category 6 under the new system. The exponential tendency of the rise in capital requirements also explains why Barclays analysts expect very few bonds to account for the majority of additional required capital.

Losses on Different CMBS

Scott Buchta, head of investment strategy at Braver Stern Securities, made a graph of the losses to be experienced by the different CMBS classes in the various NAIC scenarios.

In terms of triple-A CMBS. 29% of 2007 LCF dupers should take a loss in one of the stress scenarios. According to Buchta, these bonds are going to be capped in the high $100s for NAIC 1 capital treatment. Insurance firms that purchased these bonds at a premium  in 2010 should most likely sell them at a profit and reinvest in other "non-loss" dupers rather than take the write-down. Bonds that they own at $100 or less will be mostly unaffected, Buchta said.

Although insurance firms probably own few AMs above 100, Buchta said that the biggest effect might be these firms' inability to purchase new bonds considering how many are trading above 100. "Legacy bonds will become just that, legacy bonds," he said. "Bond swaps in this sector will be very difficult due to the higher cost of the reinvestment."

In terms of AJs, many insurance firms will be forced to make a mark-down or sell because of the new NAIC marks, according to Buchta. Given the recent rally in AJs, the NAIC marks and market prices might be close enough that some insurance firms will mark-down and hold the bonds as a result of the limited reinvestment opportunities, he said. Others will use the forced mark-downs as a chance to exit the AJ space. "Trading themes in AJ space will be very company specific and not industrywide," Buchta stated.  

He believes that NAIC prices will be higher than market prices, particularly if insurance firms are going to write bonds down to NAIC 2 or 3 levels instead of NAIC 1. Because of this, there will likely be a rise in write-downs compared with outright sales, although some sales by insurance companies are now possible.

Sell candidates might include seasoned credit bonds or bonds higher up in the capital structure where market prices might be closer to the NAIC marks, he said. Market versus NAIC valuations will be critical to the decisions made in all sectors, but will be particularly significant in credit.

Buchta thinks that an important point will be how limited insurance firms might be in purchasing 2007 A4s and many 06/07 AM bonds, which are now trading at premiums.

Additionally, volatility in this year's RMBS markets is likely preventing insurance firms from purchasing marginal bonds that are not expected to take losses because of fears of future mark-downs. Buchta doesn't forsee a rush in buying at market values that are significantly below NAIC value by insurance firms since Moody's Investors Service, Fitch Ratings and Standard & Poor's also rate these companies based on their overall portfolio composition.

Composition of CMBS Holdings

The universe of CUSIPs released by the NAIC effectively portrays the CMBS holdings of a typical U.S. insurance company. The NAIC release compiles this data in one list.

Barclays analysts said that not surprisingly insurance firms never limited themselves to 'AAA' rated bonds. Instead, over half of the bonds from the NAIC list are below-'AAA' by original rating and CUSIP count, Barclays analysts said.

In terms of vintage, 2005-07 bonds comprised around 54% by bond count. According to analysts, some recently issued 2010 deals were also included. This shows that insurance firms were active in the new-issue CMBS space.

Based on the data, Barclays analysts said that it is clear that insurance companies were active in the new-issuance market through 2010. It is likely that they will continue buying into 2011 new issuance. But, it is not apparent at this juncture how the NAIC designation for the new deals will be communicated, Barclays analysts said.

The firms' portfolios included AM and AJ tranches off most conduit deals — roughly 98% of AMs from 2006-08 and about 90% of AJs from the same vintages.

As such, contrary to popular belief, it does not appear that the insurance companies were concentrating in the better-quality AJs. Rather, the coverage appears to be very broad.

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