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A $92 million mistake, or was it?

May 20, 2011

Once again, Credit Sails make Business Day, only this time, the well trained journalist takes advantage of ongoing litigation in the United States, Loreley Financing vs Calyon.  Please or find the article, published May 18 below or by clicking here.

Here’s a scenario. You are a financial institution. You advise clients to invest millions in a certain stock. It bombs. You lose all your clients’ money.

Do you:

  1. Shrug?
  2. Sue?

The answer in New Zealand is usually “a”, but Americans hate losing money so much they regard any loss as probably someone’s fault.

Hence a major lawsuit in the Supreme Court of the State of New York between Loreley Financing and Credit Agricole Corporate & Investment Bank, also known as Calyon.

If the latter name sounds familiar, it may be because Calyon, a unit of huge French bank Credit Agricole, was the arranger and promoter a few years ago of a New Zealand product called Credit Sails, which turned $92 million into zero in relatively short order.

We’ll come back to that, but first Loreley v Calyon.

Loreley, a New York group, was part of an arrangement set up by Canadian Imperial Bank of Commerce and IKB Deutsche Industriebank of Germany to invest in collateralised debt obligations – CDOs.

Between June 2006 and July 2007 Loreley bought three CDOs from Calyon – Orion, Pyxis, and the ironically named Millstone – investing a collective US$70.5 million.

A standard CDO involves the acquisition of a real loan portfolio with its cashflows from repayments sliced into different priorities, from low risk, low return to high risk, high return.

But Calyon was selling synthetic CDOs, in which a loan portfolio was referenced through a credit default swap. Like an insurance deal, Loreley was effectively putting up capital to protect someone else against losses in the reference portfolio, receiving income from “insurance premiums” in exchange.

In financial parlance, Loreley was “long” on the deal, because its returns relied on the continued strength of the portfolio, while the other party was “short”, because it would get a payout if the portfolio suffered defaults over a certain threshold.

It did. Or rather, they did.

C’est la vie, n’est-ce pas? You win some, you lose some.

Pas du tout, says Loreley.

Smelling a rat, it alleges the reference portfolios on Orion and Pyxis were influenced by hedge fund Magnetar, which then took the short side of the CDOs.

In its statement of claim, Loreley says: “Eager to churn out CDOs, Calyon allowed Magnetar to secretly control the selection of collateral for at least two of the Constellation CDOs, Orion 2006-1 and Pyxis 2006-1, knowing that Magnetar would select only weak and poor quality assets and bet against the success of the CDOs by taking short positions and profit when the deals failed.”

Loreley’s claim includes this helpful description of the alleged structure cribbed from Econned, a book about the financial crisis by Yves Smith.

“The Hedgie (i.e. Magnetar) purchases ‘short’ protection from the Dealer (e.g. Calyon) through CDS on the bonds referenced in the synthetic portion of the CDO portfolio. The Dealer has now committed to sell CDS protection against … assorted BBB trash [i.e. the Dealer is itself ‘long’]. At the moment this is exclusively the Dealer’s risk, so Dealer needs to get rid of this risk as quickly as possible. That means coming up with investors in the CDO.

“The Dealer (i.eCalyon) thus arranges and markets a CDO to long investors, such as the Loreley Companies, who contribute hundreds of millions of dollars to the CDO Issuer in exchange for notes. At closing, the Dealer buys protection from the CDO Issuer that is back-to-back with the short protection that the Dealer has sold to the Hedgie. The Dealer has thus passed its long position to the CDO investors who have no idea that the CDO came about on the order of a short investor that sponsored and controlled the deal. The cash infused by the long investors is then used to pay the short investor when the deal it created fails. That is precisely what happened in the Orion 2006-1 and Pyxis 2006-1 CDOs.”

For the other CDO, Millstone, it appears someone at Calyon may have had a dark sense of humour and Loreley a limited knowledge of English idioms.

Apparently, Calyon’s CDO staff defected en masse in December 2006, forcing Calyon to quit the CDO business in a hurry.

