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Alternative Collateral Update An Efficient Approach

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Title: Alternative Collateral Update An Efficient Approach


1
Alternative Collateral UpdateAn Efficient
Approach
  • June 2, 2008
  • Confidential

2
  • SECURITIES OR INVESTMENTS ARE OFFERED THROUGH MMC
    SECURITIES CORP (MMCSC), A REGISTERED
    BROKER-DEALER, AND MEMBER OF FINRA/SIPC. MAIN
    OFFICE 1166 AVENUE OF THE AMERICAS, NEW YORK, NY
    10036. PHONE 212.345.5000. MMCSC, OLIVER
    WYMAN, AND MARSH INC., ARE AFFILIATED ENTITIES
    THAT ARE OWNED AND OPERATED BY MARSH MCLENNAN
    COMPANIES, INC. MMCSC OR ANY OF ITS AFFILIATES
    MAY HAVE AN INDEPENDENT BUSINESS RELATIONSHIP
    WITH ANY OF THE COMPANIES DESCRIBED HEREIN.
    TRADEMARKS AND SERVICE MARKS ARE THE PROPERTY OF
    THEIR RESPECTIVE OWNERS.
  • THIS MATERIAL HAS BEEN PREPARED FOR INFORMATIONAL
    PURPOSES ONLY. IT IS NOT AN OFFER TO BUY OR SELL
    ANY SECURITY OR COMMODITY OR OTHER FINANCIAL
    INSTRUMENT OR TO PARTICIPATE IN ANY TRADING
    STRATEGY. AN INVESTMENT IN THE ALTERNATIVE
    COLLATERAL PROGRAM (ACP) IS SPECULATIVE,
    INVOLVES A HIGH DEGREE OF RISK AND SHOULD BE
    CONSIDERED ONLY BY INSTITUTIONAL INVESTORS WHO
    CAN BEAR THE ECONOMIC RISKS OF THEIR INVESTMENTS
    AND WHO CAN AFFORD TO SUSTAIN THE LOSS OF THEIR
    INVESTMENTS. INSTITUTIONAL INVESTORS SHOULD
    THOROUGHLY CONSIDER THE INFORMATION CONTAINED
    HEREIN.
  • CERTAIN OF THE INFORMATION CONTAINED HEREIN
    CONCERNING CREDIT RATINGS AND DEFAULT RATES IS
    BASED UPON OR DERIVED FROM INFORMATION PROVIDED
    BY THIRD-PARTIES AND OTHER INDUSTRY SOURCES AS
    INDICATED HEREIN. NO REPRESENTATION OR
    WARRANTY, EXPRESS OR IMPLIED, IS MADE BY MMCSC AS
    TO THE ACCURACY OR COMPLETENESS OF THE
    INFORMATION SET FORTH HEREIN, AND NOTHING
    CONTAINED IN THIS PRESENTATION IS, OR SHALL BE
    RELIED UPON AS, A PROMISE OR REPRESENTATION,
    WHETHER AS TO THE PAST OR THE FUTURE. MMCSC HAS
    NOT INDEPENDENTLY VERIFIED ANY SUCH INFORMATION
    AND ASSUMES NO RESPONSIBILITY FOR ITS ACCURACY OR
    COMPLETENESS. IN ADDITION, THIS PRESENTATION
    INCLUDES CERTAIN ESTIMATES AND ASSUMPTIONS MADE
    BY MMCSC WHICH MAY OR MAY NOT PROVE ACCURATE.
    PAST PERFORMANCE DOES NOT GUARANTEE FUTURE
    RESULTS.
  • RESULTS FROM SIMULATIONS ARE FOR ILLUSTRATIVE
    PURPOSES ONLY AND CERTAIN ASSUMPTIONS HAVE BEEN
    MADE REGARDING SIMULATIONS BECAUSE SOME MODELS
    ARE PROPRIETARY TO THEIR RESPECTIVE OWNERS AND
    CANNOT BE REPLICATED. THEREFORE, RECIPIENTS
    SHOULD NOT PLACE UNDUE RELIANCE ON THESE RESULTS.
  • NO PERSON HAS BEEN AUTHORIZED TO MAKE ANY
    REPRESENTATION OR GIVE ANY INFORMATION WITH
    RESPECT TO THE ACP, OTHER THAN THE INFORMATION
    CONTAINED HEREIN. PROSPECTIVE INSTITUTIONAL
    INVESTORS SHOULD NOT RELY ON ANY INFORMATION
    OTHER THAN THAT CONTAINED IN THIS PRESENTATION OR
    ANY SUPPLEMENT TO THIS PRESENTATION.
  • NEITHER MMCSC NOR ANY OF ITS REGISTERED
    REPRESENTATIVES, IS MAKING ANY REPRESENTATION
    REGARDING THE LEGALITY OF AN INVESTMENT HEREIN BY
    INSTITUTIONAL INVESTORS. PROSPECTIVE
    INSTITUTIONAL INVESTORS ARE NOT TO CONSTRUE THE
    CONTENTS OF THIS PRESENTATION AS LEGAL, TAX OR
    BUSINESS ADVICE. EACH INSTITUTIONAL INVESTOR
    SHOULD CONSULT WITH ITS OWN ADVISORS AS TO LEGAL,
    TAX BUSINESS, FINANCIAL, AND RELATED ASPECTS OF
    INVESTING IN THE ACP.
  • THIS MATERIAL MAY NOT BE REDISTRIBUTED WITHOUT
    THE PRIOR WRITTEN CONSENT OF MMCSC.

