(Bloomberg) -- A legal battle is heating up over scraps of a synthetic securitization structured before the global financial crisis, highlighting risks in derivatives trades that are proliferating again.
Deutsche Bank AG and Morgan Stanley are fighting over 36 million euros ($43 million) that wasn’t repaid to junior noteholders. The deal matured in December 2016 and was designed to provide credit protection to Deutsche Bank on a portfolio of about 2.9 billion euros of loans to small and medium-sized enterprises.
Morgan Stanley, which holds most of the outstanding Class F notes, is reviving an argument applied to other legacy deals that the structuring bank had a conflict of interest because it stood to benefit from credit-default swap payouts. Complex trades that allow banks to reduce the amount of capital they have to hold against losses on loans by paying investors to take the first hit have rebounded as yields on traditional fixed-income assets declined.
“As was often the case in pre-crisis deals, the arranger has an economic interest that was divergent from that of the noteholders,” said Vincenzo Bavoso, a lecturer at the University of Manchester, England, who’s written papers on securitization. “This divergence was exacerbated, or perhaps created altogether, by the CDS that the arranger had entered.”
Lawyers for the banks have to submit documents for the dispute by the end of the month, after agreeing to an extension in April. Depositions are due to be completed two months later and a case management meeting is scheduled for August, according to court filings in New York. The case is The Bank of New York Mellon, London Branch v. Smart Sme Clo 2006-1, LTD. et al.
Spokesmen for both banks declined to comment on the case.
Under the swap, Deutsche Bank made periodic premium payments to noteholders in exchange for compensation on loan losses.
Morgan Stanley has said Deutsche Bank breached its obligations by embarking on a “firesale” of defaulted loans in a bulk auction months before the deal matured, worsening potential recoveries for investors. The sale “was designed to accelerate losses rather than maximize recoveries,” according to court filings.
Morgan Stanley said that the trade documents called for defaulted loans to be sold individually. The average recovery in the October 2016 auction was less than 18 percent, compared with nearly 42 percent for the previous three years, the U.S. bank said.
The German lender has argued that it’s owed the 36 million euros as insurance payments for the defaulted loans, according to court filings. It denies that it breached obligations under the swap and contends that its bulk sale was permissible.
“Pre-crisis deals will still knock at our door,” Bavoso said. “It is likely that investors will choose to litigate in order to recover some of the losses.”
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