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?

 So exactly what is the connection between the value of the Lehman financial guarantee, the current value of the Willow Re bonds X-guarantee and the value of the guarantee being a signal Lehman was in trouble? The answer, despite the complex subject matter is very straightforward and the Financial Times spills the beans.  Simply put, of the universe of ABS/CDO’s issued since 2002 roughly 47% are in default:

So-called CDOs of ABS caused huge losses to banks such as Merrill Lynch, UBS and Citigroup, which held large amounts of the supposedly safest, top-rated chunks of them. They have since been damned by bodies such as the Bank for International Settlements as being too complex to risk manage effectively.

CDOs of ABS were used increasingly at the peak of the credit bubble to keep the securitisation machine moving by recycling hard to sell bits of subprime mortgage bonds and other risky tranches into new structures with top-notch credit ratings.

However, the ratings of these deals proved unsustainable, as evidenced by the fact they have accounted for 92.9 per cent of all 16,587 ratings downgrades globally from all rating agencies since the beginning of last year, according to Morgan Stanley.

The way these complex and risky transactions were exploited at the peak of the bubble can be seen in data from analysts at Wachovia, who reckon that 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default.

If we were to extrapolate the default rate across the universe of impacted securities including the related derivatives the dollar value certainly runs into the trillions of dollars. Swiss Re was a big Cat Bond derivative counterparty which brings to mind the next question namely, how are they doing these days. Sam Friedman’s boys at the National Underwriter ran that story last week:

Eight days after Swiss Re announced it sustained an $860 million loss last year, and needed a Berkshire Hathaway $2.6 billion capital infusion, the company said it has replaced its chief executive officer, Jacques Aigrain.

The Zurich, Switzerland-based reinsurance giant said Deputy Chief Executive Officer and Chief Operating Officer Stefan Lippe will take over as CEO.

Mr. Aigrain, who joined Swiss Re in 2001, was appointed CEO on Jan. 1, 2006. The company said he will support the transition to Mr. Lippe through Wednesday, along with a statement from Mr. Aigrain.

“Having taken measures to reinforce the Group’s capital strength and further de-risk its investment portfolio, the interests of Swiss Re are now best served by a change in executive leadership,” the outgoing CEO said.

Does the TARP stretch to Switzerland?


3 thoughts on “Anyone else curious why Allstate’s SPE WillowRe’s bonds are trading at half their par value?”

  1. I can’t see how TARP is doing anything but keeping as many balls in the air as it can – everyone hoping that Congress will pass the usual type of reform package – one that just shuffles the deck and gives them what they want,

    If figure if the US isn’t borrowing from a country, it’s floating it.

    The finance industry is going “global” while the rest of us are going into “orbit” JMHO

  2. TARP unclogged the credit market. It’s utility against the financial storm these idots in Gucci suits created is akin to using a garden house against a forest fire IMHO.

    Does this hit close to home? Check the last link I left and scan the list Nowdy and look at the Texas ratio. Whitney is in there and except for TARP would be insolvent. Can you think of a big Mississippi bank that had to take TARP? Texas ratio of 19? Insolvent except for TARP??? You bet.

    At some point in time the only answer will be to let these big companies work out their problems in bankruptcy – hopefully we don’t run our national debt up by trillions of dollars before our leaders figure that out.


  3. Re: Tarp
    The following is an extended quote from here:

    The subprime mortgage mess alone does not force our hand; the $1.2 trillion it involves is just the beginning of the problem. Another $7 trillion — including commercial real estate loans, consumer credit-card debt and high-yield bonds and leveraged loans — is at risk of losing much of its value. Then there are trillions more in high-grade corporate bonds and loans and jumbo prime mortgages, whose worth will also drop precipitously as the recession deepens and more firms and households default on their loans and mortgages.

    Last year we predicted that losses by U.S. financial institutions would hit $1 trillion and possibly go as high as $2 trillion. We were accused of exaggerating. But since then, write-downs by U.S. banks have passed the $1 trillion mark, and now institutions such as the International Monetary Fund and Goldman Sachs predict losses of more than $2 trillion.

    But if you think that $2 trillion is high, consider our latest estimates at the financial Web site RGE Monitor: They suggest that total losses on loans made by U.S. banks and the fall in the market value of the assets they are holding will reach about $3.6 trillion. The U.S. banking sector is exposed to half that figure, or $1.8 trillion. Even with the original federal bailout funds from last fall, the capital backing the banks’ assets was only $1.4 trillion, leaving the U.S. banking system about $400 billion in the hole.

Comments are closed.