Editor: Please tell our readers about your work in the Eversheds subprime initiative.
Allen: I am leading the Eversheds LLP team which draws on lawyers from our banking, restructuring and dispute management groups. Since the middle of last year we have been engaged in wide ranging discussions with a whole host of institutions, clients, contacts, and professional services companies that operate in this space. We have been exploring with them the issues as they develop and have provided a forum for discussion and debate. We have found in that process that a number of themes have started to emerge, particularly in the context of how European companies are responding to the threats posed by the structured products market. This has in turn led to a number of instructions.
Editor: Doesn't the problem involve a credit crisis that goes beyond the subprime issue?
Allen: This may have started out as a U.S. issue with the collapse in the subprime market but it is now very much a global problem, with all structured products tainted by association and many SIVs, hedge funds and other entities struggling to obtain lines of credit to keep their businesses going. This is a global phenomenon and Europe is far from immune. Many of these structures were put together or sold outside the U.S. by investment banks in London, Frankfurt and elsewhere. The European CDO market was getting pretty big by the middle of last year and continues to operate at some level although deals are much smaller and far less complicated. The other issue is that while certain products did major in the subprime area the default risk in many of these baskets arose from a variety of different sources including high yield bonds, consumer finance and corporate debt, and of course the use of synthetic structures allowed massive leverage which in some cases has wildly exaggerated the effect of default when it occurs.
Editor: What is the role of your firm in this picture?
Allen: At the moment the big issue in Europe is not one of litigation against the banks but the question of loss crystallization and loss mitigation. A lot of these deals are now going into early pay down or are at risk of going into early pay down; they are being accelerated. Even up to the turn of the year many institutions were to an extent paralyzed by this challenge. Now people are being much more proactive in terms of seeking to put pressure on CDO managers and trustees to ensure that events unfold in a way which will be of greatest benefit to them. What this is doing is flushing out a lot of embedded issues such as dubious collateral substitutions, conflicts of interest and arguments over how deals should be unwound or creditors handled during a refinancing or winding up, particularly where SIVs are concerned.
Where the deals were bespoke and investor led the arranging banks are at risk, but the main focus in most of the arms length transactions has been the role of the collateral manager. When the markets in structured financial products started, they were often static in the sense that a bunch of assets would be bought and a coupon paid out of the income during the life of the structure and that the pool of assets would never change. That very quickly changed as the deals became dynamic and managed, so a manager was employed by the special purpose vehicle (SPV) issuing the notes to buy and sell collateral for the life of the product in an effort to maximize the return. As a result manager quality and the extent of their discretionary mandate came to be a key risk factor in these deals.
The collateral manager may be the daughter company of an investment bank or another financial institution. As the CDO market matured, a number of the financial whizz kids jumped ship and created their own companies as there was a huge amount of money to be made trading the collateral. Whether or not they were in part capitalized by some of the banks isn't clear, but they are in effect institutional managers. The credit pool could be made up of cash assets ( i.e., direct exposure to the underlying default risk) or be purely synthetic in that you have a derivative exposure to an underlying reference portfolio through a credit default swap and other structures.
Editor: Are credit default swaps involved in this as well?
Allen: Yes, they were the principal way of getting synthetic exposure to the default risks because you effectively sell credit protection to another party, thereby getting exposure to and margin from a default risk which you otherwise would have no connection with. The swap can involve enormous exposure because, although it references the underlying default risk, it may create a potential liability many times that underlying exposure.
Editor: Does all of this involve conflicts of interest?
Allen: A big issue that has been identified in our discussions is the conflicts of interests which are inherent in these structures. Many of these conflicts were recognized and in fact commonly disclosed in the offering memoranda. For example, it would be common for a CDO manager to advise lots of different CDOs in respect to the same collateral pool. That CDO manager might also be receiving fees from the originators of asset backed securities which are then purchased by the CDO manager for his asset pool. And there might be all sorts of cross holdings in terms of directorships and equity holdings.
