Banks' CDO Litigation Risk

 |  Includes: BAC, C, CS, DB, GS, JPM, MER, RBS, UBS
by: Gene Phillips

There are numerous themes we’re seeing with regards to arbitration claims and lawsuits filed and submitted against the broker-dealer houses. One major theme is the possible misrepresentation, or material omission, of risks associated with investments in complex CDO products that subsequently went bad, or awful.

Certain CDOs are good: the run-of-the-mill CLOs, for example, turned out just fine (aside from some slight hiccups with certain Lehman LCDS CDOs that were hit by the torturous ipso facto clause decision in U.S. bankruptcy court). Several market participants, however, are trying to estimate comparative litigation risk by estimating the percentage market share of all CDOs, assuming that all CDOs are toxic. This is a mistake: it usually portrays banks like JP Morgan (NYSE:JPM) as a comparatively high litigation risk (>10% market share) by this metric, whereas JPM was indeed rather a small player (<4% market share) in structuring the CDOs that subsequently underperformed. The opposite seems to be true for Goldman Sachs (NYSE:GS).

Thus, one needs to separate the “good” CDOs from the rest before tabulating the litigation risk for underwriters, as lawsuits usually revolve around the “damages” caused by any alleged material misrepresentations (or omissions).

Here is our list of bookrunners’ by cumulative market share of ABS CDOs, CRE CDOs and CDO-squareds structured. It does not purport to be entirely accurate, but represents the best breakdown we could put together based on the approximately $420bn of “problematic” CDOs we’re able to track.

Underwriters of ABS CDOs (incl. CRE CDOs) and CDO-squareds
1 Merrill 17.96%
2 Citigroup 13.77%
3 UBS 10.10%
4 Goldman Sachs 8.28%
5 Wachovia 6.73%
6 Credit Suisse 6.46%
7 Deutsche Bank 5.85%
8 Calyon 4.51%
9 Bank of America 4.20%
10 RBS Greenwich 4.11%
Others 18.03%
Click to enlarge

Aside from client disclosure or non-disclosure issues in the marketing of CDOs, banks continue to face many of the same litigation battles that challenge hedge funds, registered investment advisers, insurance companies and the like: their internal pricing, risk, and accounting controls and corporate governance procedures are being heavily scrutinized.

Among other things, regulatory bodies are investigating the extent to which the board was informed of, and played a role mitigating, the key risks facing the financial institutions. The true independence of the risk management function is another concern gaining increased interest, as is what may be called the active adverse selection of prices from external (or even internal) pricing sources. This is conceptually similar to a mix of ratings shopping and forum shopping.

One choice excerpt brings together many of these themes.

The SEC has commenced proceedings over the pricing procedures of securities backed by subprime mortgages in certain mutual fund and closed-end fund portfolios. The SEC’s Order alleges, in addition to fraudulent manipulation of the funds’ securities prices, that:

A certain registered broker-dealer affiliate of the Adviser (the “Distributor”)] and the Valuation Committee failed to comply with the Valuation Procedures in several ways, including: (1) pricing decisions were made by lower level employees in the Distributor’s Fund Accounting Department (“Fund Accounting”) who did not have the training or qualifications to make fair value pricing determinations; (ii) Fund Accounting relied on “price adjustments” provided by the Portfolio Manager without obtaining any basis for or documentation supporting the price adjustments or applying the factors set forth in the Valuation Procedures; (iii) the Distributor gave the Portfolio Manager excessive discretion in validating the prices of portfolio securities by allowing him to determine which dealer quotes to use, without obtaining supporting documentation; and (iv) neither the Valuation Committee nor the Distributor ensured that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for many months at a time. Further, the Adviser adopted its own procedures to determine the actual fair value of portfolio securities and to “validate” those values “periodically.” Among other things, those procedures provided that “[q]uarterly reports listing all securities held by the Funds that were fair valued during the quarter under review, along with explanatory notes for the fair values assigned to the securities, shall be presented to the Board for its review.” The Adviser failed to fully implement this provision of its policy. The Portfolio Manager was aware that the “price adjustments” he provided, which in many cases were arbitrary and did not reflect fair value, were used to compute the Funds’ NAVs.

Disclosure: Author holds a long position in JPM