Tuesday, February 9, 2010

Lehman ruling creates new doubts for CDOs

Posted in the Financial Times by Aline van Duyn and Nicole Bullock:

Collateralised debt obligations, the complex debt securities linked to pools of risky mortgages and derivatives, have caused astronomical losses across the global financial system.

Many of the macroeconomic assumptions about house prices - and the likely default rates on mortgages - have turned out to be so wrong that the resulting losses for banks and insurance companies turned a financial crisis into a global economic disaster which continues to be felt to this day.

A look at defaults on CDOs backed by asset-backed securities (see chart) highlights how wrong the beliefs underpinning deals struck at the height of the US housing bubble were: nearly 90 per cent of $186bn of such CDOs issued in 2007 have been defaulted on, compared with a 3 per cent default rate on deals backed by mortgages from 2001.

Much of that is due to the poor mortgage underwriting which prevailed at that time. In other words, these CDOs proved to be among the most toxic of toxic assets.

So much for the past. Now a new uncertainty looms, and it is linked to the assets and money that might be available to investors as these distressed securities are unwound.

This follows a US court ruling last month in the Lehman Brothers bankruptcy which may turn the conventional wisdom which has driven many of these deals on its head.

Structured deals such as CDOs are composed of many different tranches of securities, each representing different levels of risk. When these deals are liquidated, the legal structure of the deals determines which investors are repaid first.

It had long been assumed that investors in structured deals - the ones owning the notes - will get paid before swap counterparties do.

Often swap counterparties have only a small stake in a CDO, providing a hedge on interest rates, for example. But in some of the Lehman deals being contested, swap counterparties had a huge stake. This is particularly true for so-called synthetic CDOs, a shadowy market the scale of which is still hard to pin down, and which surged once banks ran out of mortgages to repackage into CDOs. Instead, credit derivatives linked to these mortgages were repackaged - creating the synthetic CDOs - and at the centre were credit default swaps written by dealers like Lehman's.

Now, Lehman's lawyers are seeking to get paid before other investors do. This position has now been backed by US courts but not by English ones.

"If not overturned, this decision could result in [Lehman Brothers] receiving billions of dollars from various CDOs that would otherwise be distributed to noteholders," said lawyers at Cleary Gottlieb in a note to clients.

Lawyers say they have received requests for advice from investors who have been paid on synthetic CDOs deals after Lehman's default triggered the unwinding of deals. They fear they may be forced to repay money already received, which could add up to $8bn, according to Cleary Gottlieb.

"The problems around CDOs, particularly synthetic CDOs, are really highlighting just how deficient and insufficient many of the assumptions underlying this huge market were," said a lawyer working for a hedge fund which has been paid money on a CDO.

The next step in the Lehman case will come at a hearing in New York on February 10.

Regardless of the outcome, another question mark has been added to the future of structured finance. Even though new deals are not expected to be structured in the same way or linked to mortgage-backed securities, the basic building blocks of structured finance could be affected by the turmoil around CDOs.

The Lehman rulings, for example, could affect whether or not structured finance deals can be rated higher than the ratings of the swap counterparties backing parts of the deal.

If there are divergent decisions in England and the US, one answer may be to just use non-US swap counterparties. However, it highlights the risks that courts may rule in a way which is different to the way lawyers thought they would.

Other issues which have come to the fore are uncertainty about how holders of different slices of the CDOs stand when there are defaults, as well as numerous uncertainties relating to the valuation of these securities when investors are seeking to settle or sell.

Such valuation issues have been particularly in the spotlight since the collapse of AIG, brought down by the weight of CDS insurance sold on hundreds of billions of dollars of CDOs. The pay-outs made by the Federal Reserve Bank of New York when it took over the insurer in 2008 to AIG counterparties like Goldman Sachs and Société Générale - the terms of which appear to have allowed the banks to determine the value of the CDOs when asking for collateral payments - continue to be a source of political scrutiny.

"The provisions in these CDS contracts, with hindsight, do not work well when you have hard-to-value, illiquid financial instruments," said Paul Forrester, partner at Mayer Brown.

"This is just one of the assumptions underpinning structured finance markets that is being re-examined. The status of swap counterparties is another one. All of these outcomes will need to be taken into account when future financial innovations are developed and designed.," Mr Forrester went on.

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