These were known conflicts within this industry which were recognized and often disclosed. But there are other conflicts which were not disclosed and arguably were misrepresented. The one that keeps coming up is the situation where the CDO manager was an equity noteholder in the deal. This was actually sold in most instances as a deal benefit; the idea being that if the CDO manager has skin in the game, then he ought to be incentivized to perform to the best of his abilities for the benefit of all noteholders.
Unfortunately, because of the way the subordination operates if you are an equity noteholder then clearly you are at greatest risk of losing your capital and you are therefore incentivised to carry out a high correlation low diversification investment strategy. That is to say, it is in your interests to put all of your eggs into one basket because that offers you the best possible chance of you getting your money back. The downside to that is that it also increases the likelihood of investment grade noteholders also losing their money. Their interests are best served by a highly diversified investment strategy, so you have immediate tensions built into these deals as a consequence of the manager being an equity noteholder.
The other aspect to this is, as an equity noteholder, your main interest in the deal is the excess spread, by which I mean that, to the extent the collateral pool can generate income in excess of the liability to pay the coupon on the notes, the excess spread goes to the benefit of the equity noteholders. What that does is to incentivise the manager, as an equity noteholder, to pursue a high yield strategy. The more likely a bond or credit asset is to default the higher the yield or the higher the spread. Increasing the excess spread is in the manager's interest, but from the investment grade noteholders point of view this was not so great because they were looking for more security and overall asset credit quality.
What happens as part of the syndication is a process of subordination with the default risk being concentrated on the equity noteholders. The idea is that they act as a buffer with the result that the deal will have to lose a lot of money before it starts affecting the mezzanine noteholders, let alone the AAA investors. However, with the CDO manager incentivized to put all his eggs in one basket and to pursue a high yield strategy this arguably undermined the whole rationale. The interesting thing about conflicts as a legal concept is that they are internationally viewed as a bad thing and that they need to be properly disclosed. Most jurisdictions would recognize that what you are in fact looking for is full disclosure and the informed consent of all contracting parties and that without that there is a possibility the deal can be unwound.
Editor: Where were the in-house legal and group risk teams while all this was happening?
Allen: What has emerged from our discussions about these structures is that there is often a surprising lack of knowledge within these teams about the risks. These structures were considered rocket science and were dealt with by the product teams and external counsel and often in-house legal and group risk had a limited role so in some institutions there is now something of a knowledge gap when it comes to unraveling events forensically.
Editor: What was the consequence of the failure to indentify the risks involved?
Allen: At the end of the day, the issue was how much capital should be allocated against the potential risks associated with these structures. Everybody thought they were safe in the sense that the structures were rated AAA and it seemed like pretty much all the other institutions were involved and the default risk was therefore negligible. Having said that, I have spoken to a couple of banks that took a more pragmatic view. One, in particular, pulled out of this market about three years ago because one of their risk guys looked at the book and decided that they needed to allocate a level of capital to it which the board just wasn't prepared to support. It was either great foresight or good fortune or both. They are sitting back smiling now, but not many other banks seemed to go through this process.
Editor: What is the background at Eversheds that enables you to serve clients with respect to the outcome of some of these deals?
Allen: We have a very strong financial services and banking practice here and a lot of embedded knowledge. Our work over the last few months has also given us a tremendous insight into how the market is currently behaving. We have been heavily involved over the years in a lot of financial structures that have gone wrong including systemic problems within the industry such as split capital trusts and structured capital at risk products as well as issues around trading, settlement, treasury and counterparty disputes in wholesale markets. We also have an award winning approach to dispute management called RAPID resolution which is all about identifying strategic exit points at the outset of a problem and project managing the issues in a transparent way and with cost certainty wherever possible. Formal litigation is in our experience rarely the right solution and with our multi disciplinary team and commercial focus we can help clients manage their exposures in a pro active way without riding a coach and horses through what might be sensitive commercial or shareholder relationships.
Published May 1, 2008.
