UBS, which denies all the allegations, issued another statement on February 26, saying: “We discussed and negotiated the transaction over a period of several months and agreed to all of the client’s conditions. We executed all of our contractual obligations and the transaction is not in default.”
HSH Nordbank accused UBS of exploiting the CDO to reap gains at its expense, including a $120 million profit on the day the deal closed – later increasing to more than $275 million, the bank alleged.
“UBS appears to have condoned actions that benefited only itself, at the expense of its clients,” a bank spokesperson commented. “After repeated attempts to discuss our concerns with senior management at UBS, we find we have no alternative but to commence legal proceedings against UBS.”
In its statements, however, UBS said it had invited the bank to mediation before a judge.
HSH Nordbank’s allegations centre on a synthetic CDO originated in early 2002, North Street Reference Linked Notes 2002-4. Arranged and managed by UBS, the deal was one of a series used by the bank for portfolio management purposes. Landesbank Kiel was apparently the sole investor in four out of six classes of notes, an investment totalling $500 million. LB Kiel merged with Hamburgische LB to form HSH Nordbank in 2003.
The North Street CDO was designed to enter into a credit default swap (CDS) with UBS referencing a portfolio of fixed-income investments with a total notional value of $3 billion. In its court filing, HSH Nordbank alleged UBS proposed North Street as a vehicle for achieving conservative returns on securities backed mostly by US real estate assets. But it claimed UBS “regarded it not as an investment vehicle but as an opportunity to defraud HSH Nordbank”. It charged UBS with exploiting the CDO at the expense of HSH Nordbank, “in violation of its contractual and fiduciary duties”.
In structuring the transaction, HSH Nordbank said UBS made a closing-day profit of $120 million through a technique known as ‘barbelling’. Barbelling entails selecting CDO reference entities whose credit spreads trade relatively widely compared with their rating. While this increases the overall spread earned on the portfolio, it is likely to destabilise the transaction if the credits are impaired and destined for a future downgrade. In the case of North Street this “substantially or entirely eliminated” the $74 million of subordination that protected its classes of notes, HSH Nordbank alleged.
Subsequently, the filing alleged UBS increased the profit it made from North Street to more than $275 million via manager substitutions. According to the claim, the gains arose from replacements designed to transfer exposures from the Swiss bank’s balance sheet on to North Street, as well as short positions in reference entities held on its own trading books.
The largest substitution cited by HSH Nordbank involved the inclusion of around $555 million of exposure to the (now Markit) ABX indexes in February 2007. As the outlook for the US mortgage market rapidly deteriorated, it claimed the asset management arm of UBS imported $500 million of exposure to the ABX.HE A 06-2 index, and another $55 million to the ABX.HE BBB- 06-2 index. The indexes reference CDSs on US home equity loans originated in 2006 and rated A and BBB-, respectively. These substitutions, HSH Nordbank said, increased the CDO’s exposure to home equity loans to the tune of $49 million.
The German bank also alleged UBS offered a number of safeguards to it when investing in the deal that were subsequently breached. These included North Street’s substitution rules, stipulating all reference entities should be rated investment-grade or above.
In addition to the deal documents, HSH Nordbank claimed UBS pledged in a separate agreement to set up an oversight committee, to ensure the long-term stability of the CDO’s collateral. Later, it said it discovered this committee comprised just one person – something it thinks enabled faulty substitutions.
Despite North Street’s holding the opposite side of a CDS with UBS, HSH Nordbank says it was led to believe the interests of UBS would be aligned with its own, as it would be taking positions in the CDO both junior and senior to its own. But according to HSH Nordbank, UBS only took exposure in the vehicle subordinate to its own.
In its court filing, HSH Nordbank described LB Kiel as a “regional bank with little familiarity in international structured finance”. In its statement, however, UBS characterised its client as a “professional and sophisticated market participant”. The North Street CDO was tailored to satisfy the German bank’s demands, it added.
The court case is the second involving an actively managed CDO bought by Kiel LB. In late 2004, HSH Nordbank filed a suit against Barclays Capital seeking to recover losses on a $151 million investment in a CDO sold to Kiel LB during 2000, called Corvus. The case was settled out of court in February 2005 for an undisclosed amount.