Insurance companies investing in "kitchen sink" bonds may get a closer look from regulators, who are growing uneasy about the current accounting treatment for these instruments.
"Kitchen sink bonds" are a type of structured instrument created by taking leftover pieces of other instruments and repackaging them to create a set of tranches with varying risk and returns.
They get their name because they are said to contain everything- -including the kitchen sink--that broker/dealers have left in their portfolios after selling off the more attractive pieces of collateralized mortgage obligations.
"What really muddies the waters is that you get all these different things, for example a mortgage-backed security and a zero coupon bond, mixed together," said Larry Gorski, the Illinois regulator who heads the Invested Asset Working Group of the National Association of Insurance Commissioners. "So in the event of an insolvency, trying to unwind the instruments and applying the appropriate accounting treatment could be a difficult task."
Kitchen sink bonds are an extreme example of a new class of securities called ReRemics. "A ReRemic is a combination of securities previously issued utilizing the Real Estate Mortgage Investment Conduit [Remic] election for federal income tax purposes," said Walter J. Chossek, of Northwestern Mutual Life in Milwaukee. ReRemics also elect the conduit tax treatment.
While kitchen sink bonds have a bad connotation because of the volatility of their cash flows, other kinds of ReRemics can fit into a relatively conservative asset/liability strategy. These are called "reconstitution bonds," and they are intended to reproduce the investment attributes of other MBSs in a cost-effective manner.
The new instruments may lead the NAIC to change its accounting rules for loan-backed securities. In September 1993, the IAWG adopted CMO accounting and valuation principles that were based on the concept of using estimated cash flows to set the value of an instrument. "This basic concept should apply to all loan-backed securities," Chossek said.
But at the time the working group made the decision on accounting treatment, instruments like kitchen sink bonds and ReRemics were not widely available. "I don't think this was in the minds of regulators. It certainly wasn't in mine," Gorski said.
The main issue is "what do you do when the cash flows are dependent on the cash flows of other structured securities and those securities do not have homogeneous characteristics," Chossek said in a presentation to the working group during the NAIC winter meeting in New Orleans Dec. 4 to 8.