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Friday, January 29, 2010

Counterparty Risk

In 2009 we discussed in great depth many of the risks relating to both CDO structures and to their underlying securities. We'll continue to explore these nuances in 2010, but first we'll kick off with one of the risks we only covered lightly in '09 - counterparty risk.

Stepping back for a second here: the key concept is that in the complex, opaque and illiquid world of CDOs, at each credit rating level you were being paid more -- higher coupon or spread -- to assume additional risks, other than credit risks. These include but are not limited to illiquidity risks, model risk, operational, legal and counterparty risk.

We commented in a NYSSA article that: "We desperately need to move away from a culture in which investors, sophisticated or not, would buy the highest-yielding asset at each rating level, irrespective of its other-than-credit risks and without having performed an adequate analysis (or even possessing the tools or skills to perform such an analysis)."

The recent U.S. Bankruptcy Court ruling in the Dante CDO lawsuit captures several of these key risks: complexity, model risk, counterparty risk and legal risk. For an immature product (synthetic CDOs) supported by an imperfectly defined-or-tested bankruptcy process, the several layers of risks and dependencies inevitably give way when the unexpected occurs: in this case, the default of Lehman Brothers. (Lehman was single-A rated, not AAA, and so it raises an additional eyebrow that its default should impinge upon the performance of a tranche whose AAA ratings were designed to have been removed from any such dependencies.)

Debtors: LEHMAN BROTHERS HOLDINGS INC., et al.
Plaintiff: LEHMAN BROTHERS SPECIAL FINANCING INC.
Defendant: BNY CORPORATE TRUSTEE SERVICES LIMITED

Here follow some choice extracts from the ruling:

"This is a matter arising out of a complex financial structure that includes an added layer of complexity due to the pendency of parallel and potentially conflicting legal proceedings in this Court and the United Kingdom. The litigation in England (the “English Litigation”) was first commenced in the High Court of Justice, Chancery Division (the “High Court”) followed by an appeal to the Court of Appeal, Civil Division (the “Court of Appeal” and, together with the High Court, the “English Courts”). At issue both here and in the English Courts is the priority of payment to beneficiaries (one a noteholder and the other a swap counterparty) that hold competing interests in collateral securing certain credit-linked synthetic portfolio notes. The swap counterparty is Lehman Brothers Special Financing Inc. (“LBSF”), one of the Lehman entities whose chapter 11 case is before this Court.

... After a trial, the High Court issued a judgment in which it held, inter alia, that LBSF’s interest in the collateral securing the Swap Agreements (the “Collateral”) was “always limited and conditional,” and, therefore, payment pursuant to Noteholder Priority did not violate the so-called “anti-deprivation principle” under English law.

... the Court has learned that the Debtors are perhaps the most complex and multi-faceted business ventures ever to seek the protection of chapter 11. Their various corporate entities comprise an “integrated enterprise” and, as a general matter, “the financial condition of one affiliate affects the others.”

... The issues presented in this litigation are, as far as the Court can tell, unique to the Lehman bankruptcy cases and unprecedented. The Court is not aware of any other case that has construed the ipso facto provisions of the Bankruptcy Code under circumstances comparable to those presented here. No case has ever declared that the operative bankruptcy filing is not limited to the commencement of a bankruptcy case by the debtor-counterparty itself but may be a case filed by a related entity -- in this instance the counterparty's parent corporation as credit support provider. Because this is the first such interpretation of the ipso facto language, the Court anticipates that the current ruling may be a controversial one, especially due to the resulting conflict with the decisions of the English Courts.

One of the distinguishing characteristics of the Lehman bankruptcy cases is the complexity of the underlying financial structures many of which are being analyzed for the first time from a real world bankruptcy perspective. It is to be expected, as a result, that the cases of LBHI and LBSF on occasion would break new ground as to unsettled subject matter. This is one such occasion.

This decision places BNY in a difficult position in light of the contrary determination of the English Courts confirming that Noteholder Priority applies to claims made against it in England by Perpetual. This is a situation that calls for the parties, this Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting
judgments.

For more on counterparty risk in CDOs, see: Hedged Trades: Lessons from the Crisis (slide 9)

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