Add credit default swap counterparty litigation to the growing list of subprime-related litigation categories.
Credit default swaps have, of course, already been drawn into the subprime litigation wave to a certain extent. For example, as I previously noted (here), Swiss Re has been sued in a subprime related securities lawsuit in connection with its write-down in the valuation of certain credit default swaps. And I also previously noted (here) litigation between an institutional CDO investor and the CDO originator where the investor also had credit default obligations for the CDO.
But according to news reports earlier this week (here), Citibank and Wachovia have each been sued in separate lawsuits brought by a credit default swap counterparty. A closer look at the pleadings in the lawsuits suggests we may be seeing a great deal more of this kind of litigation ahead.
First, some definitions. As explained in Wikipedia (here), a credit default swap is an agreement between two parties under which one party (the seller) agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving an underlying instrument. A credit default swap is like insurance, except that there is no requirement that the buyer actually hold the underlying instrument, so credit default swaps are often used as a means so speculate on interest spreads.
Both Citigroup and Wachovia entered credit default swaps with a hedge fund incorporated in the Bailiwick of Jersey (one of the Channel Islands) The hedge fund, previously known as CDO Master Fund Ltd., is now known as VCG Special Opportunities Master Fund Limited. During 2007, the hedge fund entered two credit default swaps, one with Citibank and one with Wachovia, that are now the subject of litigation.
According to the hedge fund’s January 12, 2008 Amended Complaint against Wachovia (here), on May 21, 2007, the hedge fund entered a $10 million credit default swap with Wachovia in connection with a Class B tranche of a collateralized debt obligation. The hedge fund was to be paid a 2.75% per annum fee for the swap, to be secured by a deposit of $750,000. According to the hedge fund’s allegations, during the course of 2007, Wachovia demanded that increasing amounts of collateral, which by November 2007 cumulated to an amount in excess of the swap’s notional $10 million face value.
The hedge fund kept pace with the demands for additional collateral until the demands exceeded $8,920,000, at which point the hedge fund initiated the dispute resolution mechanisms in the agreement, and ultimately initiated litigation in New York Supreme Court, which Wachovia removed to federal court.
The hedge fund contests that there has been an event of default or any other event that would trigger their payment obligation under the swap. Wachovia for its part submitted a notice of termination, foreclosed on the collateral, and counterclaimed (here) against the hedge fund for the “deficiency.” Wachovia bases its justification for the demands for the increased collateral on the absence of any commercial market for the CDO. The hedge fund’s lawsuit seeks to rescind the swap, on the grounds of fraud and mistake; and also seeks damages for fraud, breach of contract and breach of the covenant of good faith and fair dealing; and unjust enrichment. Wachovia’s counterclaim alleges breach of contract.
The hedge fund’s lawsuit with Citibank is based on more or less the same dispute, albeit in connection with a different credit default swap. According to the hedge fund’s February 14, 2008 complaint (here), the notional value of the Citibank default swap was also $10 million, and Citibank ultimately “extracted” (according to the complaint) collateral of $9,960,000 from the hedge fund.
There are a number of interesting things about these circumstances. Perhaps the most interesting is that according to the complaints, the hedge fund has approximately $50 million of capital under management. In other words, the notional amount of just these two swap contracts alone represented 40% of the hedge fund’s capital. I am going to go out on a limb and guess that the hedge fund had other contracts too. But whether or not the hedge fund had other contracts, it is hardly surprising that, given its limited capital, the hedge fund reached a point where litigation seemed like a better option than any further collateral advances; the fund’s managers may have decided they had nothing to lose by fighting
But even more interesting than the hedge fund’s huge vulnerability to just these two transactions is the fact that a couple of major financial players like Wachovia and Citibank were accepting what amounts to insurance from a thinly capitalized pocket portfolio incorporated in the Bailiwick of Jersey. Certainly if they had been placing insurance as such they would never in a million years have transacted with an offshore insurer whose total capital was both so small and such a small percentage of the exposure. Perhaps a belated realization of these shortcomings explains the banks’ demands for additional collateral…
But whatever may have led two of the world’s largest banks to accept guarantees from a small, thinly capitalized hedge fund, these circumstances at a minimum demonstrate something that I suspect we will be reading about a lot more in the coming days – that is, “counterparty risk.”
There are several important things to be recognized about counterparty risk. The first is that it is not a prerequisite to a credit default swap transaction that either party holds the instrument to which the swap relates. The practical consequence of this fact is that the aggregate notional value of all swaps in force far exceeds the value of the underlying instruments. Here’s a number that we all need to contemplate – according to the Wall Street Journal’s March 4, 2008 article (here) about the above-described litigation, the market for swaps totals $45 trillion (that’s trillion with a “t”), an amount that is “comparable to all the bank deposits world wide.” That, my friends, represents a whole lot of counterparty risk.
Another important thing to be recognized about counterparty risk is that, according to the Journal article, hedge funds have in recent years become the predominant players in this market. The Journal says that hedge funds accounted for 60% of the credit default swap trading in high-grade debt and 80% of the low grade debt in the 12 months ending in April 2007.
While many of the hedge funds involved in this marketplace may be better capitalized than the hedge fund described above, the very fact that two banks like Wachovia and Citibank dealt with this fund at all, despite the low ratio of its capital to the notional value of the swap transaction, suggests that a certain amount of business (who knows, perhaps a considerable amount of business) involved hedge funds, and perhaps others, who like the hedge fund described above, will be challenged to respond to calls for additional collateral.
The same turmoil that caused Wachovia and Citibank to call for additional collateral in these transactions is undoubtedly resulting in countless similar communications throughout the marketplace. The longer the disruption in the underlying marketplace continues, the more abrupt the calls will be. The pressures that the principal firms face to protect their own balance sheets adds greater urgency to each of those calls. And the previously hidden but now revealed demon within each transaction motivating those calls is the suddenly frightening prospect of counterparty risk. The particularly frightening aspect of these circumstances is that all of the calls are going out more or less simultaneously – and counterparties with limited capital will find themselves forced against the same wall as the hedge fund described above.
The litigation will be bad. The financial consequences could be worse.
Indispensible Reading: The best way I can think of to end this really depressing blog post is to reward everyone who has read this far and suggest that the best way to put the circumstances described above in context is to read University of Virginia Graduate Business School Professors’ Robert Bruner and Sean Carr’s eminently readable and deeply thought-provoking book, The Panic of 1907 (refer here for more information).
Even though their book describes circumstances from a century ago, there is a chillingly familiar resonance to the events addressed in their book. Among other things, in their efforts to explain how financial panics arise, the professors describe the following factors:
It begins with a highly complex financial system, whose complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness with which they act ultimately determines the length and severity of the crisis.
Read the book. It is worth reading in and of itself, but under the present circumstances, the book is simply indispensible.
A very grateful hat tip to Floyd Norris, of the New York Times (whose column, here, discussed the Panic of 1907) and whose blog, Notions of High and Low Finance (here), specifically referenced the professors’ book.