CDO litigation: a risk assessment

Author: | Published: 1 Aug 2005
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What is a CDO?

A CDO is a vehicle for repackaging risk. Income-yielding assets, such as credit card receivables or corporate bonds, are packaged into one product. Different classes of notes are then sold to investors in tranches that yield, over the term of the CDO, the repayment of principal and interest from the income stream of the underlying assets. In the event of a default in one or more of the underlying assets or reference obligations, the ultimate repayment of principal and interest to the investor can be reduced. By this means, the party selling the notes in the CDO, which has the exposure to the underlying assets, has transferred the risk associated with those assets to the investor. The seller has bought risk protection. Each class of note sold carries a different rate of interest and has a different risk profile. Those affected first in the event of a default in one of the reference obligations carry the greatest interest payment, as they are the highest risk class of the notes. Those notes that carry the smallest interest payment are those with least risk. This concept is known as the payment waterfall. The greater the extent of the defaults in the underlying portfolio, the higher up the ranking of notes the losses bite.

Periodically, particular financial products come under scrutiny from regulators and market commentators. During these periods it becomes fashionable to predict imminent difficulties for those products and their market segment. In 2005, it has been the turn of the credit derivative market, and CDOs in particular, to receive such attention.

The CDO market has grown exponentially since the beginning of the decade, with 1,843 deals, worth $120 billion, concluded in 2004 alone. The value of the CDO market is $360 billion and the overall credit derivative market (of which CDOs form a part) is estimated to grow to $8 trillion by the end of 2006. Increasingly innovative products are regularly created to generate acceptable returns for investors.

This burgeoning sector is fuelled by a growing number of hedge funds, which are investing surplus capital into CDOs. Institutional investors, including pension funds, are also investing more widely in CDOs and similar products as they seek the risk diversification that higher rated, senior tranches of CDOs can offer, and as they become more comfortable with CDO structures and documentation.

Increasing scrutiny

In the UK, the Financial Services Authority (FSA) has begun to take an interest in participants in the credit derivative market. In February 2005, the FSA wrote to companies active in the market, advising them that they must keep their back office operations up to date to maintain the integrity of their operations. This initial expression of interest has focused on internal administration and record keeping, but it highlights a growing awareness that the expanding credit derivatives market could in some circumstances pose a systemic risk to the financial system. In June 2005, the FSA launched its discussion paper entitled "Hedge funds: a discussion of risk and regulatory environment," which flagged the FSA's desire to monitor more closely the activities of hedge funds as their importance to London's financial market grows. Although not focusing specifically upon hedge funds' investments in CDOs, the paper highlighted that routine stress testing by hedge funds needs to be sufficiently robust to take into account the complexity of products such as CDOs.

More recently, a senior representative of the US Federal Reserve has warned that some investors now participating in the structured credit market might not fully understand the potential risks inherent in the CDOs in which they are investing. The representative, while not speaking in an official capacity, said that sophisticated experienced investors were indicating that the inexperienced minority constituted about 10% of CDO investors.

These expressions of concern acquired more weight in May 2005 when Alan Greenspan, chairman of the Federal Reserve, voiced his own concerns, stating: "The rapid proliferation of derivative products inevitably means that some will not have been adequately tested by market stress." Also highlighting the benefits of derivative products, which generally spread risk, he questioned investors' appreciation of the risks of CDOs when he said that "understanding the credit risk profile of CDO tranches poses challenges to even the most sophisticated market participants."

The increasing scrutiny of the regulators has coincided with a report from the rating agency, Standard & Poor's, which has warned that some investors in collateralized loan obligations (CLOs), a type of CDO where the underlying asset is effectively debt, are at risk of investing in a portfolio of CLOs while being unaware that the CLOs in which they are investing might contain a large number of the same underlying credits as reference obligations. The global issuance of CLOs in 2005 was four times what it was in the comparable period in 2004. The report, "CDO Spotlight: Is Overlap affecting Diversity in the US CLO Market?," sets out the results of quantitative research by the agency that has sought to identify the overlap between reference obligations in different CLOs. It highlighted that some investors are opening themselves up to greater risks and potential losses if one or more of the underlying credits default, such as happened with the bonds issued by Parmalat. This real or perceived lack of diversification is seen as a reflection of the fact that some investors are not undertaking a comprehensive analysis of the underlying portfolio of reference obligations in the CLOs in which they are investing. On a positive note, the agency found that sophisticated asset managers were aware of the issue of overlap and were managing and mitigating the exposures accordingly. However, for those not aware of the issue of reference obligation diversification, the risks remain.

Reasons for concern

Why are the regulators, rating agencies and market commentators raising concerns and why at this particular time?

Economic conditions

Changing economic conditions are one reason for the increasing focus. After two years of benign economic conditions, in which spreads have narrowed and the market has seen low volatility, in 2005 a growing body of opinion believes that market conditions are about to become more difficult, resulting in widening spreads.

