Lehman expected CDO market to worsen

Lehman expected CDO market to worsen
By finance reporter Sue Lannin

Posted Tue Mar 22, 2011 8:24am AEDT


A total of 72 local councils, charities and churches have launched a $260 million class action against Lehman Brothers Australia. (Reuters: Brendan McDermid)
The local arm of collapsed US investment bank Lehman Brothers expected the market for complex investments linked to mortgages and corporate debt to deteriorate before the onset of the subprime crisis in the US housing market, according to Lehman's internal documents.

The revelation in a Federal Court class action lawsuit was contained in documents from Grange Securities, the local arm of Lehman Brothers, which went bankrupt in September 2008.

The hearing is part of a $260 million class action taken by 72 local councils, charities and churches against the estate of Lehman Brothers Australia (LBA). Lehman Brothers took over Grange in 2007.

The plaintiffs accuse LBA of misleading them into buying collateralised debt obligations (CDOs), which helped trigger the global financial crisis.

LBA denies misleading the councils and is fighting the claim. It says the councils signed agreements which authorised Lehman to buy CDOs on their behalf.

Tony Meagher SC, barrister for the councils, told the Federal Court in Sydney that Grange did not tell their clients about the risk of a rise in defaults among lower investment grade rated companies, which were part of the CDO investment portfolio.

Instead, Mr Meagher told the court Grange's investment advisers bought and sold the complex products on behalf of their clients to maximise Lehman's profit rather than returns for investors.

Referring to Grange's budget for 2005/2006, Mr Meagher said the investment company made around $500,000 a year from fees on investment agreements with clients, but made millions of dollars from underwriting the products and trading CDOs between clients, many of whom were New South Wales councils.

The document said Grange wrote CDO deals of between $50 million and $100 million and had a CDO deal every six weeks.

"The market has been good but it will get worse over the next year," the document read. "I'm expecting defaults to increase."

The councils allege Grange bought and sold the CDOs between investors therefore creating a secondary market because there was little demand from professional investors for already issued CDOs.

In another document, the head of the structured finance team at Grange, Moray Vincent, told staff the "prime targets" were existing clients who "operate on a high trust basis with Grange."

A number of the councils signed investment agreements with Grange which authorised Grange to make investments on their behalf.

In an email, Rod O'Dea, senior vice president of investment markets at Grange, expressed his concerns in response to an August 2005 internal report about the company's lack of formal procedures for managing clients.

He feared inadequate portfolio management could trigger demands from clients for Grange to buy back CDOs.

"If we blow up, we will get a tsunami of stock back to us," Mr O'Dea said.

A June 2007 email from Michael Clout, the head of fixed income at Grange, to sales staff told of a $100 million CDO inventory that the company wanted to reduce its exposure to.

"Can we focus on the usual suspects," Mr Clout said in the email.

Mr Meagher said Grange should have been aware of a January 2005 report on CDOs from the Bank for International Settlements, which coordinates financial regulation globally and serves as a bank for central banks.

The report said CDOs could be riskier than corporate bonds with equal credit ratings.

Collateralised Debt Obligations (CDO) are bundles of loans grouped together into an investment portfolio, which exposed investors to subprime and corporate debt.

Synthetic CDOs involve an extra layer of complexity called Credit Default Swaps, which are insurance contracts, often taken out by the seller or issuer, such as a bank.

The insurance contracts are paid out if a company within the portfolio defaults, reducing the pool of money available to investors. In some cases, the entire investment value of CDOs has been wiped out.

The case is continuing.