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Bankers in the gun, but no NZ bullets

November 7, 2011

Bankers in the gun, but no NZ bullets

TIM HUNTER

Last updated 16:39 07/11/2011

The wheels of justice grind slowly, especially in New Zealand.

Some readers may recall a nasty financial product called Credit Sails, which generated a total loss for Kiwis who bought into it.

In my view the failure of Credit Sails three years ago smelled like a bag of frozen squid bait forgotten and left to thaw on a boat after a fishing trip (yes, eew).

It was interesting, therefore, to see this story in the Financial Times last week, recording that a group of Singaporean investors had been granted leave to sue investment bank Morgan Stanley in a New York District Court.

Their grievance bears a remarkable similarity to the experience of Kiwi investors in Credit Sails (some background is available herehere and here).

The case – Dandong et al v Pinnacle Performance Ltd et al  – was filed in October last year and involves US$154.7 million invested, and lost, in a product created by Morgan Stanley called Pinnacle Notes.

Some of the claims in the case will ring a few bells with investors in Credit Sails.

At the heart of the Pinnacle product was a complex structure called a synthetic CDO, or collateralised debt obligation.

In essence, synthetic CDOs work like insurance – money from the investors provided capital to protect someone else against an adverse event, in exchange for an income stream.

In Pinnacle, it appears the money invested by the Singaporeans ended up covering Morgan Stanley against default in particular portfolios of bonds. The portfolios, assembled by Morgan Stanley, included bonds issued by three Icelandic banks – Landsbanki, Glitnir and Kaupthing – as well as exposures to the leveraged US housing market and risky corporate debt through entities such as Washington Mutual, Idearc, Lehman Brothers, Freddie Mac and Fannie Mae.

As with ordinary insurance, these arrangements can work well for both parties, but also as with ordinary insurance, they can be skewed to one side’s advantage.

For example, if someone takes out health insurance knowing they have just been diagnosed with a serious illness, this is not so much insurance against risk as a one-way bet.

This is basically what the Singaporeans allege occurred with Pinnacle. According to their statement of claim: “Morgan Stanley funnelled plaintiffs’ … investment in the Pinnacle Notes into a rigged financial instrument of Morgan Stanley’s own design, in which it had simultaneously positioned itself as the party to benefit when that instrument failed.”

Among the claims, they allege Morgan Stanley knew, as did other investment banks, that Icelandic banks were likely to fail and that a winning strategy would be to buy protection against that failure – a strategy achieved through products such as Pinnacle.

Morgan Stanley, of course, denies the claims. And while the investors won the right to sue the bank for fraud in New York, they were not permitted to pursue their claims for negligent misrepresentation, breach of fiduciary duty or unjust enrichment.

The relevance for Kiwi investors is that Credit Sails had a similar structure to the Pinnacle Notes.

There was a synthetic CDO at the heart of the structure, there was a reference portfolio of corporate bonds whose exposure to risky Icelandic banks and US housing related debt was boosted at the last minute, there was an investment bank appearing to be both designer and beneficiary of the insurance, and there were investors who thought they were buying into a low-risk product.

The investment bank on Credit Sails was Calyon, now known as Credit Agricole Corporate and Investment Bank.

Calyon has not been immune to fallout from the financial crisis and was sued by New York financial group Loreley over its role in creating synthetic CDOs based on mortgage-backed securities. The products caused huge loss for Loreley and triggered legal action in New York Supreme Court, with Calyon alleged to have designed them to fail so as to benefit from the “insurance”.

It appears that legal action was settled on confidential term in the last few weeks, although it is understood Loreley won a substantial payout.

What all this suggests is if Kiwi investors want to have a go at recovering the tens of millions they lost in Credit Sails they may have a case worth pursuing.

If the practices alleged by the Dandong investors occurred in Credit Sails, it would be a shame to let the bankers get away with it.

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