This weekend Hurricane Irma is set to unleash hell over Florida, resulting in devastation and damages worth tens of billions of dollars... and many hedge funds are on the hook ahead of their own coming balance sheet "catastrophe."
On Wednesday we reported that as a result of the imminent destruction to befall Florida, investors in catastrophe bonds - among them prominently one Stone Ridge Capital - could be facing a total wipeout on their investments (those unfamiliar with (Cat)astrophe bonds and Insurance-LInked Securities are urged to read the original article, especially since this will be a very prominent topic in the weeks to come). As a quick reminder, as their name suggests, catastrophe, or cat, bonds are a bet (by the buyer) that a catastrophic event such as a hurricane won't take place, instead allowing them to clip 3 years work of generous coupons and get principal repayment at maturity; they are also a bet (or insurance) by the seller that a catastrophic event will take place, in which case the bonds contractually default, and as much as the entire principal amount could be forgiven.
In short, cat bonds are a form of securitized "reinsurance", sold to hedge funds, catastrophe-oriented funds, and various other return-starved "alternative" asset managers and offer diversification as they are uncorrelated with other risks such as equity market risk, interest rate risk, and credit risk.
It will probably not come as a surprise to anyone, that the firm behind catastrophe bonds is, drumroll, Goldman Sachs:
Michael Millette, the former head of structured finance at Goldman Sachs Group Inc., helped the bank develop a market for cat bonds in the 1990s. It was one of the first signals that high finance had discovered the reinsurance market. Millette now runs his own fund, with backing from Blackstone, according to Artemis, a trade publication
Cat bonds are also largely untested, especially at a time when two "100-year storms" are set to hit the US within 2 weeks of each other.
“The market for this kind of thing is pretty untested,” said Ryan Tunis, an analyst at Credit Suisse Group AG. “There are questions of how fast they’ll pay out, whether they’ll pay out” he added quoted by Bloomberg.
The cat-bond market is currently valued at almost $90 billion, and almost half is tied to risks in Florida, where insurers are mostly state-run entities and small regional carriers looking to mitigate risk. "For the most part, the cat bonds have remained resilient. Part of this is due to a lack of major disasters in the biggest U.S. cities, where losses would be large."
As Bloomberg writes, cat bonds began to proliferate in the wake of Hurricane Andrew, a disaster so devastating that the World Meterological Organization discontinued the use of the name after the 1992 hurricane season, according to Swiss Re AG. Significant losses from California’s Northridge earthquake in 1994 and the Kobe temblor in Japan a year later motivated many companies to find reinsurance, or insurance that backs insurance.
More than a dozen hurricanes during the 2005 season, including Katrina, Rita and Wilma, resulted in more than $75 billion of insured losses, causing a dramatic rise in cat-bond issuance, according to the Journal of Alternative Investments.
Not everyone is rushing in. David Havens, an insurance analyst at Imperial Capital LLC, said his company considered wading into the market. Since the firm would be matching buyers and sellers rather than using their balance sheet to invest in the debt, the trading spread was “like a dime,” he said.
“There’s already a preexisting world of clubby guys,” Havens said. “So it’s a hard market to get into.”
As we showed on Wednesday, the Swiss Re Cat Bond Total Return Index has climbed more than 100 percent in the past decade, outperforming the S&P500 and generating the same return as the Barclays High Yield index but with a higher Sharpe ratio.
So, thanks to its Ponzi-like returns, the market has drawn in a record amount of cash in the first half of this year, according to insurance broker Aon Plc. Issuance was $11.3 billion. The problem is that with Harvey and Irma, this record outperformance is about to hit a brick wall, leading to historic losses for most cat bonds investors.
Investors like Brett Houghton, managing principal at Fermat Capital Management, which has most of its $5 billion fund in cat bonds, said he spent most of Thursday avoiding televised forecasts.
