Low volatility in the past two years has encouraged investors into highly-leveraged investments such as collateralised debt obligations (CDOs). But many do not understand the pitfalls, say lawyers, and will blame their bankers should the bets go wrong.
"Spread reversal will produce large losses which inevitably will lead to lawsuits," said Claude Brown, a partner in the CDO group at Clifford Chance. "The value of these transactions means many will regard litigation as a tool in the negotiation toolbox."
European and US credit spreads are hovering near record tight levels after a sustained period of low interest rates and stable ratings. With global growth slowing, however, and interest rates predicted to rise, spreads could widen in coming months, analysts say.
Collateralised debt obligations are structured assets that can be divided into tranches. Returns are higher than on single-name investments but lose more when spreads widen or underlying credits default.
Further, says Brown, their complexity makes them fertile grounds for legal machinations. "Litigants will argue either they were sold something they didn't want, were sold a toxic product or were exposed to some risk that was hidden from them," he said.
Already many cases are thought to have been settled out of court. Those reported include the European Bank for Reconstruction and Development settling a claim against Barclays, while Prudential Bach last year paid out on an unspecified $40 million claim for misselling.
"The vast majority of cases are dealt with without ever reaching court," said Simon Hart, a solicitor at Richards Butler. "The volume of disputes is impossible to estimate but where complex products are developing quickly there is always scope for litigation."
Among innovations heavily marketed this year are CDO squared - or CDOs of CDOs - and options on credit default swaps. The credit derivatives market reached $5 trillion at the end of 2004 and is expected by the British Bankers Association to hit $8 trillion by December 2006. Such is the level of concern among regulators that the Bank for International Settlements last month warned investors to beware credit ratings on structured products.