Chaos of rulings on toxic CDOs means uncertainty for investors
One of the notable losers in the U.S. housing crash was a set of special purpose entities organized in the UK island of Jersey and collectively known as Loreley. Loreley erroneously believed in the long-term health of the subprime mortgage market in the United States. So as banks stuffed toxic mortgage-backed securities into collateralized debt obligations and sold the CDOs to offload their subprime exposure, Loreley was a buyer. The funds invested hundreds of millions of dollars in mortgage-referenced CDOs in late 2006 and 2007.
That turned out, of course, to be a very bad bet. But Loreley has since claimed that it was something else as well. According to suits Loreley has filed against Citigroup, Wells Fargo, UBS and Merrill Lynch, the investment vehicle was the unwitting dupe of a scheme between the banks and a Chicago hedge fund called Magnetar, which Loreley accuses of secretly selecting the underlying mortgage-backed securities referenced in the CDOs the banks marketed and it bought. If you remember the Goldman Sachs Abacus deal involving Paulson & Co, you can predict Magnetar’s supposed motive: The hedge fund, according to Loreley, picked securities that doomed the CDOs to fail because it had shorted them via credit default swaps.
Loreley certainly wasn’t the only one to suspect that Magnetar and the banks had rigged the CDOs they peddled in 2006 and 2007; in 2011, JPMorgan agreed to pay $153.6 million to resolve allegations by the Securities and Exchange Commission that it marketed the Squared CDO without telling investors that Magnetar had a hand in selecting the CDO’s reference portfolio while simultaneously shorting the deal. Since then, State Street, Mizuho and Deutsche Bank have all reached regulatory settlements over undisclosed Magnetar involvement in CDO deals. According to ProPublica, Magnetar had a role in about 30 deals in which it bought equity tranches of mortgage-referenced CDOs while at the same time shorting the same or similar CDOs through swaps. (I should note here that Magnetar, like Paulson in the Goldman deal, has not been accused of wrongdoing by the SEC. Magnetar has always maintained that its short positions were a hedge against equity tranche investments.)
Loreley has not sued Magnetar, which, after all, didn’t sell it the CDOs and had no duty to the investment vehicle. Instead, its counsel at Kasowitz, Benson, Torres & Friedman brought claims against the banks that arranged the CDOs and solicited Loreley’s investment. In the last few months, three of Loreley’s cases have faced bank motions to dismiss. In December, New York State Supreme Court Justice Jeffrey Oing refused to toss claims against Citigroup, finding Loreley adequately alleged that Citi’s subprime portfolio failed to comply with its stated underwriting guidelines. In March, however, U.S. District Judge Richard Sullivan of Manhattan dismissed Loreley’s suit against Wells Fargo. He said that the emails Loreley cited didn’t actually show that Magnetar was picking a reference portfolio to doom CDOs, but merely that the hedge fund wanted to be kept apprised of the collateral agent’s selection process. “At most, the exchange can be plausibly read to reveal that Magnetar was looking to hedge the CDO’s long bets by staking out short positions,” Sullivan wrote, adding that there was “nothing improper about Magnetar’s hedging its exposure to the equity tranche.”
Perhaps most frustratingly for Loreley, on Tuesday New York State Supreme Court Justice Shirley Kornreich threw out its case against UBS - even though Kornreich, unlike Sullivan, seemed entirely persuaded by the investment vehicle’s purported evidence. The complaint provided “ample, thoroughly fleshed-out detail” that UBS “was hiding the nature of Magnetar’s involvement,” the judge wrote. “If true, these alleged concealments were not proper.” Nevertheless, Kornreich said, Loreley hadn’t established that the UBS CDOs were truly designed to default. “It is not clear how Magnetar – even if it wanted to – caused the securities to fail,” she wrote. “Even if Magnetar was capable of hand-picking securities that it knew would fail, to establish that defendants committed fraud by allowing that to happen, Loreley (needs) to allege facts establishing that defendants knew the securities selected by Magnetar were going to fail.”
Nor, she said, did Loreley offer adequate allegations that it wouldn’t have invested in the CDOs if it had known about Magnetar’s short. In that finding, Kornreich distinguished the case from a suit by the portfolio selection agent ACA Financial Guaranty against Goldman Sachs and Paulson. ACA’s case, which stems from Paulson’s involvement in Goldman’s Abacus CDO, has already gotten past a defense motion to dismiss, but Kornreich said that’s because ACA provided evidence it wouldn’t have backed the CDO if it had known Paulson’s position. “It was clear that the affirmative misrepresentations about Paulson’s long positions were essential to ACA’s decision to insure Abacus,” she wrote. “Here, in contrast, based on Loreley’s overall investment strategy, this court cannot draw a reasonable inference from the complaint that the disclosure of Magnetar’s role would have saved Loreley from betting on RMBS-related CDOs.”
The mishmash of Loreley rulings reminded me a bit of divergent judicial decisions in CDO investor suits against Goldman. Some state and federal judges (including Kornreich, in a fraud case by the defunct hedge fund Basis Yield Alpha) have refused to dismiss claims that the bank lied about subprime mortgage-backed instruments. Others have held that Goldman sold CDOs to sophisticated investors who had a duty not to rely only on the bank’s representations.
The only consistency for CDO investors, in other words, is inconsistency. In three very similar fraud cases, three judges have analyzed Loreley’s claims very differently, basing dismissal rulings on disparate considerations that prompted them to reach divergent conclusions. (Merrill Lynch’s motion to toss Loreley’s fourth case is pending before Judge Oing.) The Loreley cases, like the surviving cases against Goldman, still have a long way to go before final resolution, and perhaps appeals courts will codify standards that are inscrutable from lower-court decisions.
But we’re now five years past the financial crisis, and the most compelling lesson we’ve learned from CDO litigation isn’t of much comfort to investors. Caveat emptor.
Loreley’s counsel at Kasowitz declined comment. UBS counsel Richard Rosen of Paul, Weiss, Rifkind, Wharton & Garrison didn’t return my call. Magnetar sent an email statement: “Magnetar was not a party to the lawsuit,” it said. “The litigation was related to the adequacy of certain disclosures related to CDOs. As an investor, Magnetar had no responsibility for the disclosure or marketing of the CDO in question. As we have said before, Magnetar did not control the asset selection process and our investment strategy maintained a market-neutral portfolio. It did not express a fundamental view about the direction of housing or mortgage markets.”
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