As a disturbing counterpart to the recent LTV Steel controversy in the U.S. (see ASR 3/12, p.1), pending litigation in the U.K. related to Lexington Insurance-AIG's refusal to honor its insurance policy on two downgraded film-backed deals (see ASR 2/19, p.1) has engendered its own firestorm of criticism and debate in the global ABS community.
The case is troublesome to market observers on many different levels. U.K.-based Quadrant Capital, which manages a structured investment vehicle (SIV) that was the sole investor in one deal (Hollywood Funding No. 5, or HF5) and a 50% investor in the other deal (Hollywood Funding No. 6, or HF6), was forced to deleverage its AAA-rated SIV by $100 million as a result of Lexington's refusal to meet its obligations. This took place even after Lexington was warned that its decision would have severe consequences for Quadrant's SIV.
Furthermore, many market participants are particularly frustrated by the manner in which the rating agencies have addressed the issue. Standard & Poor's - who recently downgraded the two HF deals from AAA to the lowest non-investment grade rating of CCC-minus - has not yet addressed the potential impact of the situation on the rating of AIG itself, despite the fact that the agency concurs with Quadrant and other investors that Lexington, an AIG subsidiary, has no valid reason for stalling on paying the claims. No rating action against Lexington/AIG has taken place yet.
"We feel that there's enough ambiguity in this case that would make generalizing this issue to [Lexington's] overall claims-paying ability premature," said Cliff Griep, the executive managing director of S&P's insurance unit. "We are investigating Lexington's claim policies, and we cannot generalize past these Hollywood transactions, which were unique situations. We are monitoring the legal developments in the U.K. to determine whether Lexington had a valid reason to deny claims or not."
The most important issue raised by this case, however, is that triple-A-rated AIG's refusal to to pay out on the downgraded deals - seemingly without a valid excuse - is construed by some to represent yet another attack on a core principle of securitization: that a triple-A-rated insurer should have to abide by the convention in the capital markets to pay on a timely basis for triple-A-rated bonds.
While Quadrant's SIV, called Asset Backed Capital (ABC), was resilient in the face of the rapid downgrades of the HF deals, the need for Quadrant to quickly liquidate some of the SIV's assets leaves questions regarding market-value risk, or price risk, that still exists in SIV structures, which are typically impervious to most market stresses.
"The deleveraging is harmful in terms of our portfolio," said Timothy Lyons of Quadrant Capital. "While our AAA-ratings on the ABC SIV have been confirmed, we are now short of $100 million of capital and incurring consequential losses as a result of AIG's actions."
That being said, Lyons asserted that SIVs are designed to be immensely robust vehicles; they are actual companies that are subject to daily rating compliance and a battery of tests.
ABC was a leveraged investor in the HF5 deal, and is required under the terms of its own triple-A ratings to hold 100% capital against any securities rated below BB-/Ba3/BB-. Quadrant was forced to delever its portfolio accordingly.
"We breached our capital gearing test for one day, but we've exceeded the average mark-to-market on what we sold, which is a very good sign," Lyons noted. "This is not a bad credit story or even a story about SIVs as much as it is a story about the world's largest insurance company stepping aside from its triple-A obligations."
SIV market-value risk?
Quadrant's Asset Backed Capital was established in 1996 as a triple-A-rated, leveraged credit investment company. Currently, it has a diversified portfolio of $3.5 billion of predominately triple-A-rated assets with a strong weighting to the ABS sector. Quadrant also manages an SIV known as Abacas, and is in the process of setting up Amazon, which is expected to be the first multi-seller SIV.
The ABC vehicle was 90% AAA, 7% double-A, and 3% single-A; "We had to sell a whole lot of bonds" in order to delever, Lyons said. The SIV is now approximately 86% triple-A.
As soon as it became apparent that Lexington did not intend to meet its obligations under HF5 and HF6, and prior to S&P's downgrading of the bonds, Quadrant, on behalf of ABC, held discussions with representatives of Lexington's parent AIG with the assistance of representatives of Credit Suisse First Boston, which acted as lead arranger on several of the Hollywood Funding deals.
"Quadrant and ABC believe that Lexington's actions in seeking to avoid its unconditional obligations to meet any shortfall in the film revenues attributable to HF5 and HF6 are unacceptable from a AAA-rated entity," Lyons said.
Even though Moody's and Fitch have reaffirmed their credit ratings on ABC's senior and subordinated debt programs (while S&P is in the process of completing its review process), market observers knowledgable about SIVs say that there is still substantial price risk in SIV structures.
SIV credit risk is mitigated because of the vehicle's high quality assets and its portfolio performance triggers, which require the manager to liquidate before any assets become a problem. However, price risk is not so easily mitigated: when an SIV is liquidated the paper is only worth what the market will give for it.
"The problem we've seen in SIV programs is that you can have triple-A-rated assets be downgraded and default very quickly," said a market source. "It is never contemplated that it would happen to a triple-A. But we have seen cases where these can be a problem for an SIV.
"The risk is not totally neutralized."
By all accounts, however, the circumstance and specifics of the Lexington case are unique, and SIVs are, for the most part, extremely adroit structures in the capital markets.
"This situation shows how well those transactions [SIVs] are structured," said Thomas Gillis , chief credit officer of S&P. "This is really the first situation to test an asset falling out of bed and the SIV having to liquidate assets to come into capital compliance. It is highly unlikely that that will happen again. Not many triple-As go from AAA to CCC-minus so precipitously. It doesn't happen everyday."
As a defense, Lexington has cited a recent controversial ruling in the British courts (HIH vs. New Hampshire) in which Australian insurance company HIH, which coincidentally filed for bankruptcy last week, sought recompense from its re-insurers for a similar claim which arose on earlier Hollywood Financing transactions, in which the court found in favor of the re-insurers on the grounds that the requisite number of films was not completed. The HIH case is currently before the Court of Appeal, and may even reach the House of Lords, sources said.
HIH eventually paid out on the deal, Lyons points out, but notes that the controversy shows the huge demarcation between monoline guaranties, who must adhere to capital markets rules, and the attempt of multiline insurers to enter the market adopting the conventions of the property and casualty insurance market, where insurers typically dispute claims before paying.
"Lexington thought they got lucky in that they are relying on this controversial point made in the HIH case," said Quadrant's Lyons said. "But that case was different in that it examined the relationship between reinsurers and insurers, and did not focus on the documents which investors rely on, which gave no remedy for the insurer to step aside.
"This is a cynical attempt to take advantage of the HIH judgment," Lyons added.