In his best head in the sand impression, Houghton said that "If people just watched the Weather Channel, they’d sell everything. The round-the-clock coverage is looking for ways to sound as sensational as possible. We’re trying to look at it from a more cold, detached, calculative perspective.”
That, or investors like Houghton, after a decade of virtually no hurricane losses, have forgotten what a "fat-tail" event means, and more to the point, that one can also lose money in this business.
Someone else who will lose lots of money, is Stone Ridge Asset Management, which we first pointed out on Wednesday. As we said, within the universe of buyers, "one particular name emerges more frequently than any other: that of Stone Ridge, and its various Reinsurance Funds, most notably the aptly named "High Yield Reinsurance Risk Premium Fund."
Two days later Bloomberg has caught up, discussing the rising cortisol levels of one Stephen Barnes, a financial advisor from Phoenix, who is invested in the Stone Ridge Reinsurance Risk Premium Interval Fund, "a mutual fund that dropped 11 percent this week as the hurricane wreaked havoc in the Caribbean. In calmer times, Barnes has enjoyed solid returns uncorrelated with stocks and bonds while accepting risks that the fund that may be on the hook when disaster strikes. “I won’t tell you it wasn’t unsettling,” said Barnes.
The $4.5 billion Stone Ridge offering is one of a small number of U.S. mutual funds that invest in reinsurance products like catastrophe bonds. They provide regular payments to investors but lose money if damage costs are too high. The Stone Ridge fund also bets on quota shares, essentially small slices of a reinsurance company’s book of business.
Like all other cat bond investors, the Stone Ridge fund made lucrative gains in recent years, rising 6.4% last year, 7.9% in 2015 and 11% in 2014,. But this year, even ahead of Irma’s unprecedented damage, the fund has sunk 7.9% as of Thursday. It will suffer much more before all is said and done, especially if the recent repricing of Citrus Re's cat bonds due 2020 from par to 50 overnight is indicative of what is coming.
Not surprisingly, on Tuesday, Stone Ridge Asset Management marked down Tuesday based on models of possible losses from the hurricane, said Frani Feit, managing director of Tradition Capital Management, whose clients have invested in the fund for the past three years.
“We realize there will be events that may negatively impact accounts,” Feit said.
The question is whether 7.9% will be enough to cover all the losses from Harvey and Irma. The realistic answer, it won't.
Ironically, just as Goldman was instrumental in creating the Cat bonds space, Stone Ridge was the creation of another financial crisis veteran, Magnetar Capital:
New York-based Stone Ridge was founded by Ross Stevens, who previously was with Magnetar Capital, a hedge fund. The Stone Ridge fund, which is aimed at advisers, requires a minimum investment of $15 million.
What makes Stone Ridge unique is its quarterly liquidity structure: "Investors can only withdraw money at certain intervals, typically quarterly." In other words, we won't know if there is a run on the fund for at least a few more weeks.
Yet while Stone Ridge's mark down was optimistic, some of its peers are hoping Irma will avoid Florida entirely:
The $391 million Pioneer ILS Interval Fund, which also invests in reinsurance products, gained 9.1 percent last year and 9.9 percent in 2015. It is up 3.4 percent in 2017 as of Thursday and was not marked down this week.
What we find most surprising is that even when faced with near certain "catastrophe" for which they counter-hedged, investors still remain optimistic: Barnes said there could be opportunities for investors if Irma causes significant damage. When reinsurers suffer losses, he said, they typically raise prices, which translates into higher premiums for customers and better returns for investors.
Meanwhile, the abovementioned Brett Houghton - who simply refuses to watch the Weather Channel - of Fermat Capital, which was founded in 2001, maintained a similar philosophical coolness despite contemplating possible Irma-related losses.
“Even if our investors do end up losing a lot of money on this event,’’ he said, “there will be opportunities to make money in the aftermath.”
Sure... unless all the remaining investors decide to pull their money after the imminent, pardon the pun, "catastrophic" losses.