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Last week HSH Nordbank, the German bank, filed a case in London's high court to recover $150m (£85m) of losses it said it suffered by investing in collateralised debt obligations (CDOs) issued by Barclays. It claims it was mis-sold the products.
Barclays yesterday strongly denied taking out short positions in the bonds, but the scale and bitterness of the legal battle is already causing deep alarm among other investment banks operating in the lightly regulated $500bn market for credit derivatives such as CDOs.
One document circulating among disaffected investors makes the strongest possible accusation against Barclays. "The whole system seems to be created to fleece their own asset management clients by using their information advantage," it states.
Barclays yesterday made an equally strong defence of its position. "We think this [Nordbank] case is without merit and we are confident this matter will be resolved in our favour. We did not short any bonds. Typically, we do not comment on profitability, but we can say that we did not make $300m from these products."
Credit derivatives have enjoyed exponential growth in the past decade. They are synthetic instruments designed to allow risk to be spread around the financial system and their fans argue they improve overall stability. However, Sir Howard Davies, when head of the Financial Services Authority, referred to some CDOs as the "toxic waste" of the financial system.
If the Barclays-Nordbank case reaches court, it will be one of the first opportunities for outsiders to glimpse the detailed workings of this market. Another potential case, between the European Bank of Reconstruction & Development and Barclays, is thought to have been settled out of court.
Nordbank declined to comment, but it is thought a central part of its claim will rest on the allegation of short-selling - in other words, a charge that Barclays in effect bet that the value of the CDOs would fall. Nordbank would then argue that this was a direct conflict of interest with Barclays' supposed mandate to manage the portfolios on behalf of clients.
The wording and legal status of that management contract is likely to be a key aspect of the case, said one specialist in credit derivatives. Such mandates have a variety of forms: some place a formal fiduciary duty on the CDO manager, similar to the obligation on a pension fund manager to act for the benefit of the pensioners; others give explicit rights to the issuer to substitute assets within a CDO portfolio within agreed parameters.
It is already clear that there was significant substitution of assets within some of the 16 CDOs, with a face value of more than $3bn, created by Barclays between 1999 and 2001. Early last year Fitch, the credit rating agency, took the highly unusual step of publishing details of the underlying assets of Corvus, one of the biggest Barclays CDOs and one where Nordbank was an investor.
Corvus appeared to have increased its exposure to aircraft leases soon after the September 11 attacks in the US. It was also a buyer of poorly performing bonds related to prefabricated housing in America and had invested significantly in other Barclays CDOs which had fallen in value.
Fitch downgraded its rating on Corvus at extraordinary speed. By September last year, the top three tranches of debt, which were supposed to be the safest, had been reduced to junk status. By contrast, one of the main attractions of CDOs is supposed to be the stability generated by investing in a diversity of assets.