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Could this legal squabble between Merrill and SCA have implications for billions of dollars of CDOs?
The squabble is a lawsuit filed by monoline SCA against Merrill Lynch. Merrill Lynch had already filed a lawsuit against SCA in mid-March. So this latest broadside is a retaliatory effort.
The dispute concerns $3.1bn in credit default swaps against CDOs. SCA subsidiary XLCA wrote contracts on seven such deals with Merrill Lynch back pre-crunch. (Among them, West Trade Funding II, Silver Marlin CDO I, and Jupiter High-Grade CDO VI).
The gist of the matter is that SCA is refusing to honour those contracts. It sent a notice to Merrill mid-March saying it was terminating the agreements.
On the face of things, it sounds like another whining monoline.
Actually, however, the case is far more interesting.
SCA says it wrote the CDS contracts on the condition that it was given "control rights" over the CDOs it was writing them against:
XLCA required sole control rights under the seven CDOs at issue as a "fundamental condition" to entering into the CDS with Merrill Lynch International.
In other words, it demanded to be classed as - or above - the super-senior investor in those CDOs, giving it the power to liquidate, accelerate or continue operation of the CDO portfolio in the likelihood of an "event of default" trigger being hit.
Merrill reneged on that agreement, say SCA:
Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions...Determined to get these CDO risks off its books at all costs before the third quarter of 2007 closed, Merrill Lynch made the decision to blatantly ignore its prior commitments to XLCA.
So what happened?
Here's a stab: Merrill feared a painful unwind of negative basis trading it had set up.
Under those trades, Merrill basically structured CDOs, sold off all the in-demand mezz tranches and kept the AAA tranche on its books. It completely hedged out that AAA tranche using a CDS agreement - written, in this case, with SCA. (Since Merrill wasn't interested in the CDO tranches as an investor, but only as one part in a simple arbitrage, it's not inconcievable that they waived control rights to the monoline in order to facilitate the trade.)
But with monolines tottering, and with SCA in particular looking ropey, Merrill was starting to have to mark down the value of its monoline-written CDS insurance contracts: thus uncovering, like rocks in a very low tide, all those AAA CDO tranches, hitherto hedged out of mention in the bank's books.
Merrill had to sell those AAA CDO tranches quickly, or face massively increasing its at risk exposure. In the "rush" to do this, allege SCA, Merrill promised the buyers that they had the control rights.
Imagine then, you're a distressed debt investor. A bank is offering AAA rated CDO assets for sale at knock down prices. You know those CDOs are likely to breach their EOD triggers soon - if they haven't already — and, crucially — you're told that you'll have the control rights. So you buy the CDO paper cheap, with the specific intention to exercise your control rights on the CDO and accelerate all payments (all your coupons and principal are repaid in a timely fashion before anyone else sees a penny) or else liquidate it. You're highly likely to get all your money. If you're insuring tranches of CDO debt, however, it's no so good.
In other words, if the control rights are with the distressed debt buyers, there's huge incentive to liquidate or accelerate. If the control rights are with the CDS contract - and SCA - there isn't.
The Merrill SCA case may have huge implications. There are, of course, a lot of CDOs out there which have accelerated or liquidated. But there's even more which have hit their Event of Default triggers and opted to just continue operating.
Given that SCA is expected to loose their case against Merrill, it may be that suddenly, a whole lot of CDS contracts find out they are not so senior - or controlling - afterall. There might then be big incentives for a whole slew of AAA noteholders to exercise their newly returned "controlling rights" and accelerate, if not liquidate.
This entry was posted by Sam Jones on Thursday, April 3rd, 2008 at 13:03 and is filed under Capital markets. Tagged with merrill lynch, SCA.
http://ftalphaville.ft.com/click?ty...y+effort. The+dispute+concerns+$3.1bn+i...
The squabble is a lawsuit filed by monoline SCA against Merrill Lynch. Merrill Lynch had already filed a lawsuit against SCA in mid-March. So this latest broadside is a retaliatory effort.
The dispute concerns $3.1bn in credit default swaps against CDOs. SCA subsidiary XLCA wrote contracts on seven such deals with Merrill Lynch back pre-crunch. (Among them, West Trade Funding II, Silver Marlin CDO I, and Jupiter High-Grade CDO VI).
The gist of the matter is that SCA is refusing to honour those contracts. It sent a notice to Merrill mid-March saying it was terminating the agreements.
On the face of things, it sounds like another whining monoline.
Actually, however, the case is far more interesting.
SCA says it wrote the CDS contracts on the condition that it was given "control rights" over the CDOs it was writing them against:
XLCA required sole control rights under the seven CDOs at issue as a "fundamental condition" to entering into the CDS with Merrill Lynch International.
In other words, it demanded to be classed as - or above - the super-senior investor in those CDOs, giving it the power to liquidate, accelerate or continue operation of the CDO portfolio in the likelihood of an "event of default" trigger being hit.
Merrill reneged on that agreement, say SCA:
Merrill Lynch undertook a rushed campaign to find parties willing to hedge or provide protection on its remaining CDO positions...Determined to get these CDO risks off its books at all costs before the third quarter of 2007 closed, Merrill Lynch made the decision to blatantly ignore its prior commitments to XLCA.
So what happened?
Here's a stab: Merrill feared a painful unwind of negative basis trading it had set up.
Under those trades, Merrill basically structured CDOs, sold off all the in-demand mezz tranches and kept the AAA tranche on its books. It completely hedged out that AAA tranche using a CDS agreement - written, in this case, with SCA. (Since Merrill wasn't interested in the CDO tranches as an investor, but only as one part in a simple arbitrage, it's not inconcievable that they waived control rights to the monoline in order to facilitate the trade.)
But with monolines tottering, and with SCA in particular looking ropey, Merrill was starting to have to mark down the value of its monoline-written CDS insurance contracts: thus uncovering, like rocks in a very low tide, all those AAA CDO tranches, hitherto hedged out of mention in the bank's books.
Merrill had to sell those AAA CDO tranches quickly, or face massively increasing its at risk exposure. In the "rush" to do this, allege SCA, Merrill promised the buyers that they had the control rights.
Imagine then, you're a distressed debt investor. A bank is offering AAA rated CDO assets for sale at knock down prices. You know those CDOs are likely to breach their EOD triggers soon - if they haven't already — and, crucially — you're told that you'll have the control rights. So you buy the CDO paper cheap, with the specific intention to exercise your control rights on the CDO and accelerate all payments (all your coupons and principal are repaid in a timely fashion before anyone else sees a penny) or else liquidate it. You're highly likely to get all your money. If you're insuring tranches of CDO debt, however, it's no so good.
In other words, if the control rights are with the distressed debt buyers, there's huge incentive to liquidate or accelerate. If the control rights are with the CDS contract - and SCA - there isn't.
The Merrill SCA case may have huge implications. There are, of course, a lot of CDOs out there which have accelerated or liquidated. But there's even more which have hit their Event of Default triggers and opted to just continue operating.
Given that SCA is expected to loose their case against Merrill, it may be that suddenly, a whole lot of CDS contracts find out they are not so senior - or controlling - afterall. There might then be big incentives for a whole slew of AAA noteholders to exercise their newly returned "controlling rights" and accelerate, if not liquidate.
This entry was posted by Sam Jones on Thursday, April 3rd, 2008 at 13:03 and is filed under Capital markets. Tagged with merrill lynch, SCA.
http://ftalphaville.ft.com/click?ty...y+effort. The+dispute+concerns+$3.1bn+i...