3
  • However beautiful the strategy, you should
    occasionally look at the results
  • Sir Winston Churchill (1874
    1965)

4
Contents
  • Overview
  • Credit Market Overview
  • ACP Program Performance
  • Conclusion

5
Overview
6
Overview
  • Over 20 billion in collateral posted within
    state WC self-insured programs.
  • Posting Letters of Credit (L/C) and Surety uses
    valuable credit capacity
  • Alternative Collateral Programs access financial
    markets
  • Credit markets have gone through unprecedented
    turmoil over the last twelve months
  • increased credit spreads (including individual
    companies)
  • marked by decreased liquidity
  • large writedowns at leading institutions to
    re-create business
  • However, financial institutions are seeking well
    structured transactions
  • Alternative Collateral Programs continue to
    perform well

Alternative Collateral Programs continue to
provide a more efficient method to manage
collateral.
7
Overview Self Insurance Programs
For most WC self-insurance programs, companies
post collateral individually
Collateral
Claims
Company 1
  • collateral (letter of credit, surety or escrow)
    posted to regulator / security fund
  • companies manage and pay claims
  • annual collateral fees paid to market (banks,
    sureties) and lost each year

Company 2
Collateral
Claims
Claims
Company 3
Collateral
Company 4
Collateral
Claims
Security Fund
8

Overview Self Insurance Programs
In the event of default, a Security Fund (SF)
uses collateral and additional assessments to pay
claims
Claims
Collateral
Defaulted Company
  • collateral used to pay claims
  • additional assessments made for shortfalls
  • (remaining companies liable)

Claims
Company 2
Additional Assessments
Company 3
Claims
Company 4
Claims
Security Fund
9
Overview Self Insurance Programs
  • Individual instruments (letters of credit,
    surety, cash) are not ideal
  • inefficient use of resources
  • use credit capacity scarce resource, especially
    in current market
  • premium / fees lost to market in excess of
    150 million annually1
  • silo effect
  • inflexible
  • credit exposure to sureties / bank
  • capacity constraints (surety)

A portfolio based risk management approach
provides a more efficient means for companies to
post security.
1. MMCSC estimate, assumes L/C fees of 1.25
10
Overview Self Insurance Programs
A portfolio based approach, where the Security
Fund arranges collateral on behalf of companies
Company 1
Claims
Risk Transfer
AA-/Aa3 or better Counterparties1
Premium
Company 2
Claims
Program Fees
Credit Protection
Credit Protection
Company 3
Claims
Retention
Claims
Company 4
Security Fund
1. Minimum counterparty credit rating determined
by the security fund
11
Overview Self Insurance Programs
  • ACP only impacts the method by which collateral
    is posted, not the underlying program

Underlying program unchanged companies must meet minimum requirements annually report outstanding WC liabilities security deposit requirements regulator retains full oversight and provides approval of the program
Members pay premium to Security Fund premium based upon creditworthiness and outstanding WC liabilities SF arranges security on a portfolio basis on behalf of all eligible companies all eligible companies (based on minimum credit rating) must participate
Security Fund retains risk loss cash and investment income net of program costs is retained designed to mitigate additional assessments cost to members may be reduced significantly as fund becomes self-sustaining
12
Credit Market Overview
13
Credit Market Overview
  • Credit market problems emerged summer of 2007
  • Sub-prime mortgage crisis began with the bursting
    of the US housing bubble
  • Mortgages repackaged through securitizations
    (mortgage backed securities MBS) using
    Collateralized Debt Obligations (CDOs)
  • The underlying assets (mortgages, home equity)
    created the problems, not the CDOs
  • Credit markets have gone through unprecedented
    change
  • extreme price (credit spread) volatility
  • disappearance of liquidity for certain segments
    e.g. asset backed, Auction Rate
  • large writedowns in excess of 300bn at May 30,
    2008
  • re-evaluation of business, e.g. monolines (Ambac,
    MBIA, Assured Guaranty, FSA)

Market consensus is that the worst is behind us
and conditions are becoming less volatile, but
liquidity remains tight.
14
Credit Market OverviewGeneralized Credit Spreads
  • Generalized credit spreads (CDX Indices) peaked
    in March 08, but are settling

