December 17, 2007

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CDO Battles:
Royal Pain Over
Who Gets What

First came the bankers who created funky mortgage investment vehicles. Now come the lawyers.

A recent filing in New York state court provides a window into the legal battles likely to ensue from battered investments. Big players, including Deutsche Bank AG, bond insurer MBIA Inc., Wachovia Corp. and UBS AG are tangled together over a mortgage investment vehicle named Sagittarius.

Sagittarius CDO I Ltd. is a $985 million collateralized debt obligation, an investment vehicle that pools together mortgage-backed securities and sells bonds related to these pools. During the U.S. housing boom, Wall Street scattered the risk in investments like Sagittarius -- selling pieces to investors around the globe. It also parceled out to different institutions the responsibilities of overseeing these portfolios. Now that losses are piling up, financial players are lining up to battle over the remnants.

On Nov. 6, Sagittarius triggered "an event of default." This prompted MBIA to claim it should get all the remaining payments. That put it into potential conflict with Deutsche, the CDO's trustee, and UBS, an investor with fewer rights in the event of default.

Sorting out how to value the assets, who gets paid and whether to pull the plug on struggling CDOs is complicated business. Often little is known about who holds what. "If there's one safe prediction for 2008, it is that legal teams will be busy," wrote J.P. Morgan Chase in a recent report led by analyst Chris Flanagan.

So far, three CDOs have started the process of liquidation. More are expected. J.P. Morgan projects that by the second quarter, $40 billion to $50 billion in subprime-mortgage bonds could be sold by distressed CDOs that decide to liquidate.

Sagittarius isn't in liquidation, but conflict already is brewing. It was sold to investors in March by Wachovia Securities and ran into trouble when its holdings fell in market value and were downgraded by ratings providers.

An MBIA affiliate called LaCrosse Financial Products LLC is senior to other Sagittarius noteholders -- it entered into a derivatives transaction that is senior to other securities associated with the CDO. The day after the event of default, LaCrosse sent Deutsche Bank a letter saying that no interest or principal should be paid to other junior noteholders.

Other investors, unnamed in the legal filing, disagreed, telling Deutsche that MBIA's position "is neither reasonable nor correct," according to court papers filed by Deutsche Dec. 3. These other bondholders also might disagree about how they would share continuing payments, assuming they got any money. The disputed payments total several million dollars and will pile up until the dispute is settled, according to a person familiar with the matter.

With its legal filing, Deutsche is essentially asking the court to guide it on whom exactly should be paid. (As trustee, Deutsche distributes funds to the investors.)

A Deutsche Bank spokesman declined to comment on the investors. Two UBS mutual funds -- UBS Absolute Return Bond Fund and UBS Global Bond Fund -- bought about $1.2 million of the CDO this year, according to fund regulatory filings. If MBIA wins, they could have less chance of getting paid back.

MBIA has reason to aggressively protect its interests -- its stock has declined more than 60% this year amid concerns about its mortgage exposure. The company recently brought in Warburg Pincus LLC as an investor to help boost its capital level. Moody's Investors Service called MBIA's outlook "negative," but affirmed its top bond rating in a broader review of bond insurers Friday. Spokesmen for MBIA and UBS declined to comment on the matter. A Wachovia spokeswoman said the bank isn't a party to the filing and hasn't taken a position on it.

CDOs had become one of the most popular ways for sophisticated investors to tap into the housing boom. Now many of the opaque portfolios are suffering deep losses.

"No one has cracked the code on how to work these out and divvy things up," says Julia Whitehead, a senior adviser at valuation advisory firm Miller Mathis.

About 40 consumer-debt backed CDOs have declared an event of default; their face value is near $45 billion -- about 7% of the $640 billion in CDOs outstanding rated by Moody's. Under the terms of many CDOs, an event of default prompts a shuffling so that more payments are shifted to senior investors who originally took the least risk in return for a lower yield.

Three mortgage-related CDOs -- Carina CDO, Adams Square Funding I and Vertical ABS CDO 2007 I -- have decided to liquidate. Many others are holding out to see if the market recovers.

When senior holders stake their claim to struggling CDOs, it threatens other investors who accepted more risk to get higher returns. The process of sorting out the rights of different holders is complicated and seems likely to play out differently than in corporate bankruptcies, analysts say.

"If you liquidate a lot of assets at once, you don't always get the best price," says Janet Tavakoli, president of consulting firm Tavakoli Structured Finance.

Write to Aaron Lucchetti at aaron.lucchetti@wsj.com¹