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CDOs: Murky Deal Documents Compound Woes

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An article in the Financial Times, “Credit crisis lurches from bad numbers to bad writing,” by Arturo Cifuentes, contains a stunning revelation: the deal documents governing CDOs are in many cases so badly written that, for instance, it isn’t clear how to handle a default.

To give readers a sense of proportion, the contracts governing transactions involving large amounts of money are typically the focus of a great deal of legal attention. Negotiation of definitive agreements in M&A transactions are done on a line-by-line basis. For financings, law firms usually have standard forms that give them boilerplate for major elements of the transaction. For CDOs, which had been done in high volumes in 2003, it seems inconceivable that a good deal of contractual language wasn’t largely pre set (firms and investment banks have different stylistic preferences, but the general framework and key terms ought to fall within certain well accepted parameters).

But no, the Financial Times tells us quite the reverse:

Understandably, the rating agencies have embarked on an effort to restore their shattered reputations. But, surprisingly, the risk management profession has not received the same criticism the rating agencies have.

That is odd. The fundamental assumptions of this discipline should be, if not trashed, at least re-examined critically. After all, most recent subprime-related losses were suffered by institutions that took pride in the sophistication of their risk management systems.

To summarize: the crisis so far has been an unfortunate sequence of bad decisions related to models, default probabilities, correlations, real estate valuations, expected losses, etc. In short, a massive failure of numbers.

These bad decisions, in turn, have resulted in the collapse of many investment vehicles: more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

For instance, in a number of cases it is not clear whether the assets should be sold (liquidation) or let to run off (acceleration). Moreover, even the rules to distribute the money post-EOD (who gets what) are unclear.

In essence, we have gone from bad models to bad writing. From a failure of numbers to a failure of words. Which brings us to another issue: maybe the “quants” who ran the models and interpreted the results were incompetent. But what about the structured finance lawyers who drafted these legal documents? Did they read them? More relevant perhaps, did they understand what they wrote?

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4 comments

  1. Observer

    “stunning revelation”

    I hope you’re being ironic. Martin Mayer wrote about the defects of CDOs in the late 1990s. Satyajit Das has an entire chapter in his book about even worse problems (with recourse, even the definition of the covered entity) on CDS in his book. CDS not the same thing as CDO, of course, but the metaproblem with the metadata is metamega.

  2. Ginger Yellow

    It would be helpful if he provided some concrete examples. Certainly I’m aware of poorly written docs from 2000-2002, and there is some degree of ambiguity in CDS definitions, especially before the ISDA standards were published. But I’d be surprised if the wording for something as basic as post-EOD distribution was really ambiguous in a significant number of recent transactions.

    Also, usually the question of liquidation or acceleration is left to the discretion of the controlling creditor. You can call that “unclear” if you want, but it’s not legal uncertainty.

    I strongly suspect there’s an element of non-controlling creditors using any angle they can to try to get more money here. Of course, I can’t know that for sure because there are no details. One to look into.

  3. Steve Waldman

    Hopefully ginger yellow is right, and the issue is different parties angling for the most favorable interpretation, not outright shoddiness in the contracts. Model risk, when it bites, is not usually litigable. But legal risk can be. You can’t sue the modelers, because they did tell you somewhere they were working off a model, whose assumptions could fail. But you could sue a deal sponsor or lawyer for not adequately covering a circumstance so foreseeable, a probability was attached even in the event the model held. We may have yet another negative-sum loss-shifting game to watch and cluck over.

    You would think the CYA instinct would have assured that bad scenarios be attended to with great care in these contracts, since everybody knows everybody sues whenever something goes wrong. But then, I guess there’s lots of things you would think.

  4. Ginger Yellow

    I wouldn’t be surprised if there were a few shoddily worded deals, but I suspect that if there’s any significant number they’re going to be older ones. From what my contacts tell me CDO docs were tightened up considerably after the first CDO blowup post-WorldCom et al.

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