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Announcement:

Moody's: Ongoing uncertainty over flip clauses has no rating impact for most cashflow SF transactions

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.

BACKGROUND

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 court.

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 default.

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 occur(2).

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 double-hedged.

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 time.

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 liquid swaps.

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 Swaps.

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.

End Notes:

(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.

London
Edward Manchester
Senior Vice President
Structured Finance Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

New York
Maria E. Leibholz
VP - Senior Credit Officer
Structured Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom

Moody's: Ongoing uncertainty over flip clauses has no rating impact for most cashflow SF transactions
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