Black and White Program

Wall Street Insurers: A Discussion with Managers About Risk, Asset Management, and Loan Servicing

October 28th, 2008 by John Eastman

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The failure of American Insurance Group (AIG) and subsequent government rescue has cast a sharp focus on other insurance firms on Wall Street. While much of the public did not initially associate an insurance firm with high-risk securities, it is well know that insurers have a substantial amount of cash generated from premiums that they invest in various investment vehicles and instruments, including loans, pension funds, and securities.

Black and White talks to Managers from several Wall Street Insurers about investment and operational strategies, how their companies vary from AIG and how their approach changes risk. Also discussed is how the current financial crisis affects large properties in the retail world, and the leases available for tenants. For legal and confidentiality purposes, the managers requested to remain anonymous for these interviews.

So tell me how life insurers differ from other Insurance related firms in terms of how they operate and invest their premium proceeds. Of course I want to draw some parallels and differences between AIG and even investment banks on Wall Street.

One of the big problems was that investment banks didn’t have any “skin” in the game

INS: Life insurance companies are historically more conservative when it comes to commercial real estate lending because they are different from the Wall Street investment banks in several ways. Life companies use the proceeds from their life insurance business and invest them in many different ways, one of which is through issuing commercial mortgages. Because they are using their customers’ insurance premiums, they are more conservative when it comes to lending than an investment bank on Wall Street would be, because Wall Street lenders can just go to market and “buy” the money, then issue it to a borrower via a commercial loan that is secured by a property, and then quickly sell it to investors. So, one of the big problems was that investment banks didn’t have any “skin” in the game– until of course they issued a bunch of mortgages that they could no longer sell because the market for buying these mortgages dried up, caused liquidity problems, and investors were worried about the increasing default ratio and the aggressive terms of these mortgages – only then did investment banks have to take write-downs.

Life companies do not securitize or sell their mortgages to investors in bundles that are first rated by Moody’s, S&P, and/or Fitch and then sold to investors. Investment banks do that to move the liability off their balance sheets, where as Life Companies are in the business of monitoring/servicing each loan that they fund throughout the term of the loan. If an insurer such as MetLife funds a $50 million mortgage to a borrower where the loan is secured by a high-rise Class A office building in downtown New York, for example, after funding, the insurer would also service the loan and asset manage the loan.

Tell me about the loan servicing aspect.
INS: The servicing part of a loan is done by accounting via collecting the monthly debt service payments, escrowing for real estate taxes, collecting for insurance, making sure these bills are paid on time, et cetera.

Explain to me how the Asset Management aspect of the business operates.
INS: The asset management part of a loan deals with the structure of the loan. For instance, if there was a tenant improvement/leasing commission/capital expenditure escrow account established at closing for further lease up at the property where the funds are only reimbursed by lender to the borrower once borrower meets certain leasing criteria, the asset manager deals with that.
The asset management also deals with analyzing the rent roll for tenant exposure, upcoming lease expirations, tenants vacating due to bankruptcy (i.e. Mervyn’s, Goodys, Linens ‘N Things, Steve ‘N Barry’s) and how this activity will affect the property’s net operating income and its ability to generate enough bottom-line revenue to pay its monthly debt service payment– this includes projecting income at the property and considering the market itself in terms of how it will affect how quickly a building leases back up, how much competition there is, what is the absorption ratio– i.e. how much space is being leased up in this market versus how much new space is being constructed via new buildings within this market.
Further, the asset manager is active in approving leases that meet certain parameters established at closing, including tenants paying market rent, a reasonable amount of free rent, a reasonable amount of tenant improvement allowances, making sure each lease is subordinate to the lender’s mortgage– meaning the lender gets paid back first before any tenant claims if the borrower liquidates– this also includes the situation where if the borrower were to default on its mortgage obligation, the lender will step in as the new landlord, and each tenant must begin to remit it’s monthly rent payment to the lender, now that the borrower is out of the picture, et cetera.

Why was someone like AIG so exposed and leveraged and companies like MetLife or Prudential not? Did AIG not service their loans? Did they not manage their properties?

INS: My understanding is that AIG, in addition to your historical, typical life company commercial lending, were also involved in the securitization world which is what some of the life insurance companies– other firms have done that as well— they started trending towards the conduit markets just because it was so profitable. So they were still doing their in-house insurance investments and they were using that money to do your low leverage, low-risk loans, but then they were also buying into some of these securitizations. And, unfortunately, as we all know, the market for that dried out and they were stuck holding some securitizations and some pools that they had purchased and where no longer worth what they had bought them for. That’s the understanding, that’s the word on the street, that they were involved in transactions of that nature. They also got involved on some other risky financial instruments and, unfortunately, were too involved and they had to take massive write downs to the point that they failed.

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