A hedge fund has sued Swiss banking giant UBS in Connecticut state court for unloading risky collateralized debt obligations (CDOs) on the eve of the financial crisis without disclosing that the CDOs were about to be downgraded and would eventually become “toxic waste. ” So far the Connecticut court has allowed the case to proceed in order to give the plaintiffs an opportunity to prove their allegations and has required UBS to post a bond sufficient to cover a $35 million judgment in the event that it loses the case.
Collateralized debt obligations, or CDOs, are a form of securitized debt backed by debt obligations like mortgages, commercial paper, student loans or even credit card debt. Such debt instruments are pooled in large number, bundled, and packaged as highly complex securities that are sold to investors. Within each security, there are multiple layers or “tranches” of debt that are classified according to risk, with the senior tranches being higher rated and paying conservative returns while lower-rated junior tranches pay higher returns to compensate for their higher risk level. Principal and interest payments are first allocated to the higher tranches, while the risk of default falls first upon the lower tranches. The distribution formulas are highly complex, and a single CDO can have dozens of tranches. Once the debt is securitized, it is very difficult to evaluate the value and creditworthiness of the constituent debt, and as the securities are sold and resold they become even more opaque.
Critics of CDOs have long charged that these securities do not just spread credit risk, but they conceal it. Moreover, due to the impact of leverage in both the underlying debt and in the market for these securities, CDOs can be highly volatile?meaning that the slightest shifts in the credit, real estate, and securities markets can have a greatly magnified effect upon the value of the CDO tranches. When the financial markets crashed, many CDOs literally imploded, leaving investors holding securities that were worth just pennies on the dollars that had been paid for them.
Like many big banks, UBS was holding a large inventory of CDOs when warning signs appeared in the financial markets in mid-2007. The plaintiffs in the Connecticut lawsuit allege that UBS knew that the CDOs were about to lose substantial value, and that rating services were about to downgrade their creditworthiness due to troubling developments in the credit markets, but they did not disclose those material facts when they unloaded their inventory of problem CDOs to unsuspecting investors. Emails that have surfaced in the Connecticut litigation show that UBS employees referred to the CDOs as “vomit” and “crap” in internal communications but did not disclose those concerns to investors.
“Such emails will undoubtedly be used in other cases against UBS,” says Craig T. Jones of Page Perry who represents investors in securities fraud cases, “but UBS is by no means the only investment bank or brokerage firm that cut corners trying to get rid of toxic assets.” Jones’ firm is not involved in the Connecticut case but represents many defrauded investors around the country. “If you invested in any kind of toxic security because of misrepresentations made to you by someone in the financial industry, we may be able to help you recover your losses,” says Jones.