Lehman Brothers International Europe, or LBIE, a London-based subsidiary of the defunct bank, is suing bond insurance company Assured Guaranty Ltd. 2009. A trial to resolve the case began Monday in New York State court, with Judge Melissa Crane presiding over a virtual hearing.
LBIE claims it owes more than $ 500 million because Assured did not use market prices when it closed a series of swaps, instead accounting for them by a method that its attorney says has challenged “the laws of financial physics” in court on Monday. For his part, Assured says he followed the contracts to the letter when settling them, and the results show that it was in fact Lehman on the hook – facing the bond insurer with a termination fee of $ 20.7 million afterwards. closing the bank.
That such arguments still rage some 13 years after the collapse of Lehman Brothers Holdings Inc. underscores the complexity of disentangling the value of credit protection bets placed as the global financial crisis approaches. The 28 credit default swaps in question, linked to US and UK residential mortgage pools as well as some business loans, had a face value of $ 5.6 billion , but some quirks of these particular swaps make it more difficult to establish a settlement price.
âAnytime the underlying instruments are unusual and illiquid, this type of litigation can arise,â said John Williams, partner at Milbank LLP who heads the company’s derivatives practice. “There can be very big differences between what one person thinks the contract is worth against another.”
In their simplest form, CDSs allow parties to bet that large companies will meet their financial obligations, and the settlement process is standardized. The swaps at issue here occupy a more obscure and often more personalized corner of the market, potentially leaving their value more open to interpretation.
As a buyer of the insurance, Lehman says the swaps should have been settled based on market data. But Assured, the seller, said it was difficult to do because there was no market on which to base the ratings. In fact, he says he held an auction for Lehman’s positions and no bidders emerged. Instead, the insurance company estimated the future performance of the securities underlying the transactions.
Unsurprisingly, the two methods provided drastically different valuations – nearly $ 600 million apart.
âEveryone knows that the framework for stock quotes is great, except when it’s not working,â said Julia Lu, partner at law firm Ashurst LLP, who counts Assured as a client but not in this case. “When there is a major market dislocation, you may not be able to get a quote anywhere because no one is willing to review your trades.”
Credit default swaps are designed to insure cardholders against a borrower’s failure to honor debts. Much like an insurance contract, the buyer of credit protection makes fixed payments in exchange for a payment from the seller if something goes wrong.
In the context of the financial crisis, CDS are perhaps best known as a tool for speculation rather than insurance, as traders have used swaps to make bearish bets on weak mortgage bonds. Buying insurance on titles before they collapsed and then selling them in the midst of the crisis paid huge dividends for the few premonitories that did so early on.
Lehman is the best-known victim of the crisis that subprime mortgage bonds helped provoke. The swaps at issue in this case covered defaults on UK mortgage-backed securities, corporate loans and, most importantly, two indices that tracked subprime US residential mortgage securities. It was an insurance on a part of the market in great difficulty.
“Almost half of the subprime mortgages underlying these indices were already over 60 days past due, bankrupt, in foreclosure, or held by a lender after a failed foreclosure auction,” Andrew J Rossman, a partner at Quinn Emanuel Urquhart & Sullivan LLP in New York, who is acting on behalf of LBIE at the trial, said in a memo: “Any reasonable party within industry practice to use market prices, or at least market data, would have valued CDS transactions at hundreds of millions of dollars in favor of LBIE. “
Assured’s argument, however, is that the swaps at the heart of the matter were particularly difficult to value due to their unorthodox structure. They had a so-called “pay-as-you-go” setup and the insurance company was not required to provide a guarantee if market prices moved against them.
This is why Assured hired Henderson Global Investors to conduct an auction. He found 10 parties willing to consider replacing Lehman on swaps, but none submitted an offer. So instead of valuing the swaps with reference to the market, he calculated them based on his own models of what the losses of the underlying securities would be.
âNone of the bidders, which included many of the world’s most sophisticated financial institutions, were willing to pay an amount to get into LBIE’s shoes in transactions,â said Rishi Zutshi, partner at Cleary Gottlieb Steen & Hamilton LLP in New York who advocates on behalf of the insurance company. “Assured acted reasonably in determining his loss.”
A spokesperson for Assured declined to comment.
When the CDSs were written, Assured was one of the many insurers known as monoline insurers, meaning it only wrote bond insurance. A number of the larger monolines, such as MBIA Inc. and Ambac Financial Group Inc., have been rocked by the subprime mortgage crisis and have seen their own credit ratings drop. Concerns about the health of these insurance companies may have weighed on the valuation of these CDS contracts and made other parties less likely to buy them.
The difficulty in assessing correlation risk and the high cost of hedging “made it unlikely that a counterparty would be willing to pay Assured to enter into replacement transactions,” Zutshi said in the pre-trial memo.
The outcome of the trial will be closely followed by hedge funds such as King Street Capital Management and Farallon Capital Management as well as lenders such as Deutsche Bank AG and Barclays Plc. They are awaiting a judgment from the London Court of Appeal, where a ruling to settle disputes between LBIE’s ultimate subordinate creditors could reap huge windfalls.
Directors of PriceWaterhouseCoopers LLP have liquidated Lehman’s European branch since 2008, attempting to recoup cash for the bank’s creditors. Money earned by LBIE would eventually flow through the capital structure to holders of Lehman’s subordinated debt, now held primarily by distressed debt investors. This could significantly improve the payout of the holdings of the funds that hold these notes.
“This represents one of the last stages of the administration of LBIE, Europe’s largest bankruptcy,” said Russell Downs, partner at PwC and one of the co-directors. “This litigation will resolve a key issue regarding compensation that we believe is owed to LBIE.”
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