Updated 4/18/08
__________________________________________________________________ The Credit Crisis and Collateralized Debt Obligations
A collateralized debt obligation (CDO) is a type of asset-backed security in which the income stream from a portfolio of fixed-income assets is divided into different groups, or tranches.1 The equity and junior tranches receive income last and bear losses first, while the senior and mezzanine tranches receive income first and bear losses last. Because of this subordination structure, the lower tranches bear more risk and receive a higher interest rate than the higher tranches. In the case of CDOs based on residential mortgage-backed securities (RMBS), the value of each individual tranche can be difficult to determine because neither the tranche as a whole nor its components have readily observable market prices, although the CDO has been modeled on the basis of expected payments for each tranche reduced by the risk of nonpayment. Recently, RMBS CDOs have seen their market prices decline steeply because of a perceived increase in the risk of default.2 In substantial part, this reassessment of CDO credit risk has flowed from the realization that underwriting quality for the underlying mortgage loans was not as high as originally thought and/or because the CDO modeling assumptions turned out to be incorrect. CDO valuations and reassessments raise many difficult issues because, among other reasons, the individual loans that underlie a particular CDO may have different types of underwriting data which in turn have different levels of relevance and accuracy. For example, mortgages in some loan pools may have higher credit scores than those in a second pool, but the second pools’ loans may be better documented with information about the borrowers’ income and assets. Some loan metrics in turn may predict higher incidence of default then others. 3 Purchasers of RMBS CDOs who were given assurances about the quality of the underlying loans have asserted fraud claims based on statements about default rates, the criteria used to originate the loans, and the CDO modeling process. Several recent cases involving RMBS CDOs or similar securities illustrate the possibilities: • Luminent Mortgage Capital, Inc., et. al. v. Merrill Lynch & Co., et. al., No. 7cv5423 (E.D. Pa. Filed Dec. 24, 2007). In this case, the plaintiffs claim they purchased subordinate classes of RMBSs based solely upon the defendants’ misrepresentations. The plaintiffs claim that the defendants misrepresented certain information about the underlying pool of mortgage loans, including the borrowers’ credit scores, the original interest rates on the loans, and the level of due diligence the defendants had performed on the loans.
DOUGLAS J. LUCAS, ET. AL., COLLATERALIZED DEBT OBLIGATIONS 3 (2d ed. 2006). Aaron Lucchetti, CDO Battles: Royal Pain Over Who Gets What, WALL STREET JOURNAL, Dec. 17, 2007, available at http://online.wsj.com/article/SB119785147303432641.html?mod=hps_us_whats_news (stating that “[a]bout 40 consumer-debt backed CDOs have declared an event of default; their face value is near $45 billion – about 7% of the $640 billion in the CDOs outstanding rated by Moody’s. . . . J.P. Morgan projects that by the second quarter, $40 billion to $50 billion in subprime-mortgage bonds could be sold by distressed CDOs that decide to liquidate.”). 3 Thomas Brown, News Flash! Underwriting Discipline Makes a Difference in Subprime Mortgage Lending, BANKSTOCKS.COM, Feb. 15, 2008, available at http://www.bankstocks.com/print.asp?id=9881648.
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Carrington, Coleman, Sloman & Blumenthal, L.L.P. • 901 Main Street, Suite 5500 • Dallas, Texas 75202 • www.ccsb.com
Updated 4/18/08
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• Lone Star Fund V, et. al. v. Barclays Bank, et. al., No. 8cv00261, (N.D. Tex. removed Feb. 13, 2008). In this case, Lone Star Fund V and its bond holders (Lone Star) claim that Barclays Bank and Barclays Capital (Barclays) misled them about the quality of the certificates of the mortgage pass-through certificates that they purchased. Specifically, Lone Star claims that Barclays misrepresented that (a) none of the mortgage loans comprising the certificates were delinquent or had ever been delinquent on the date of closing; and (b) it had performed extensive due diligence on the quality of the underlying mortgage loans. Lone Star contends that these representations were false when made and that it relied on these false statements when it purchased certificates. MetroPCS Communications, et. al. v. Merrill Lynch & Co., Inc., et. al., No. 07-12430 (116th Judicial District., Dallas County, Texas, Filed Oct. 18, 2007). MetroPCS alleges that Merrill Lynch failed to disclose that CDOs it sold them were backed by collateral at risk of default due to wide-ranging subprime exposure.
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Carrington, Coleman, Sloman & Blumenthal, L.L.P. • 901 Main Street, Suite 5500 • Dallas, Texas 75202 • www.ccsb.com