Lehman Brothers International Europe, or LBIE, a London-based subsidiary of the defunct bank, is taking bond-insurance firm Assured Guaranty Ltd. to court over decade-old claims that a swath of credit-default swaps it had bought were incorrectly settled in 2009. A trial to resolve the matter started in New York state court on Monday, with Justice Melissa Crane presiding over a virtual hearing.
LBIE claims it’s owed more than $500 million because Assured failed to use market prices when it closed out a series of swaps, tallying them up instead through a method its lawyer said defied “the laws of financial physics” in court on Monday. For its part, Assured says it followed the contracts to the letter when settling them, and the results show that it was actually Lehman on the hook — owing the bond insurer a $20.7 million termination fee after the bank folded.
That such arguments still rage some 13 years after the fall of Lehman Brothers Holdings Inc. underscores the complexity of unraveling the value of credit-protection bets placed in the run-up to the global financial crisis. The 28 credit-default-swap contracts in question, tied to bundles of U.S. and U.K. residential mortgages as well as some corporate loans, had a face value $5.6 billion, but certain quirks of these particular swaps make establishing a settlement price harder.
“Any time the underlying instruments are unusual and illiquid, this kind of dispute can arise,” said John Williams, a partner at Milbank LLP who leads the firm’s derivatives practice. “There can be very big differences between what one person thinks the contract is worth versus another.”
In their simplest form, CDS allow parties to wager on whether large companies will meet their financial obligations, and the settlement process is standardized. The swaps at issue here occupy a murkier and often more bespoke corner of the market, potentially leaving their value more open to interpretation.
As the buyer of the insurance, Lehman says the swaps should have been settled on the basis of market data. But Assured, the seller, says that was hard to do because there was no market to base valuations on. In fact, it says it held an auction for Lehman’s positions and no bidders emerged. Instead, the insurance company estimated the future performance of securities underpinning the trades.
Unsurprisingly, the two methods provided drastically different valuations — almost $600 million apart.
“Everybody knows that the market-quotations framework is great, except when it doesn’t work,” said Julia Lu, a partner at law firm Ashurst LLP, which 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 nobody’s willing to look at your trades.”
Credit-default swaps are designed to insure the holders against a borrower’s failure to meet its debt payments. Much like an insurance contract, the buyer of the credit protection makes fixed payments in exchange for a payout from the seller should something go wrong.
In the context of the financial crisis, CDS are perhaps better known as a tool for speculation rather than insurance, as traders used the swaps to make bearish bets on shaky mortgage bonds. Purchasing insurance on securities before they were set to collapse and then selling them in the midst of the crisis reaped huge rewards for the prescient few that did so early.
Lehman is the best-known casualty of the crisis that risky mortgage bonds helped to cause. The swaps at issue in this case covered defaults on U.K. mortgage-backed securities, corporate loans and, crucially, two indexes that tracked subprime U.S. residential-mortgage securities. They were insurance on a part of the market that was in serious trouble.
“Nearly half of the subprime-mortgage loans underlying these indices were already more than 60 days delinquent, in bankruptcy, in foreclosure, or owned 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 following industry practice to use market prices, or at least market data, would have valued the CDS trades at hundreds of millions of dollars in LBIE’s favor.”
Assured’s argument, however, is that the swaps at the heart of the case were particularly difficult to price because of their unorthodox structure. They had a so-called “pay-as-you-go” set-up and the insurance firm wasn’t required to post collateral if market prices moved against them.
That’s why Assured hired Henderson Global Investors to conduct an auction. It found 10 parties willing to take a look at replacing Lehman on the swaps, but none submitted bids. So, instead of pricing the swaps in reference to the market, it calculated them based on its own models of what the losses of the underlying securities would be.
“None of the bidders, which included many of the most sophisticated financial institutions in the world, were willing to pay any amount to enter into LBIE’s shoes in the transactions,” said Rishi Zutshi, a partner at Cleary Gottlieb Steen & Hamilton LLP in New York who is arguing on behalf of the insurance firm. “Assured acted reasonably in determining its loss.”
A spokesperson for Assured declined to comment.
When the CDS were written Assured was one of a number of insurers known as monolines, meaning that it only wrote insurance on bonds. A number of the biggest monolines, like MBIA Inc. and Ambac Financial Group Inc., were rocked by the subprime crisis and saw their own credit ratings cut. Worries about the health of these insurance companies might have weighed on the valuation of these CDS contracts and made other parties less likely to buy them.
The difficulty of pricing correlation risk and 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 pretrial memo.
The result of the trial will be keenly watched by hedge funds like King Street Capital Management and Farallon Capital Management as well as lenders such as Deutsche Bank AG and Barclays Plc. They’re awaiting a judgment from London’s Court of Appeal, where a ruling to decide on disputes between LBIE’s ultimate subordinated creditors could reap huge windfalls.
Administrators at PriceWaterhouseCoopers LLP have been winding down Lehman’s European arm since 2008, attempting to recover cash for the bank’s creditors. Money won by LBIE would eventually flow through the capital structure to holders of Lehman’s subordinated debt, now mostly owned by distressed debt investors. That could drastically improve the payout on the holdings for the funds that own those notes.
“This represents one of the final milestones of the LBIE administration, Europe’s biggest-ever bankruptcy,” said Russell Downs, a partner at PwC and one of the joint administrators. “This litigation will settle a key issue around compensation we believe is owed to LBIE.”
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