The National Association of Insurance Commissioners’ recently proposed
“We expect alt-A fixed-rates and subprime securities to be affected most by the proposed changes,” Barclays researchers said in the report.
NAIC has proposed that the U.S. Treasury strip curve be used as the discount rate for fixed-rate coupon bonds and the Libor curve as the discount rate for floating-rate coupon bonds “when deriving expected losses and the intrinsic prices of RMBS/CMBS positions,” as opposed to the current method of where NAIC applies each security’s coupon as the discount rate.
The association also has proposed that interest shortfalls be incorporated when forecasted expected losses on a security rather than only taking into account principal losses.
“The proposed change was likely driven by a desire to add consistency when evaluating securities with different coupons,” the Barclays researchers said, noting that NAIC has said that a bond’s “net present value of expected loss should not depend on a security’s coupon rate.”
The analysts noted that they found “some ambiguity in the memo describing the proposed methodology” but said that their interpretation is that “the Treasury/Libor curve is only used as the discount rate on expected losses and interest shortfalls, while the discount rate is kept at the bond’s coupon when calculating the present value of scheduled cashflows.
“This would essentially deduct the net present value of expected losses and interest shortfalls from par and result in a more conservative approach to modeling these securities,” according to the report.
Barclays researchers believe the proposal could lead to “lower intrinsic prices on modeled nonagency RMBS” and “lower NAIC breakpoint prices (the prices at which NAIC levels are determined), which could result in higher capital requirements on some bonds if the carrying value of the bond is above the new NAIC breakpoints.”
“Alt-A fixed rates, which generally pay high coupons and are expected to incur moderate losses, will experience a fairly substantial increase in the present value of their expected losses when discounted at the Treasury strip rate,” they said.
In contrast, “jumbo fixed rates are likely to experience only modest declines in their NAIC breakpoints, despite a drop in their discount rates because they are also forecasted to incur minimal losses.”
Meanwhile, “subprime bonds are forecasted to experience only a small increase in the present value of principal losses; however, a significant amount of interest shortfalls…will add to their total forecasted losses,” according to Barclays.
If implemented, the NAIC’s changes “could lead to some nonagency supply, as some insurers seek to reduce holdings of assets with high capital requirements,” the researchers said.
Alt-A fixed rates in particular “could see some selling, especially if capital requirements on some bonds increase significantly.”
But according to Barclays, “even in a worst-case scenario in which insurers sell all of their alt-A fixed-rate holdings, the $33 billion of supply can likely be well absorbed by the market, especially as the NAIC’s proposed changes are unlikely to take effect until January 2014.
“Thus, any sales will probably be spread out over the rest of this year.”
