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Judge Finds That Investors Who Bought A Security Called “Draco” Pretty Much Got What They Deserved

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One thing that a lot of crisis-era synthetic CDOs referencing residential mortgage-backed securities have in common is that they were "designed to fail," in that the short credit (protection buying) party to the synthetic CDO (1) was short and (2) had a hand in selecting the reference property. There's nothing particularly odd or nefarious about that: a synthetic CDO requires a short party,1 and since you can't force John Paulson or Magnetar or whoever to short securities that they don't want to short, you have to give them some input into selection. Someone bought the Herbalife shares that Bill Ackman's shorting, and from Bill Ackman's perspective that trade is designed to fail, though not perhaps from Herbalife's.

There are various flavors of woolyheadedness about all of this, some of which, to be fair, are the fault of the banks who peddled the synthetic CDOs. Unhelpful behavior would include, for instance, saying things like "the collateral manager selected the collateral all on its own with your best interests in mind." This is a somewhat obvious absurdity - of course the collateral manager had to select collateral that was acceptable to the short party - but you can understand why people would feel aggrieved when it turned out that the collateral manager was just an empty room into which cackling short-sellers tossed ill-begotten prospectuses. Another bad idea would be saying "ooh look John Paulson is so long the equity of this thing because it is so good" when in fact his net position was massively short the senior tranches. Outside of the eleven minutes when Paulson was the greatest investor ever, no one might care about John Paulson's position in the security, but that's still not a great reason for the bank to lie about it.

Stuff like that is definitely unpleasant behavior, but is it fraud? Fraud is, basically, you lie to me and I believe you so I do something about it. And the problem with the synthetic CDOs is that that link is pretty tenuous. People pretty much bought synthetic CDOs because they thought house prices were going up and therefore residential mortgages would be a good investment. The particular mechanics of the particular negotiations that led to the picking of the particular collateral was less relevant. If they had been given the truth about who chose what collateral and why, they'd probably have made the same decisions, and been just as screwed.

I think all of the above is pretty much conventional Wall Street wisdom, but not everyone sees it that way. In particular that view has had a rough time with courts and regulators. Lotta lawsuits, lotta nine-digit settlements, occasional judge rejecting a nine-digit settlement for being insufficiently harsh. Yesterday, though, UBS got a break:

UBS AG won dismissal of a lawsuit brought by Loreley Financing entities, which sued the Swiss bank to recover $331 million in losses on collateralized debt obligations.

Loreley investment vehicles sued UBS last year over what it said were four fraudulent CDOs. One of them was arranged by UBS “at the behest of” Magnetar Capital, which was betting against the housing market and selected collateral for the securities, according to the complaint. Loreley claimed Magnetar’s short position had been concealed.

Justice Shirley Werner Kornreich of New York State Supreme Court in Manhattan threw out claims against UBS in a decision filed yesterday, saying Loreley had made a “massive bet” on the housing market, while Magnetar had “shrewd insight” that the subprime mortgage market would crash. Magnetar was not named as a defendant in the lawsuit.

“There is nothing in the complaint that indicates that Loreley particularly cared about Magnetar’s investment strategy,” the judge wrote. “Importantly, Loreley, as sophisticated investors, knew that there has to be deep pocketed counterparties to their long positions.”

The opinion is here and it's maybe the most pro-Wall-Street judicial opinion you'll read this year? Here's a passage about a CDO ("Draco") in which Magnetar was the short party, Loreley a long investor, and Declaration the collateral manager; Loreley had claimed that, despite representations about Declaration choosing the collateral, Magnetar had actually picked the underlying bonds and designed them to fail and so forth:

Moreover, though the Draco Offering Materials represent that Draco's collateral manager would be independent, Loreley was clearly willing to make large bets on the housing market without insisting on an independent collateral manager. For instance, Loreley invested $100 million ($40 million more than it invested in Draco) in AMP without insisting on an independent collateral manager, and it did so at a time (May 2007) when the number of investors willing to take long positions was rapidly shrinking. This belies the notion that the independence of Declaration was essential to Loreley's decision to invest in Draco.

That's basically: "yes, they lied to you about the motives of the collateral manager who was supposedly picking the CDO for your benefit, but whatever, you would have invested anyway, you dummy." I mean, that's pretty rough, no? It seems clear that a lot of RMBS CDO investors were in fact interested in the collateral manager's track record and motivation, though fair point that Loreley seems to have been particularly undiscerning.2

It's weird stuff, and goes a little farther than I would go, which is saying something.3 On this theory vast amounts of lying by banks could be excused, because the judge looked into Loreley Finance's vacant eyes and intuited that they were the sorts of mortgage-addicted dummies who would have bought these bonds even if they'd known that they were "designed to fail." Which I guess is probably right. Still. Weird.

And meaningful? Hard to say - it's one opinion by one New York state judge, and much of the other current and potential liability lives in federal court or at the SEC or with others who've been more skeptical of the mortgage-peddling banks. On the other hand, these CDO claims haven't been tested very much in court, with the banks proceeding straight to the giant settlements in part because of their own propensity to send horrible embarrassing emails about the relevant deals. Perhaps the spectacle of a bank actually winning one will embolden the rest of them. "Sure," they will say forcefully in open court, "we lied to our clients. But they were such dopes that it didn't matter." Should go over pretty well.

UBS Wins Dismissal of Loreley Financing Lawsuit Over CDOs [Bloomberg]
Loreley v. UBS: opinion [S. Ct. NY]
Loreley v. UBS: complaint [S. Ct. NY]

1.Right? I guess you could distinguish an outright short party, like Paulson or Magnetar or whoever, from a hedging short party; perhaps a lot of buyers believed that they were effectively buying banks' excess mortgage credit risk from those banks rather than taking on new risk from fundamental shorts. I don't exactly know why that should matter to anyone but perhaps it did.

2.Actually Loreley is a collection of investment pools run by IKB, a German bank known as rather a champion of undiscerning RMBS investing. They bought the Goldman Abacus deals too.

3.The judge also rather unconvincingly tries to distinguish this case from the Goldman Abacus case, saying:

Unlike this case where Loreley [sic, read UBS] did not make any affirmative representations about Magnetar, in ACA, the defendant made numerous misrepresentations regarding Paulson's long positions on ABACUS. The facts in ACA make it clear that ACA would not have provided financial guarantee insurance for ABACUS had it known that Paulson was betting short because ACA specifically did not want to bet against Paulson. Here, in contrast, there is nothing in the Complaint that indicates that Loreley particularly cared about Magnetar's investment strategy.

But this isn't quite right. The Abacus complaint does say "It is unlikely that ACA Capital would have written protection on the super senior tranche if it had known that Paulson, which played an influential role in selecting the reference portfolio, had taken a significant short position instead of a long equity stake in ABACUS 2007-AC1," but that's not "ACA didn't want to bet against Paulson" or "ACA particularly cared about Paulson's investment strategy." That's "ACA didn't want to take the long side of a portfolio that was selected by the short side." Which may or may not be a coherent thing to think - every trade involves taking the [long | short] side against someone who consciously took the [short | long] side of the same trade. But whether it makes sense or not, it's the same claim in the Paulson/Goldman/Abacus/ACA case and the Magnetar/UBS/Draco/Loreley case.