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?”