Total return swap in a cat bond
A contract by which a bank guaranteed a cat bond vehicle a benchmark return on its collateral in exchange for the actual return, a structure abandoned after Lehman Brothers failed in 2008.
The capital paid in by cat bond investors is held in a collateral account, whose return pays the risk-free part of the coupon and which must remain intact to be returned at maturity or paid to the sponsor after an event. Until 2008, many cat bonds placed this collateral with a bank through a total return swap: the bank received the actual return on the assets and paid a benchmark rate in exchange, also guaranteeing the value of the principal. The structure brought into an instrument meant to carry only catastrophe risk a bank credit risk and a risk on the value of the invested assets. When the counterparty defaulted, the securities lost value with no catastrophe occurring. Since then, collateral has been invested in US Treasury money market funds or supranational securities, with strict eligibility rules, and counterparty risk has become a due diligence point for investors.
When Lehman Brothers failed on September 15, 2008, four cat bonds for which it was the swap counterparty, including Willow Re and Ajax Re, saw their prices collapse on the secondary market even though none of the covered perils had occurred.
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