Tuesday, April 15, 2008

‘Tranche warfare’ breaks out over CDOs

(FT) “Tranche warfare” has broken out in the $450bn market at the heart of the credit crunch as hard-hit investors scrap over the pools of debts that make up ­so-called collateralised debt obligations.

Some investors in the differently rated and ranked slices of CDOs – known as tranches – have taken advantage of the ­little-noticed terms in the ­structuring of such instruments to seize control of the assets and cut off payments to other debt-holders.

Such conflicts have resulted in lawsuits as investors question the rights of others, such as senior noteholders who supposedly hold the least risky tranche of a CDO. Trustees of some debt, including Deutsche Bank and Wells Fargo, have filed suits aimed at ensuring money continues to be paid to holders of the credit instruments.

“Investors agreed to terms which give senior noteholders control following certain triggers because they thought these were never going to happen,” said Ed O’Connell, a partner at Jones Day, a law firm. “Many CDOs are now hitting the triggers. This is creating conflicts of interest and losses and an uptick in litigation, too.”

The fights between tranche owners is another example of how little attention investors paid to the exact terms and conditions in the rush to complete CDO deals.

It also highlights the potential for stress in the structured finance market, as ratings downgrades of assets backing bonds in turn trigger more losses or ratings downgrades.

Specifically, downgrades of some of the bonds backing CDOs are triggering little-noticed “event of default” clauses, which often allow senior noteholders to take control of all the income.

Senior noteholders can then accelerate payments from the CDO, which leaves other investors with the prospect of no interest payments for months or years, and also gives them no say in whether or not the instrument should be liquidated.

The value of CDOs backed by risky subprime mortgages has plunged with the downturn in the US housing market. This is one reason for massive writeoffs on investments at banks, which hold many of the senior CDO notes.

“A good portion of the banking sector’s writedowns to date stem from super-senior holdings,” says Vishwanath Tirupattur, a strategist at Morgan Stanley.

“Thus far, a majority of deals being liquidated are ones where banks are super-senior holders. There is an incentive to liquidate and not endure further pain.”

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