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Libor rate-fixing amplified CDO losses, experts say
NEW YORK, July 20 (IFR) - The manipulation of Libor rates increased losses for investors saddled with toxic assets in the financial crisis, say lawyers and analysts evaluating the prospects for litigation over the scandal.
Many collateralized debt obligations (CDOs) were hedged with interest rate swaps, they say, and inflated payments on those swaps siphoned away money that should have gone back to investors.
Moreover, many CDOs are structured so that counterparties to those swaps are paid first, even ahead of investors in the most senior tranches of the structures -- many of which were already performing badly in the throes of the financial crisis.
"Especially for CDOs whose underlying pool of securities had to be 100% hedged, lower Libor meant ridiculously large payouts each quarter to bank counterparties -- up to $8 million to $10 million per year for some deals," said Guillaume Fillebeen, a director at PF2 Securities Evaluations, a consulting group focusing on CDO evaluations for hedge funds and other asset managers.
"The burden of having this payment is essentially like having an extra senior tranche in the CDO. We are already engaged on a CDO-related Libor case with a law firm, trying to quantify how much the manipulation in the rate increased losses," Fillebeen said.
"These are just the early stages. There will definitely be more litigation around this topic -- possibly a class action."
The swaps contracts were widely used to hedge against interest rate mismatches between fixed-rate assets and floating-rate liabilities, or vice versa.
In the typical fixed-to-floating interest rate swap embedded in many CDOs, the CDO structure agreed to pay out a fixed strike rate over the life of the contract, while the counterparty, typically a bank, paid back a floating-rate amount based on Libor.
Investors complain that the CDOs' hefty fixed-rate quarterly payouts -- generally set at 5% or higher in 2006 and 2007 -- have far eclipsed the unfairly diminished Libor-linked floating-rate payments the structures received in return from the counterparties.
Legal experts say even a small increase in Libor from 2008 onward would have cut the CDOs' net payments significantly, freeing up more money for investors, many of whom were already badly burned when their securities turned sour in the crisis.
Many CDOs are still shelling out exorbitant quarterly payments, experts say, and senior noteholders probably suffered the most.
"If the CDO was on the receiving end of payments based on Libor, and it was paid Libor plus 1% instead of Libor plus 3%, that's a major problem, because over several years the CDO got less than it should have," said Craig Wolson, a structured finance lawyer and consultant who specializes in CDOs.
"Depending on the size of the interest rate swap, it could be real money lost," Wolson said.
Charles Miller, a partner at the New York law firm of Kasowitz Benson Torres & Friedman, said he was not aware of any CDO litigation over Libor thus far, but that investors may have an argument to make in court.
"Even in a CDO that had been liquidated, if you can prove that noteholders received less value because swap payments were a certain percentage higher than they should have been, there may be a claim," Miller told IFR.
"Even prior to a CDO's collapse, or when the portfolio is underperforming or reaching an event of default, at that point investors were already getting shorted," he said.
TRUPS TAKE A HIT
While all structured finance CDOs containing interest rate swaps may have been affected by the Libor manipulation, PF2's Fillebeen reckons that so-called trust-preferred (TruPS) CDOs were the worst hit, because their underlying assets pay a fixed coupon for the first five to ten years, and then switch to floating-rate. The fixed coupons therefore need to be hedged.
The underlying trust-preferred securities are hybrid securities with characteristics of both subordinated debt and preferred stock. They enable small banks and insurers to raise capital on a tax-advantaged basis without diluting shareholder equity. Because banks and insurers experienced significant writedowns due to poorly performing residential and commercial loans, many TruPS have defaulted since the crisis, impairing the performance of CDOs that rely on their cashflows.
In one quarter of 2008, an $800 million TruPS CDO from FTN Financial's I-Preferred Term Securities series (created in 2006) paid out a net amount of about $2.2 million to its hedge counterparties (the Libor rate quoted at the time was 2.80%), according to Fillebeen's analysis.
Increasing Libor by 70 basis points would have reduced that net amount to roughly $1.5 million quarterly, so the CDO would have ended up saving some $2.8 million for each year that the swaps were outstanding.
Even aside from the swap payment, had Libor been higher, there would have been other benefits to investors, specialists say. The floating-rate collateral would have generated more interest, and accrued interest on the liabilities would have been greater.
Ratings agencies have acknowledged the damaging effect of the embedded swaps for at least two years. As recently as late May, Moody's downgraded a 2005 TruPS CDO, Alesco Preferred Funding VII, underlining that the swap was draining the excess spread available to the transaction.
"The deal is negatively impacted by large imbalanced fixed-floating interest rate swaps, resulting in payments to the hedge counterparty that are absorbing a significant portion of the excess interests," Moody's analysts wrote.
One managing director at another ratings agency who spoke to aggrieved investors confirmed the problem, saying that deeply distressed CDO bonds were not paying interest, and any cashflows that came in were going out to the swap counterparties first.
Even more troubling for investors, the structures actually allow the trustees to dip into principal proceeds to pay interest.
"There would be more money available to the CDO if Libor was higher in 2008 and after," the ratings manager said. "Investors are not getting the money they're due."
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