Source Bloomberg, 5 Year CDX.NA.IG.9 5 Year
CDX.NA.XO.9, 9/20/07 5/19/08
Note Indices are compiled as a basket of North
American company CDS, selected by major industry
participants. Investment grade 125 investment
grade Crossover 35 with at least one BB
rating, but no single-B rating
15
Credit Market OverviewCredit Spreads
  • The cost of credit for companies has lagged and
    continues to increase

Source Bloomberg 5/20/08
16
Credit Market OverviewCredit Default Swap -
Activity
  • Credit protection for individual companies
    continues to grow

Source International Swaps and Derivatives
Association, 2007 Market Survey
17
Credit Market OverviewDefault Rates
Non-investment Grade
  • and rating agencies continue to expect default
    rates to increase to historical levels

Source Wall Street Journal 4/30/08, Moodys
4/17/08, and Standard and Poors 4/29/08
18
Credit Market OverviewRisk Appetite
  • However, credit markets have begun to stabilize
    and risk takers are looking at new transactions
  • Appetite for well structured deals
  • Not asset backed and real estate related
  • Balance sheets remain constrained
  • Liquidity a primary factor
  • Investors have different risk appetites
  • Banks well structured transactions
  • Financial Guarantors focusing on core business
  • Hedge Funds opportunistic, seeking well
    structured transactions

Well structured transactions are being favorably
considered.
19
Credit Market OverviewACP Key structural points
  • ACP is attractive due to several unique
    structural features...

Double trigger Bankruptcy /Failure to pay (per ISDA) AND Non-payment of workers compensation
Alignment of interest Security Fund retains equity
Commercial motivation Not an arbitrage trade
Minimum credit rating B3/B- or equivalent
Rating Tranches rated by Moodys
Short tenor 1 year
Single name limits 3 lt BBB 4 BBB
20
ACP Program Performance
21
ACP Program Performance
  • Given the challenging credit market, how are
    existing programs performing?
  • two existing programs California and North
    Carolina
  • performing well cash accumulation ahead of
    projections
  • risk transfer completed albeit at higher rates
    (in line with market)
  • cost to members remains competitive
  • even more attractive to companies in current
    market


ACP continues to provide a more efficient method
of posting collateral.
22
ACP Program Performance California
  • The California Self Insurers Security Fund has
    continued its strong financial performance

Source California Self Insurers' Security
Fund. Past performance does not guarantee future
results.
23
ACP Program Performance California
as cost to members continues to fall
Source California Self Insurers' Security
Fund. Past performance does not guarantee future
results.
24
ACP Program Performance North Carolina
  • North Carolina has outperformed initial
    projections despite market conditions

North Carolina Self Insurers Security Association 478 million portfolio, 120 members, 2006 and ongoing Successfully completed 2nd year in challenging credit environment 70 projected increase in cash to 10.2 million (Dec 2008) from 6.0 million in (Dec 2006) Minimal assessment rate increase (6.5) average industrial spreads increased 100 year over year Total program costs were largely unchanged year over year
Past performance does not guarantee future
results.
25
ACP Program Performance Summary
More states are exploring ACP because it benefits
all stakeholders in the business environment
Workers Ensures cash is available for any claims not company specific Seamless to employees current claims and benefit process is unchanged
Employers Releases credit lines for operational purposes Less administrative burden No cross-subsidization
Regulators Reduces regulatory burden one security system replaces many bilateral arrangements Improves relationship with business more efficient self-insurance creates a competitive business environment Highly rated counterparties
26
Conclusion
27
Conclusion
  • Alternative Collateral programs remain attractive
    to risk takers
  • Corporate credit availability tightening
  • Attractive to companies
  • Several states are exploring alternative
    collateral programs to
  • secure appropriate collateral levels
  • stabilize member assessment rates
  • provide members alternative credit sources in a
    difficult credit environment
  • capture a portion of the approximately 250
    million in fees lost to the market annually
  • create a more efficient system that benefits the
    state and its membership

Alternative Collateral Programs continue to
provide benefits during a difficult credit year.
28
  • If an ideas worth having once, its worth
    having twice
  • Tom Stoppard
  • British Dramatist Screenwriter (1937
    - )

29
Conclusion
  • Questions?

30
Contact Information
Quentin Hills Managing Director MMC Securities
Corp.
Patrick W. Tully Managing Director MMC
Securities Corp.
1166 Avenue of the Americas, 10th Floor New York,
NY 10036 Phone (212) 345-3556 Cell (973)
222-2064 Fax (212) 345-2727 Email patrick.w.tul
ly_at_marsh.com
1 California Street, 7th Floor San Francisco, CA
94111 Phone (415) 743-8569 Cell (917)
292-0937 Fax (415) 743-8029 Email quentin.hills
_at_mmc.com
Quentin Hills is a registered representative and
supervisory principal of MMC Securities Corp., a
FINRA registered broker-dealer.
Patrick Tully is a registered representative of
MMC Securities Corp., a FINRA registered
broker-dealer.
31
www.mmc.com
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