To get rid of its asset inventory, Loreley alleges, Calyon marketed and sold the Millstone CDO on the basis of the purportedly high credit quality of its underlying assets, but “in reality, Calyon stuffed the Millstone IV CDO with weak and poor quality assets that it wanted to unload”.

The assets were a millstone round Calyon’s neck, presumably.

I should point out here that Calyon is denying the allegations and defending the lawsuit, as are its co-defendants NIBC Credit Management and Putnam Advisory. As the case stands, the parties are fighting preliminary skirmishes over Calyon’s attempts to strike out the action and resist document discovery.

However, observers may recall the remarkable similarity between this case and the US Securities & Exchange Commission’s case against Goldman Sachs, in which it alleged Goldman sold long positions on a synthetic CDO called Abacus, knowing the collateral had been influenced by the party on the short side, Paulson & Co.

Last July Goldmans settled the lawsuit by paying a record penalty of US$550 million, admitting its marketing of Abacus was inaccurate.

So, back to Credit Sails.

Like Abacus, Orion, Pyxis and Millstone, Credit Sails was based on a synthetic CDO, only this one referenced a portfolio of corporate bonds rather than mortgage-backed securities.

The long position was taken by New Zealand retail investors – mums and dads mostly – most of them clients of sharebroker Forsyth Barr, which was also lead manager, organising participant and underwriter of the offer.

The short position was taken by … well, we can’t be sure who ended up with it, but the offer documents say it was Calyon as CDS counterparty.

As it turned out, the short position was the winner as defaults from the bond portfolio triggered the insurance payout and wiped 100 per cent of the New Zealand investors’ money.

The question is, was the bond portfolio – which had to be fixed for six years – selected to benefit the holder of the short position?

The offer documents don’t say who selected the portfolio, though this information was regarded as crucial by the professional investors in the likes of Abacus and Orion.

But we do know that changes were made to it at the last minute which increased the portfolio’s exposure to the subsequent credit crisis and the US subprime mortgage market.

In the weeks between May 3, when the investment statement was published, and June 13, when the trust deed was signed off, 12 bonds in the portfolio were changed. The new ones included a further two Icelandic banks – Kaupthing and Landsbanki – mortgage lender Washington Mutual, major US house builder Centex and bond insurer Ambac.

There was also Verizon, whose heavily indebted directories unit Idearc was spun off later that year.

Among those removed from the portfolio were US food company HJ Heinz, Chinese oil company CNOOC, British airport operator BAA and Dutch energy company Essent.

Unfortunately Credit Sails was hit by several bond defaults from September 2008 that ultimately caused 100 per cent loss for New Zealand investors. They were:

Lehman Brothers, September 15

Washington Mutual, September 29

Landsbanki Islands, October 7

Glitnir, October 8

Kaupthing, October 9

Idearc, March 31, 2009.

So of the six companies triggering the complete wipeout for the long side of the CDS, four were introduced to the reference portfolio between May 3 and June 13.

Of others that didn’t fail at the time, it’s interesting to note that Ambac filed for bankruptcy protection last November and Centex ran up a loss of US$2.7 billion in 2008, closed its big mortgage lending business and was acquired by rival builder Pulte in 2009.

With such a series of unfortunate events it seems reasonable to ask, did the portfolio fall, or was it pushed?

It’s a question no one at Forsyth Barr seems interested in asking. Rather than fight tooth and nail to recover money for clients or investigate the strange provenance of the reference portfolio, the firm meekly passed the buck to the product’s trustee, Public Trust.

After seeing the mess corporate trustees made of supervising finance companies, the idea that Public Trust could investigate a complex credit default swap like Credit Sails is, I think, ludicrous.

Last November Public Trust told investors it had found nothing untoward, which is probably not surprising since its investigation consisted of writing letters to Calyon and discussing ratings methodology with Standard & Poor’s and Moody’s.

It also took independent advice, though who from it didn’t say.

Returning to the question posed at the beginning, the answer for Forsyth Barr looks like (b) shrug.

Is that the right answer? I don’t think so.

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