As market participants debate whether the recent bank shutdowns and the government-sponsored sale of Credit Suisse may be a precursor for another “Lehman Moment,” we are reminded of yet unresolved issues that followed the Lehman Brothers’ 2008 collapse. In the latest development of legal disputes lingering nearly 15 years later, a New York trial court upheld a non-defaulting monoline insurer’s valuation of its losses in a series of terminated credit default swaps (“CDSs”) entered into with Lehman Brothers Internationals Europe (“LBIE”), through an alternative method based on projected default rates of the underlying mortgage instruments, rather than market prices or a retroactively constructed valuation model.
The Court handed Assured a victory by holding that the valuation based on market prices was inapplicable during the period of extreme market displacement and accepted its method of pricing its risk exposure used both before and during that period.
Background
LBIE purchased credit protection from AG Financial Products, Inc. (“Assured”) under the 1992 version of ISDA (International Swap Dealer’s Association) Master Agreement, pursuant to which LBIE was required to make premium payments to Assured in return for Assured covering shortfalls of principal or interest payments as they became due over the life of 28 underlying securities (the “Securities”). On September 15, 2008, LBIE entered into insolvency proceedings, constituting an event of default entitling Assured, the non-defaulting party, to—and as it did on July 23, 2009—terminate the transactions and calculate the termination payment due from LBIE. LBIE and Assured disputed the calculation of such payment, to the extent that the amounts proffered by the parties differed by over $500 million.
The parties elected “Market Quotation” as the default method for calculating the termination payment under the ISDA Master Agreement, which required Assured to seek quotations from dealers for replacement transactions as evidence of market value of the terminated CDSs. Assured engaged an advisor and conducted an auction where no bids were submitted. The ISDA Master Agreement provided that if fewer than three quotations are obtained, the Market Quotation is deemed undeterminable, and Assured may use the “Loss” method to calculate the termination payment. The ISDA Mater Agreement provided that in calculating its “Loss,” a party may “reasonably determine[] in good faith . . . its total losses and costs . . . including any loss of bargain” and “need not” consider market prices.
After failing to obtain quotations through the auction, Assured calculated its Loss by netting the premium payments LBIE would have owed over the life of the transactions against the amounts Assured projected it would have had to pay to cover projected shortfalls of principal and interest, using its traditional methodology by taking into account projected defaults rates, seasoning/burnout (assuming that default rates decrease over time) and structural protections involved in the mortgages underlying the Securities (i.e., senior tranches are likely to suffer less losses than junior tranches). Although the premiums were fixed and mostly uncontroversial, LBIE disputed Assured’s calculation of the projected shortfalls. LBIE argued that Assured’s calculation was unreasonable because it deviated from what LBIE proposed as a “uniform market practice” based on market prices, which LBIE presented during trial in the form of a valuation model created by one of its expert witnesses using various pricing proxies for the purpose of this litigation.
Discussion
In general, the non-defaulting party is afforded “discretion and flexibility” in using the Loss calculation method, as long as the calculation is reasonable and made in good faith. Some courts have observed that the Loss method can take into consideration future replacement value of the transactions and thereby achieve “broadly the same result” as the Market Quotation method. However, citing the User’s Guide to the 1992 ISDA Master Agreements, the Court found that the ISDA Master Agreement between the LBIE and Assured specifically contemplated a situation where market prices could not lead to commercially reasonable results and need not be considered, such as during “periods of severe market disruption” where reliable market prices did not exist.
The Court noted that the 2008-09 market was in “free fall,” resulting in the disrupted environment contemplated by the ISDA Master Agreement where reliable quotes on mortgage-based financial instruments were difficult or simply impossible to obtain. The Court believed that Assured’s failed auction served as strong evidence of the Securities’ untradeable nature in 2009, much to the contrary of LBIE’s position that the markets were not dislocated and that there still existed a standard practice for valuation based on market prices.
Further, the Court found revealing that even before the auction, LBIE had tried for months to novate the transactions to no avail and sought indicative prices to bolster its litigation against Assured, but none of the parties contacted were willing to make a binding offer. The Court credited a multitude of evidence showing that market “prices [had become] divorced from value” and that there was “no consensus” on valuation methods that were to be used at the time, citing testimony of LBIE’s own experts in other cases, during which they did not use market prices for valuation, as circumstances undercutting LBIE’s argument. Accordingly, the Court found that LBIE, in unsuccessfully asserting the existence of a uniform market practice by which Assured was supposedly required to calculate its Loss, relied solely on hypothetical market prices constructed by its expert witnesses and failed to prove the existence of actual market prices.
The Court also found support for Assured’s Loss calculation in, among others, In re Am. Home Mtge. Holdings Inc., 637 F.3d 246, 257 (3d Cir. 2011), in which the Third Circuit, addressing the 2008 financial meltdown, affirmed the use of the “discounted cash flow method” as a commercially reasonable alternative valuation method to measure damages where the “mortgage market was dysfunctional on the acceleration date.”
Having concluded that Assured was not required to use market prices in its evaluation, the Court examined Assured’s alternative Loss calculation and was satisfied that Assured utilized the same practices employed in its general course of business to calculate the projected shortfalls. The Court found these methods reliable as used by a monoline insurer in a highly regulated industry, where accurate modeling was critical to Assured’s risk management in entering into CDS transactions. The modeling practices were also subject to multiple layers of review, including approval by an independent auditor. Assured calculated the projected shortfalls based on default rates of the mortgages in the mortgage pools underlying the Securities and used actual performance data for the specific Securities at issue from Intex, a widely recognized industry platform. In doing so, Assured also took into account the relative strength of the underlying instruments, including: (i) the instruments’ “super senior” position in the pool leading to a relatively low risk of loss, (ii) the improving market conditions, and (iii) other significant structural protections in place. The default rates proposed by Assured aligned with predictions made by unbiased ratings agencies and were found by the Court to be more objective and credible than the prognostications of investment banks that were already in litigation or contemplating litigation, or the pricing model created by LBIE’s expert out of whole cloth.
Takeaways
Since approximately $500 million are at issue in this case, one could expect LBIE to appeal the trial court’s decision. The dearth of case law on the subject, however, highlights the significant uncertainties that remain in valuation of derivative transactions at a time of extreme market displacement. The 2008 financial crisis was not the first, and certainly will not be the last. Parties, therefore, will serve themselves best by proactively building financial models to price these transactions such that they are not required to construct them on ad hoc bases if and when needed.
The opinion can be accessed here.
