Uncertainties Inherent In Synthetic CDOs / Credit Default Swaps

As instances of default under collateralized debt obligations

(CDOs) rise, uncertainty over the resolution of eventual disputes

takes on increasing significance for parties to derivatives

investments. Nowhere is this better demonstrated than in the

enforcement of rights under credit default swaps. By 2008,

outstanding credit default swap contracts had a combined market

value of more than US$2 trillion1.

Synthetic vs Cash CDOs

CDOs are a form of asset-backed security under which a

special-purpose vehicle (SPV) is established to hold cash-producing

assets carrying various levels of risk and reward. The SPV issues

bonds or other securities to investors in tranches which reflect

the productivity of the assets from which their value is ultimately

derived. Often the SPV is an offshore corporation established to

avoid or minimize tax otherwise payable to the revenue authorities

of the U.S., Canada and other industrialized countries.

Securities issued through CDOs are derivative in nature, funded

through either a portfolio of cash assets such as bonds or

mortgage-backed securities ("cash CDOs"), or a portfolio

of credit default swaps ("synthetic CDOs"). Parties to

synthetic CDOs enter into contractual arrangements which expose the

SPV to credit risk in exchange for periodic payments. The

arrangement is roughly equivalent to an insurance contract in which

the SPV insures its counterparty against defaults on its own

mortgage portfolio or against specified losses which it may incur

from other financial obligors in the course of its business (the

"reference portfolio").

Uncertainties Arising from Leverage

By their nature, synthetic CDOs carry with them a number of

inherent uncertainties rendering them more susceptible than cash

CDOs to litigation.

To maximize leverage, CDOs are structured so as to minimize cash

reserves. Collateral is posted equating to an agreed portion of the

aggregate potential exposure of the credit protection

purchaser.

Agreements between swap counterparties specify circumstances

(called "material adverse events") under which collateral

must be augmented. Whether such events have taken place will depend

on the terms negotiated and then current financial

circumstances.

In exercising its remedies the secured party must balance its

interests against its contractual obligations. If it purports to

terminate or demands excessive collateral, its good faith may be

called into question. Good faith is a term often implied by the

courts and specified under standard contractual terms such as

those of the International Swaps and Derivatives Association

(ISDA)2.

Similarly, there may be a question whether a material

adverse event has occurred, and/or have triggered termination

rights under the ISDA's 1992 and 2002 Master Agreements or

other comparable documents, if the party or its credit support

provider merges or amalgamates with another party under

circumstances where the creditworthiness of the merged vs

pre-merger body is arguable. Valuations may be necessary to

determine the relative values.

Valuations of assets within the reference portfolio may also be

necessary and these may give rise to difficulties. In High Risk

Opportunities HUB Fund Ltd. v. Credit Lyonnais3 a

derivatives case involving non-deliverable forwards linked to

currency fluctuations, the financial institution was found to have

improperly valued the subject contracts upon the occurrence of an

event of default. The counterparty successfully argued that Credit

Lyonnais' market quotations were not obtained in good faith and

that it interfered with market-makers' independence in the

valuation process. Credit Lyonnais, by urging an...