Anyone else curious why Allstate’s SPE WillowRe’s bonds are trading at half their par value?

Russell emailed me the answer and as is typical of what Russell digs up on complex securities and derivatives the answer is not only fascinating but begs additional questions. First let’s do a quick refresher on why this question  is topical here on Slabbed by starting with the then breaking news that Allstate’s special purpose entity Willow Re’s cat bonds were facing “imminent default“, followed by my explanation of the events that brought about the then imminent default (subprime mortgages backing the bonds). Then we linked a Reuter’s story reporting the actual default:

Willow Re and three similar deals used a unit of Lehman Brothers as total return swap counterparty, contracted to ensure the collateral backing the bonds was sufficient to meet interest and principal repayments, and to make up any shortfall.

When it collapsed, investors were left with direct exposure to market losses on assets held as collateral. S&P had said on Oct. 9 that it believed payments on Willow Re were at risk.

The default will not trigger a termination of the underlying reinsurance agreement between Allstate and Willow Re, meaning the bonds could still pay out to Allstate in the event of a severe windstorm in the northeastern United States. In that case, the exact payment received by the insurer would depend on the value of the collateral pool.

The loss of Lehman Brothers as the counterparty to the embedded total return swap is the direct cause of the Willow Re cat bond price plunge as the above story indicates.  We can also reasonably infer the market “perceived” the value of the Lehman Brothers financial guarantee was around 50 cents on the dollar and the logic for that inference is straightforward because after Lehman imploded the value of the bonds went from around 100 to 50 (as in 100% of par value to 50% of par value). Is the implied value of the Lehman financial guarantee also a signal that Lehman was in for some troubled times? Continue reading “Anyone else curious why Allstate’s SPE WillowRe’s bonds are trading at half their par value?”

Insurance and Reinsurance were sitting on a fence, Insurance fell off and…

Demand for reinsurance is increasing, regardless of the industry’s recent struggles. At the same time, no new capacity is expected to enter the market. The trend toward falling rates that prevailed in the past few years has been arrested, and double-digit price increases are expected in some markets.

Not exactly news for the SLABBED; but, a real head-scratching story in light of other trends that haven’t been arrested – including some haven’t even been called in for questioning.

Over at Sam Friedman’s, Enterprise Risk Management is a hot topic with Sam first asking –

How could so many supposedly brilliant financial minds have been so clueless about the massive exposures they were assuming?

– and later posing a more targeted version of the question, asking, Does the fault for AIG’s financial crisis lie with ERM, or with AIG’s failure to properly implement the concept?

The company’s 2007 10-K Annual Report makes clear that ERM was in place–at least in theory. Yet reckless derivatives trading–in the form of credit default swaps, covering those who blindly bought collateralized debt obligations backed by worthless subprime mortgages (or who were speculating in that Wild West market with naked trades)–still nearly drove AIG out of business, and prompted Uncle Sam to throw the company a life preserver, costing tens of billions in public bailout funds.

Unlike Sam, I don’t think those “brilliant financial minds” were clueless.  IMO, they simply had a different agenda for Enterprise Risk Management. Continue reading “Insurance and Reinsurance were sitting on a fence, Insurance fell off and…”