Wider ILN new issue spreads foreseen post-Bellemeade calls

The negative repercussions of Arch’s cancellation of eight Bellemeade insurance-linked notes (ILNs) will be felt in the market for the foreseeable future, say well-placed sources.

The decision to call these bonds on November 21 has soured the market and future ILNs from all mortgage insurance borrowers (MIs) will have to carry wider spreads to elicit investor interest, they predict.

“Does this mean investors demand a premium going forward? I think so. This will persist. Even though this particular issue is specific to Arch I think it has affected the whole market’s attitude to risk premiums,” says Pratik Gupta, head of RMBS and CLO research at Bank of America in New York.

Some investors have said that they are pulling out of the ILN market completely, while others will continue to buy the product but perhaps abjure from Arch issuance.

“The reaction of the cash investors has definitely been negative,” says another insurer.

Investors learned that the bonds would be called on November 20 and the termination date is December 27.

The cancellation of the notes indicates to some onlookers that Arch is receiving poor advice. It could have tendered the notes in question at a premium to the trading price rather than called them, for example. This would have cost the mortgage insurer more money, but it would not have alienated investors.

Instead, it chose to call the in notes at par, leaving investors out of pocket and needing to fill a hole in their portfolio with the year-end only a few weeks away and annual returns being calculated. It couldn’t have occurred at a worse time.

“Arch could have paid another $30m or $40m to tender them and preserved the relationship with the investor but they chose not to do that. The amount they saved will be eroded over time as they try and go back to the market,” comments a source close to the market.

The MI cancelled the notes because S&P unveiled its Insurer Risk-Based Capital Adequacy Criteria on November 15, and the changed methodology substantially reduced the amount of capital Arch needed to hold to secure a single A rating. Thus, the Bellemeade notes were no longer necessary.

The previous risk assumptions were underpinned by reference to RMBS data, but the new ones reflect post-GFC experience and better GSE data. Under the old formula, an MI would have to hold capital equal to 18% of risk in force (RIF) for S&P approval while now it must hold only 7.5%.

However, of the five or six MIs in the market, only Arch is affected directly by the new guidelines. The others execute ILN transactions largely to satisfy the demands of the Private Mortgage Insurer Eligibility Requirements, called PMIERS, which are a set of operational and risk-based capital criteria required to insure GSE loans.

But Arch is not just a mortgage insurer. It is a multi-line insurer and needs to satisfy S&P requirements for other areas of its business.

“If you look at their deals, some had higher detachment point, for example, presumably because they were using the S&P model. So Arch is a bit different from the other MI CRT issuers. Most of the others are solely focused on mortgage insurance and the way they do CRT deals is geared towards PMIERS,” explains Gupta.

So, the change in methodology affects only ILNs issued by Arch, and, says an investor who had a position in the ILNs that were called, other buyers should have been aware of the situation and the likelihood that these notes would be cancelled.

“When the other Mis bought excess cover they stopped at the PMIERS limit. Arch did more, so it was clear to me that they were buying for S&P reasons. We’ve always been crystal clear about their motivations so when S&P said the new regime was in place it removed the motivation to have this cover. I was not surprised,” he says.

He adds that other investors only have themselves to blame if they did not make provision for an event that was always on the cards.

Another source agrees. “The call options have been there forever. They are explicit and affect the convexity of the position. If you haven’t seen them, shame on you,” he says.

These views offer a different perspective to the whole affair.

Despite recent events, robustness of the ILN market was demonstrated by the decision this week (December 11) by Radnor Re to initiate a tender offer for eight tranches of ILNs issued in 2019 and 2020. The arranger is Bank of America, and the tender period ends this Friday (December 15) at 5pm New York time. All the offers include a premium to par.

That this event can proceed so soon after such a controversial moment in the ILN market suggests that it is still not terminally damaged by the Arch saga.

“The tender announcement is a very positive move. It helps stabilize the market fears” says Gupta.

But the tender offer by Radnor at a premium to par is also a reminder to Arch that it could have chosen to follow this route. Instead of a tender, however, it decided to cancel notes causing a loss to investors. While it might have saved millions in the short term, it made it more like injurious ramifications to itself and perhaps to other ILN issuers as well will persist.

Simon Boughey