Hedge funds

Some commentators have expressed a view that hedge funds, which are more flexible than some other types of investment funds because of the less restrictive nature of their portfolio guidelines, could stage a retreat from the CDO market just as quickly as they arrived if the economic conditions mean funds cannot make returns from CDOs high enough to satisfy their capital investors. A simultaneous reduction in hedge funds' exposure to the sector could generate circumstances in which the difficulties prompting the retreat are in fact compounded by the withdrawal itself. It is generally accepted that the CDO market is healthy, with innovative new structured products driving the market forward, but regulators always endeavour to have one eye on the future.

Lack of understanding

Linked to these economic factors is the concern, articulated in part by Standard & Poor's, that, as a result of the growth of the market, some recent investors might not be sufficiently aware of the nature of CDO structures and the exposures and risks embedded within them. This is a concern in any market where new investors, drawn in by the returns already secured by others, fail to appreciate the potential downside of the products that have generated attractive returns. The effect of a corporate default, which is more probable in a deteriorating credit environment, might well be magnified if some investors have greater exposures to a particular sector than they appreciate. The FSA has also flagged this as a more general concern that it has in the context of the wider credit derivative market.

A lack of understanding on the part of an investor can arise in a number of ways. There will be some investors, although perhaps only a few, who have simply not understood the nature of the CDOs in which they are investing and the economic dynamics of a CDO. This misunderstanding may arise either because the investor has reviewed the contractual documentation but not comprehensively understood it or the investor, for whatever reason, may not have paid heed to the presented documents. As a result, the investor can fail to appreciate the legal rights and obligations of the respective parties to the transaction or there can be a misconception as to the nature of the economic risks that the investor is assuming, arising out of a lack of analysis of the underlying reference obligations to which the CDO is exposed. The difficulties can be compounded if the investor has a portfolio of exposures to CDOs yet did not carry out enough analysis of the extent to which underlying reference obligations are duplicated across that portfolio, or whether the reference obligations are heavily focused towards particular economic sectors, thus heightening the investor's potential exposure in the event of a series of defaults across an industry sector. There is a certain degree of transparency in the information provided to investors about a CDO's underlying assets, but that transparency can diminish when those underlying assets hold interests themselves in other assets.

CDO-related disputes

It is also a possibility that the investor might not be aware of the nature and limitations of a particular CDO because the product has been mis-described and mis-sold to the investor as something that it was not. In these circumstances, a legal dispute can quickly open up between the investor and the selling party as to how far an investor can rely upon the representations made during the sales process, how far a seller can rely upon disclaimers in the marketing documentation, how far an investor has to rely upon its own investigations and review of the contractual documentation, and how a seller can use the investment management rights granted to it.

Fortunately, there has recently been a tightening of CDO documentation and a greater degree of clarity has emerged that was not evident in earlier contractual documentation. This might, to some extent, mitigate the likelihood of CDO-related disputes as the older, more problematic deals are replaced by CDO transactions with more robust documentation.

In practice, few legal precedents shed light on the rights of the parties during the sales process for complex capital markets products, because commercial parties usually seek to resolve their difficulties without recourse to litigation and a public trial. Indeed, the need for commercial parties to work together on future transactions means many disputes never reach external lawyers, still less the public domain. Despite this, if economic conditions do deteriorate over the medium term, an increase in the number of CDO related disputes is probable as investors discover their exposure to some of the risks associated with certain types and tranches of CDOs. Should legal proceedings result, the process by which CDOs are sold to investors and the obligations of the party undertaking the selling to explain the economic risks inherent within the structure, will come under far greater scrutiny than they have to date.

Why now?

In terms of timing, there are a number of reasons why regulators and rating agencies' concerns are being aired now. These include the growing view that economic conditions might be becoming increasingly difficult, and the fact that the market for CDOs is becoming important to a much broader category of financial institutions. The greater the exposure of institutional investors and hedge funds to this sector, the greater the potential for the sector to pose a systemic risk to the wider financial system.

Lastly, there have been some high-profile legal proceedings passing through the English courts that have gained the market's attention. In 2005, HSH Nordbank resolved its dispute with Barclays in relation to a CDO that HSH Nordbank had invested in during 2000. Shortly after the settlement of those proceedings, Banca Popolare di Intra issued proceedings against Bank of America alleging that a credit-linked note had been mis-sold to it. Those proceedings have also now been settled. Other disputes, involving other parties and that have been settled before reaching the stage of litigation, have also been the subject of much market speculation.

It is necessary not to exaggerate the risks or suggest that every CDO and investor carries the same risk profile, but the indicators suggest that further disputes over investments in CDOs may well arise. Regardless of whether such disputes result in legal proceedings, they will serve to keep market attention focused on this sector both in the UK and in other jurisdictions. This consideration, together with the other concerns, can only serve to compound the regulators' interest in this sector. How far that interest develops into action may, however, be determined as much by economic as legal and regulatory considerations.

Simon Hart is a partner with Richards Butler in London