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Global Credit Research - 29 Nov 2010
London, 29 November 2010 -- Moody's Investors Service says that ongoing uncertainty over the
validity of provisions subordinating swap termination payments owed by
structured finance vehicles to defaulting counterparties -- known
as "flip clauses" -- has no rating impact for most cashflow
structured finance transactions. This is because Moody's
has concluded that the validity of flip clauses is not a material consideration
in relation to liquid interest rate and currency swaps that comply with
Moody's de-linkage criteria.
The validity of flip clauses relating to structured finance swaps remains
uncertain. In January, the US bankruptcy court ruled that
a flip clause providing for the subordination of swap payments owed by
a structured finance vehicle (Dante) to a bankrupt counterparty (Lehman)
was unenforceable. On 20 September, leave was granted to
appeal that decision. The same flip clause has been the subject
of English litigation. Following the Court of Appeal's ruling
against Lehman, an appeal to the Supreme Court was scheduled for
March 2011. The parties have recently agreed to settle both the
US and English proceedings, subject to approval of the US bankruptcy
On 28 January, Moody's announced that it was investigating
the potential impact of the US bankruptcy court decision on the ratings
of structured finance transactions. It has now determined that
the validity of flip clauses is not a material consideration in relation
to liquid interest rate and currency swaps that comply with Moody's
framework for de-linking swap counterparty risk (Moody's
Hedge Framework)(1). These types of swaps are typically used in
cashflow structured finance transactions. For the remainder of
this announcement, they are referred to as Framework Swaps.
o Framework Swaps are likely to be transferred before swap counterparty
If a swap complies with Moody's Hedge Framework, the counterparty
is required to seek a replacement counterparty once it is downgraded below
A3/P-2. Therefore, is it likely that liquid Framework
Swaps will be transferred before counterparty default, even though
Moody's assumes a material likelihood that such transfer will not
o The validity of flip clauses is not significant if the issuer receives
a replacement fee with which to make its termination payment.
If a counterparty fails to transfer a Framework Swap before it defaults,
the issuer may choose to terminate the swap and enter into a replacement
with a new counterparty. If the issuer is out-of-the
money under the swap, the new counterparty will pay a replacement
fee that the issuer will use to make its termination payment(3).
In this situation, the ranking of the termination payment is not
a material consideration for rating purposes. Indeed, Moody's
Hedge Framework contemplates that the replacement fee shall pass directly
to the insolvent counterparty outside the waterfall in full satisfaction
of the termination payment.
o An issuer is very unlikely to terminate an out-of-the-money
Framework Swap before finding a replacement.
Even before January's bankruptcy court ruling, there was no
observed instance of a structured finance issuer terminating a Framework
Swap that was in-the-money for a defaulting counterparty
without first entering into a replacement swap. The litigation
on flip clauses makes the prospect of such "premature" termination
-- which would require trustee or noteholder consent -- more
remote still. An uncovered senior ranking termination payment may
cause a shortfall of funds for the issuer to make timely payments to noteholders.
Moreover, it would expose the issuer to a shift in the market value
of the swap between the time of termination and the time of replacement.
Moody's has considered whether another recent US bankruptcy judgment,
concerning a swap between Lehman and Metavante Corporation, may
influence the time at which an issuer chooses to terminate a swap with
a bankrupt US counterparty. In that case, the judge said
that a non-defaulting party can lose its right to terminate a swap
if it does not exercise it promptly. Therefore, immediate
termination has the advantage of ensuring the issuer is free to enter
into a replacement swap at a future time without the risk of becoming
However, in order to justify the risks associated with termination
before replacement, an issuer (and the trustee or noteholders) would,
at the very least, want to be satisfied that (i) the transaction
is likely to benefit from entering into a replacement swap at a future
time and (ii) there is a material risk the bankrupt counterparty will,
in practice, dispute the issuer's right to terminate at that
If a swap is out-of-the-money for an issuer,
the projected benefit to the transaction of being able to enter into a
replacement at a future time may be limited. Moreover, a
bankrupt counterparty can generally be expected to welcome the termination
or transfer of a swap where it stands to receive a lump sum payment that
reflects the market value of its position. This expectation is
confirmed by the Lehman experience. In Europe, Lehman cooperated
with issuers to achieve swap replacements; in the US, it obtained
court approval to unilaterally transfer swaps to third parties so as to
realize their embedded value.
With this in mind, Moody's believes that a structured finance
issuer is very unlikely to terminate an out-of-the-money
Framework Swap before finding a replacement. The risks associated
with an issuer incurring an uncovered senior termination payment are almost
certain to weigh more heavily than those associated with the possibility
of losing the right to terminate at a future time.
o A bankrupt US counterparty is very unlikely to reject in-the-money
Moody's has separately considered whether a bankrupt US counterparty
could be entitled to a damages claim or termination payment if it rejects
a profitable swap under the US Bankruptcy Code. If a structured
finance issuer is forced to make such a senior-ranking payment
without first receiving a corresponding replacement fee, it could
have a negative credit impact for noteholders.
However, there are strong legal arguments against this possibility.
Moreover, given the uncertainties, costs and delays involved
in litigation, Moody's believes it is very unlikely that a
bankrupt counterparty would seek to reject an in-the-money
swap if it could instead find a replacement counterparty. This
expectation is consistent with steps taken by Lehman in relation to Framework
Moody's has therefore concluded that the validity of flip clauses
is not a material consideration in relation to Framework Swaps for which
replacement counterparties can be found. Furthermore, the
recent experience of Lehman swaps supports Moody's assumption that
replacement counterparties can generally be found for interest rate and
currency swaps. For these reasons, the final outcome of the
Dante litigation -- whatever it may be -- is not expected to
affect the ratings of cashflow structured finance transactions that incorporate
Framework Swaps only.
(1) Moody's methodology, "Framework for De-Linking
Counterparty Risks from Structured Finance Cashflow Transactions",
October 18, 2010.
(2) Moody's Hedge Framework incorporates a requirement for collateral
to be posted in contemplation of the issuer terminating the swap and finding
a replacement counterparty following counterparty default.
(3) Under Moody's Hedge Framework, the termination payment
is defined to exactly match the replacement fee. Where this criterion
is not applied, the termination payment is typically defined as
the average of three or more market quotations. In this case,
Moody's expects that an issuer would not choose to accept a replacement
fee that is less than the termination payment.
Senior Vice President
Structured Finance Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454
Maria E. Leibholz
VP - Senior Credit Officer
Structured Finance Group
Moody's Investors Service
Moody's Investors Service Ltd.
Moody's: Ongoing uncertainty over flip clauses has no rating impact for most cashflow SF transactions
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London E14 5FA
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