4 July 2008

How the CDO monster will unwind -litigation

A dispute between UBS and a hedge fund that sold it protection on a complicated mortgage security highlights why banks are still having a hard time figuring out the total amount they will have to write down such debt.

UBS asked Paramax Capital International to sell it protection on $1.3bn of the most highly rated slices of a CDO made up of subprime residential mortgages that the UBS investment bank underwrote. In general, by hedging the risk fully through the credit derivatives market, banks can remove such exposures from their balance sheets and do not have to set aside capital.

The dispute is one of a growing number of such legal spats as the meltdown in the value of such securities is triggering an avalanche of litigation between parties in the $63,000 billion gross market for credit default swaps.

The litigation is feeding fears that the huge but still opaque market can cause shocks as any one dispute can set off numerous ripple effects.

"There was a lot that was done and done at a fast pace," says Andrea Pincus, a lawyer with Reed Smith in New York who specialises in such disputes, speaking generally. "The sellers never expected the CDO market to drop through the floor. They underestimated their liability and exposure. Now they are trying to get out of their obligations and the buyers are trying to enforce their rights."

Paramax claims that, from the beginning, the UBS hedge was cosmetic. In May 2007, when the original agreement was signed, the terms were a fraction of the market rate. Also, Paramax had only $200m under management and its agreements with its own investors limited it to commit no more than $40m to any single deal. Thus, it could never compensate UBS fully for any meaningful loss in value of the $1.3bn UBS was trying to insure, it claims.

Paramax also claims that UBS told it that the bank would employ "subjective valuation methodologies" that meant it would not record any loss in value that could trigger calls for additional margin from Paramax. (Because credit derivatives contracts are individually tailored agreements rather than standardised documents, in fact there is some discretion in how firms value such deals.) Paramax also claims that UBS assured it that if it needed a "real" hedge, it would tear up the agreement.

However, all the banks with major exposure to subprime mortgages, including UBS, were forced to mark down the value of CDOs tied to subprime and began asking counterparties who had provided credit protection to post more collateral.

Now UBS is taking Paramax to court, seeking to compel it to pay up as the securities drop in value, alleging breach of contract. Paramax in turn is charging UBS with negligent misrepresentation.

UBS says the bank is confident in the merits of its case. A lawyer for Paramax says its allegations are supported by both written and oral statements.

The combination of subjective valuation and hedges that may not be real because counterparties cannot or will not pay goes way beyond UBS and Paramax.

For example, in one case the seller of credit protection recently discovered that the final agreement on insuring a portfolio of collateralised debt obligations had never been signed, either by it or a French bank which in this case was buying protection. Now, with the meltdown in that market, the seller has returned all the premium payments to the buyer and torn up the agreement, saying that because it was never signed, it has no legal obligation to pay up

Copyright The Financial Times Limited 2008

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