Oct. 15 (Bloomberg) -- A fund associated with buyout firm TPG is exploiting an unintended wrinkle in the $650 billion market for collateralized debt obligations, sparking a revolt among investors that hold the safest portions of the securities.

A TPG Credit Management LP fund offered Oct. 9 to buy $115 million of bank trust preferred securities for 5 cents on the dollar from Tropic CDO V Ltd., according to a trustee report obtained by Bloomberg News. TPG Credit will pay holders of so- called equity portions another $5.75 million to allow the sale, the document says. Equity holders have the right to decide which assets the CDO sells because they’re first in line for losses.

Tropic CDO V’s equity holders may no longer have the incentive to ensure that assets are sold at fair value because their investments were wiped out by the worst financial crisis since the Great Depression. That may allow TPG Credit, a Minneapolis-based firm founded by former Cargill Inc. executive Rory O’Neill, to cherry-pick the best assets and erode senior holders’ collateral, according to John Scannell, chief operating officer of New York hedge fund Hildene Capital Management LLC.

“This is a coordinated attempt to loot the assets of the company,” Scannell said. While Hildene doesn’t have a stake in the CDO, Scannell said he’s concerned that if TPG Credit’s move is successful, others will follow suit. Hildene invests in distressed structured securities.

Profiting From Seizure

The economy’s recovery from its worst recession since the 1930s is attracting investors seeking big profits from the corresponding seizure in credit markets. TPG Credit joins Babson Capital Management LLC, GoldenTree Asset Management LP and other investors buying assets of CDOs, securities that contributed to the $1.6 trillion of writedowns and credit losses taken by the world’s largest financial institutions since the start of 2007.

Owen Blicksilver, a spokesman for TPG, declined to comment. O’Neill, chief executive officer and founder of TPG Credit Management, and Steven Gomes of trustee US Bancorp didn’t return phone calls seeking comment.

TPG of Fort Worth, Texas, is also targeting distressed real estate assets from failed banks. The buyout firm is part of a group buying the real estate assets of failed Chicago lender Corus Bankshares Inc. for $554.4 million, the Federal Deposit Insurance Corp. said this month.

CDOs parcel fixed-income assets such as bonds, loans or trust preferred securities and slice them into new securities of varying risk intended to provide higher returns than other investments of the same rating. GoldenTree and Babson are primarily buying CDO securities backed by high-yield, high-risk loans.

‘Counter-beneficial’

The highest-rated slice of Tropic CDO V, which was created in 2006 by pooling trust preferred securities issued by financial institutions, was downgraded five levels to A in April from AAA by Fitch Ratings. Rankings on other top-rated portions of the deal fell as low as B, seven steps above default.

Julie Braun, chief operating officer of TPG Credit, said in an Oct. 9 letter to Tropic CDO V noteholders that Trust Preferred Solutions LLC is seeking to buy $115 million of securities issued by 20 finance companies including Centra Financial Statutory Trust II and Forstrom Capital Trust II for 5 cents on the dollar. Investors must agree by Oct. 23, the letter said.

Trust Preferred Solutions is a TPG Credit investment vehicle. Blicksilver also declined to comment on behalf of Braun.

Safest Portions

“The 5 percent offer per security seems low and likely counter-beneficial to all or almost all noteholders in the deal, with the possible exception of the equity investors,” Gene Phillips, a director at advisory firm PF2 Securities Evaluations Inc., said in an interview from his New York office. “If this were allowed to go through, it would seem to be against the spirit of the deal, which aims to protect the senior noteholders.”

About $50 billion of so-called TRuPs CDOs are outstanding, backed by preferred securities issued by U.S. banks and thrifts, Ratul Roy, an analyst at Citigroup Inc. in New York, said in a telephone interview. While the riskiest portions of the CDOs have stopped paying interest as bank defaults have increased, the safest portions of the CDOs have more than doubled in price to 45 cents on the dollar since March, he said.

Equity portions are either receiving no cash or will soon be wiped out, Roy said.

“This loophole, if it exists, may provide the fund a cheap and easy entry point to buying some of the underlying preferred securities within the CDO,” Phillips said. “Even if some of these assets are deferring, a 5 percent bid seems rather punitive, and would thus likely be against the intended design of these deals if the senior note holders, who the deal aims to protect, aren’t able to circumvent the offer.”

To contact the reporters on this story: Caroline Salas in New York at csalas1@bloomberg.net; Pierre Paulden in New York at ppaulden@bloomberg.net

Last Updated: October 15, 2009 16:16 EDT