Swiss bank UBS, already smarting from one investor lawsuit, is facing allegations from a hedge fund that it marketed securities as investment grade that the bank knew were destined for junk status. Pursuit Partners, a Stamford (Conn.)-based hedge fund, claims in a Mar. 5 lawsuit that it bought collateralized debt obligations, or CDOs, from UBS last year based on "fraudulent concealment" of material information.
The suit's allegations are reminiscent of the Wall Street research scandal in which analysts promoted stocks they secretly considered worthless. The suit in Connecticut Superior Court claims that UBS (UBS) had been in talks with ratings agency Moody's (MCO) and knew that changes in the rater's methodology for CDOs were imminent. Despite that information, UBS continued to market the CDOs to the hedge fund between July and October as if the change would not occur, according to the lawsuit.
CDOs are complex asset-backed securities that comprise various types of loans. They grew in popularity during the U.S. housing boom as banks pooled mortgages into new investment products that were sold to a broad array of hedge funds and other institutional investors seeking robust returns.
Changes in Moody's Methodology
The changes at Moody's involved how the CDOs were valued. Under the company's previous formula, the securities were priced at current market prices. But as the market for securitized subprime mortgages collapsed and ratings agencies faced criticism over how they had rated CDOs, Moody's elected to change to a market-based formula, one focused on where prices were heading, rather than on current prices. That change would result in the immediate drop of supposedly safe mortgage-backed securities into the realm of junk.
When Pursuit paid UBS more than $50 million for pieces of the CDO, the transaction was for investment-grade securities. When Moody's announced its new ratings methodology on Oct. 10, 2007, the CDOs were immediately reduced to junk status. Although there was no change in the performance of the underlying mortgages, the ratings revision triggered a default clause in underlying derivatives contracts and Pursuit lost its entire investment. Pursuit also claims UBS took both sides of a derivatives contract, allowing it to liquidate the CDOs without sustaining a hit of its own.
UBS had no comment on the hedge fund's lawsuit. Moody's said it had no comment on the litigation.
UBS Has First Loss in a Decade
The new lawsuit adds to the troubles faced by UBS. In December, the bank wrote down $10 billion from subprime losses, and was forced to go hat in hand to recapitalize, turning to the Government of Singapore Investment Corp. and an unidentified Middle East investor who put in a total of $12 billion. That loss increased to $14 billion in January, and in February, UBS reported its first annual loss (BusinessWeek, 2/21/08) since being created from the merger of Swiss Bank and Union Bank of Switzerland 10 years ago. Analyst downgrades, predicated on more subprime writedowns, pushed UBS shares down further. On Mar. 5, UBS shares closed at 30.83, down 53% from a 52-week high of 66.26 in April.
The Connecticut lawsuit also touches on allegations made in the previous suit from a German bank, accusing UBS of pawning off toxic mortgage investments on unsophisticated buyers. In February, German lender HSH Nordbank sued UBS for $275 million, claiming that it bought $500 million in complex mortgage-backed securities that Dillon Read, UBS's now-closed hedge fund, later stuffed with troubled subprime loans as a way to reduce its own losses. UBS filed a countersuit, and said it had fulfilled all obligations to the "professional and knowledgeable German bank" and was comfortable with its legal position.
Pursuit said it tried to resolve the matter and recoup its money without going to court. Michael Burg, an attorney for Pursuit, says UBS refused to discuss the issues "so we had no alternative but to file the lawsuit."