Bloomberg Columnists
Mark Gilbert is a columnist for Bloomberg News. The opinions expressed are his own.
Barclays Opens Up a Pandora's Box of Derivatives.By Mark Gilbert
SourceFeb. 18 (Bloomberg) -- A Pandora's box threatens to creak open in the derivatives market, as aggrieved investors seek compensation from banks that sold them collateralized debt obligations whose ratings and value subsequently plummeted.
HSH Nordbank AG, a Hamburg-based lender, sued Barclays Plc over $151 million of collateralized debt it bought in 2000. The German bank said the bonds ``if saleable at all, have become worth a very great deal less.'' The London trial was set for Feb. 21.
The case raised the tantalizing prospect of a whole basket of dirty derivatives laundry airing in public. Pre-trial document teasers included claims that Barclays invested HSH's notes in another Barclays issue called Taunton, which invested in a Barclays issue named Flavius, which itself invested in Barclays notes called Savannah II, which bought part of two more issues, Dorset and Tullas, from (you guessed it) Barclays.
``Contrary to its duty and to its promises, Barclays substituted poorly performing assets,'' including buying aircraft- lease securities after terrorist attacks destroyed the World Trade Center on Sept. 11, HSH said in an outline of the case filed in the U.K. High Court in December.
Barclays said it did nothing wrong in its selling or management of the HSH bonds, which were named Corvus. The case notes said the London-based bank ``blames the fall in value of the Corvus notes primarily upon market conditions.''
Undisclosed Settlement
On Feb. 14, Barclays and HSH issued a joint press statement saying they'd reached a settlement. The terms of the accord weren't released. Given that HSH said it invested a further $420 million in two other collateralized debt sales managed by Barclays, the accommodation could have been for anything from zero to $571 million. It looked like those of us hoping to see a car crash in the derivatives market would be disappointed.
Later that day, though, Italy's Banca Popolare di Intra Scrl said in a statement through the Italian exchange that it's suing Bank of America Corp. in the U.K. courts for selling it ``securities having a higher risk than was represented by the seller and for an excessive price with respect to their risk level.''
The Italian bank, based in Verbania, wants the U.S. lender to either rewind the sales, which took place in 2000 and 2001, or pay it 40 million euros ($52 million) in compensation. Bank of America said ``the allegations are unfounded.''
$350 Billion Question
So here's the question: How many other owners of the $350 billion of collateralized debt that was in the market by mid-2002 are forming a line to sue their bankers?
To make a collateralized debt obligation, you bundle together a package of other securities, such as corporate bonds or credit- default swaps tied to company creditworthiness. By splitting the package into slices of differing quality, you make the riskiest portions absorb any losses first, cushioning the higher-rated pieces.
Yet, just as the collateralized debt market started to take off at the start of the decade, global creditworthiness plunged. Some 16 percent of securities that had AAA ratings in January 2002 lost their top grade in the next few years. The newfangled securities soured much more rapidly than other, similar asset- backed bonds had done in the past.
The collateralized debt owned by HSH, for example, started life with ratings of AAA to BBB from Fitch Ratings, all above investment grade. By the end of last year, they had dropped by at least 11 levels, to between BBB- and CC, well below investment grade.
Booming Market
The credit derivatives market has boomed in recent years, becoming very lucrative for the banks and traders involved. Recruitment consultants estimate that bonuses for U.S. derivatives professionals climbed as much as 20 percent last year as banks paid up to stop top performers from jumping on the hedge-fund bandwagon.
Barclays, for example, said in its 2004 earnings report that it held more than 191 billion pounds ($360 billion) of credit derivatives last year, a fourfold increase from the previous year, as measured by notional value. Moody's Investors Service said last month it rated $56 billion of European collateralized debt backed by default swaps in 2004, a 20 percent gain from the previous year.
As the credit derivatives market has grown, standards have improved. Everyone uses the same standard documents, and the rules governing changes in the baskets of assets underlying collateralized debt have been tightened. That wasn't the case at the start of the decade, when banks were still experimenting.
The decision by Barclays to settle with HSH will have given heart to any investor that's considering going to court to seek compensation. It's easy to see why even a bank convinced of its own innocence would rather pay off a litigant than see details of its derivatives dealing pored over in a lawsuit.
Maybe there won't be a flood of similar complaints. Still, as Dennis Gartman, editor of the daily market strategy report Gartman Letter, often points out, there's never only one cockroach.