A ticking time bomb?

The legacy of the early days of the synthetic collateralised debt obligations market could be a painful future for many of the institutions involved. In September, news broke that German landesbank HSH Nordbank was suing Barclays Capital for losses sustained from a $151 million synthetic CDO first issued in 2000, but which has later undergone multiple substitutions in the underlying collateral pool (see New Angles, for full story).

At first glance that’s nothing out of the ordinary. The problem is, these substitutions took place during one of the most dramatic downturns in the credit market’s history (certainly since the invention of CDOs), and suddenly a ‘safe’ investment was looking rather unhealthy.

Who is responsible for the losses sustained on these CDOs? The general rule, except in cases of gratuitous mis-selling (which is not alleged here), is caveat emptor.

But Barclays admits it made errors in the structuring and particularly the management of the CDO in question. Including aircraft leases post 9/11 looks bad when the overall losses were taken into account, but was this part of a prudent diversification of the risks in the pool as new credits, other than telecoms, became available, or an attempt to offload toxic waste to a client?

The two sides seem entrenched and ready for a court battle that will be the most high profile of its kind. But, particularly if HSH Nordbank is eventually successful, I doubt if it will be the last.

Those early days of the CDO market came against a backdrop of a mad rush among European institutions to get exposure to the bright new world of credit. Why bother going into the market piecemeal and gradually building that exposure when you could almost overnight hold a large amount of highly diversified credit risk through a synthetic CDO?

It seemed like a good idea at the time, particularly as many institutions were scared of missing the boat. But mistakes were made on all sides; without the recent downturn, there may have been no major after-effects, but now both investors and banks are sitting on heavy losses.

It’s always risky to speculate, but it’s a safe bet to say that a large number of HSH/Barcapstyle cases have already been settled out of court. Investment banks must be worried that any institution that lost money through an old synthetic CDO, where there’s even a hint of impropriety or poor management involved, is now considering whether it too can recover some of those losses.

The irony is that the CDO market is currently in the best of health, with secondary trading rising, and better and more sophisticated participants in the market, as we report in our CDO special report Credit risk beginning on page 19.

Also this month we look at the potential for the fast-growing structured products market. Fund managers are having to adapt quickly to the threat posed by these new products, as we report on page 46.

To help meet the need for more information on this market, Risk’s owners Incisive Media will launch in October a new, dedicated monthly publication, Structured Products. We are sure it will provide invaluable insight into an exciting, growing market.