Wall Street Securitizations Reincarnated for Life Settlements

Published by clickbroker.blogspot.com.

The New York Times’ “Wall Street Pursues Profit in Bundles of Life Insurance” reports that Credit Suisse (CS) and Goldman Sachs (GS) are gearing up for wagers that would even make Sarah Palin’s “Death Panels” cringe. The new game in town is securitizing life settlements on a scale as massive as subprime mortgages to reap the same level of fat fees.

The $26T of life insurance policies is certainly temping compared to a peak 2005 $941B of Wall Street mortgage securitizations. Mortgage securitizations dropped to $169B year to date and Morgan Stanley (MS) estimates the repackaging of old CDO (read credit challenged) tranches should exceed $30B. The trick once again is to fool or bribe the ratings agencies into granting triple-A status to the life settlement trusts. Moody’s (MCO) has not seen a portfolio that qualifies.

The life insurers are concerned that their modeling of policies lapsing before death might no longer be valid if life settlements gain momentum. If a policy holder has the guaranteed right to renew but either no longer needs the benefit or can no longer afford the premium, no payout is required. However if most policies are active until death, higher premiums across the board would be required. Likewise the tax treatment of life insurance might change if it’s viewed as a negotiable (tradable) asset.

The insurers might also start taking a hard line and challenge payouts on policies that appear to be fraudulent. Regulations vary by state, but the policyholder generally should have an insurable interest. Policy values greater than the estate are questionable. Also commission rebates to pay applicants for the trouble of going through a medical exam for a policy that will be sold directly back to the insurance broker has questionable legality.

Following the subprime methodology, Credit Suisse has purchased an originator and is building a high throughput assembly line. Next to come should be independent brokers and warehouse financing. The complexity of state by state insurance regulation and the diversity of life insurance products could lead to much more difficult underwriting than even the most complex mortgages. Whether it is the time needed to conscientiously underwrite settlements slowing down the assembly line, or numerous mistakes and frauds to speed it up, either way trouble is brewing.

But the real difficulty lies in an insurance industry unwilling to cooperate. There is a conflict of interest between insurers and the other parties. Unlike the mortgage model where everyone benefited from the fraud except investors; the insurers see only more payouts. Additionally, securitization will negatively impact the affordability of their products and subsequently reduce their potential customer pool.

Investors in these securitizations will also face their share of risks. With a limited supply of viatical settlement eligible (terminally ill) policyholders, the machine will focus on life settlement agreements for the aging and health deteriorating policyholders. Risk management such as a diversity of diseases in the portfolio is being studied.

While the trusts are waiting for benefit payouts, they must continue to pay the policyholders premiums in addition to the initial settlements. Depending on the securitizations’ initial capitalization and the timing of premiums and benefits, investor cash calls might be required. Investors might also be deceived by fraudulent underwriting such as overpaying for settlements and overstate disease severity so that the originators can complete the sales and earn commissions. Sounds just like subprime.

A black swan such as curing cancer, diabetes and heart disease in one magic pill might cause all models to blowup. Keep in mind the Holy Grail for all pharmaceuticals are to harness the immune system, so don’t say it is not possible. And Sarah Palin’s worst nightmare Obamacare might even cause life expectancy to increase dramatically. Goldman Sachs is creating a tradable index to hedge this risk or simply bet on life expectancy.

The startup of this machine should be a clear warning to Federal Reserve Chairman Bernanke that interest rates are way too low. The Times says that pension funds and other large institutional investors chomping at the bit to get in. Is history repeating itself?

You’ll know when there is trouble when retail investors are invited in and institutions try to bailout. After all is that not the purpose of the newlyweds Morgan Stanley Smith Barney?

By the way, can anyone tell me how the securitization trustee knows when the policyholder has transitioned? It not like a spouse, child, friend, business associate or other relative beneficiaries were keeping tabs on the deceased or even attending the death bed. Obviously non-beneficiaries don’t care whether the trust gets its payout.

Disclosure: Author is long MCO.

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