New York Subprime Lawsuit Between Two Foreign Banks: As I noted in prior posts (most recently here), mortgage-backed securities investors have already initiated several lawsuits against the investment banks and others that created the securities, some lawsuits filed as individual actions and some as class actions. A mortgage-backed securities investor’s individual lawsuit initiated this week in New York Supreme Court (Manhattan) presents some new twists on this evolving litigation category.
According to the company’s press release (here), on February 25, 2008, German state-owned bank HSH Nordbank AG sued UBS and UBS Securities LLC. The lawsuit relates to one of HSH’s constituent bank’s $500 million investment in 2002 in collateralized debt obligation (CDO) securities known as North Street 2002-4 that were created and managed by the Swiss bank. In its complaint, HSH described itself as a “regional German bank with little familiarity with international structured finance.” As described in a February 25, 2008 Wall Street Journal article (here), the HSH relation with UBS was “more complicated” because in addition to its investment in the CDO, HSH also provided UBS with insurance protection in the form of credit default swaps.
As reflected in news coverage describing the complaint (here and here), HSH claims that UBS’s now-shuttered internal hedge fund division, Dillon Read Capital Management, selected inferior collateral and used the CDO as a dumping ground for troubled mortgage-backed securities as a way to profit from the credit default swap.
The complaint alleges that during 2007 Dillon Read made substitutions to the “reference pool” of securities linked to the CDO, bringing in securities lined to the ABX index of subprime mortgage instruments, thereby allegedly increasing the CDOs exposure to subprime mortgages “at a time when the outlook on subprime mortgages was already negative.”
HSHS claims that the structure, and in particular its position on the credit default swap, allowed UBS to realize profits of up to $275 million at HSH’s expense. As also reflected in the bank’s February 24 press release (here), HSH alleged that “UBS exploited the structure for its own ends, at HSH’s expense,” and that “UBS evidently regarded North Street 4 not as an investment platform but as an opportunity to defraud HSH.”
HSH alleges that UBS “knowingly and deliberately created a compromised structure.” HSH accuses UBS of breach of contract, fraud, negligent misrepresentation, and breach of fiduciary duty.” HSH is demanding at least $275 million in restitution plus punitive damages.
There are several interesting things about this new lawsuit. The first is that it involved a New York state court lawsuit between two foreign-domiciled companies. This may be due in part to the role played by the now defunct UBS affiliate Dillon Read. But an even likelier explanation is the prospect of the remedies available under U.S. laws, which undoubtedly influenced HSH to pursue its claims in what would otherwise seem to be an inconvenient forum. It is, in any event, singular to find two foreign companies squaring off in a U.S courthouse.
The availability of alternative dispute resolution forums in which the case might also have gone forward may be seen from the fact that UBS itself has already filed a counterclaim against HSH, but (as reflected here), in London rather than in New York. According to news reports, the counterclaim itself has not been made available publicly.
Perhaps the most interesting thing about the HSH lawsuit is the core allegation. The prior lawsuits against the securitizers have essentially been disclosure-based lawsuits, in effect that the securitizers did not provide full or accurate information about the securities they initiated or about the assets underlying the securities. HSH’s complaint also contains these kinds of allegations, but the core of its complaint is not mere misrepresentation, but rather that UBS fraudulently manipulated the transaction structure to its own profit and to the investors’ detriment. These kinds of allegations clearly raise the stakes, and make this case most interesting to watch.
Finally, this is the first subprime-related case of which I am aware between counterparties on credit default swaps. Given the massive volume of credit default swap activity, there is an enormous potential for credit default swap counterparty litigation.
More Auction Rate Securities Write-Downs: In a prior post (here), I discussed the $275 million write-down that Bristol-Myers Squibb took related to its investment in auction rate securities. At the time, I wondered whether other companies would face similar write-downs, with particular interest in the possible impact on companies outside the financial sector.
At least two other nonfinancial companies have now taken their own subprime-backed asset write-downs, in examples that underscore that impact that the breakdown of the auction rate securities market is having on the value of those securities. These write-downs also highlight the fact that the impact of the subprime meltdown extends far beyond the financial sector.
On February 27, 2008, MetroPCS announced (here) in connection with its fourth quarter earnings release that it had recorded a fourth quarter charge of $83 million in unrealized loss on its $134 investment in auction rate securities. Including the company’s $15 million third-quarter write-down, the year-end value of its $134 investment was at $36 million. As I discussed in a prior post (here), MetroPCS has filed a lawsuit against Merrill Lynch in connection with the company’s investment in the auction rate securities. A copy of the complaint can be found here. It is worth noting that company’s reported fourth quarter loss of $47 million included the $83 million impairment charge.
And on February 21, 2008, SBA Communications reported (here) an impairment charge of $15.6 million on three auction rate securities the company held as short term investments. The company’s net loss for the quarter was $24.2 million including the asset impairment charge.
A February 27, 2007 CFO.com article discussing the MetroPCS write-down can be found here. A February 22, 2008 CFO.com article discussing the SBA Communications write-down can be found here.
Got Those Valuation Blues Again, Mama: A February 24, 2008 post on the Re:Balance blog (here) takes a look at the accounting and valuation issues arising out of the subprime crisis, and suggests that the mortgage asset-backed securities valuation problems that are currently emerging are not merely an attribute of the current disrupted market conditions but were inherent in the terms of the instruments at the time they were created.
Jim Peterson, the blog’s author, writes “the more candor and rigor are brought into this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality.” Peterson, who is the accounting columnist for the International Herald Tribune, adds that “the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable as a mirror held up to commercial society.”