CDO losses a windfall for litigators

ONE by one they fall.

The council investment saga started almost two years ago with the realisation that one of their popular investments, a Lehman Brothers-arranged investment branded Federation, was exposed to the American sub-prime mortgage market, and losses were probable.

But the losses didn't end with Federation.

Litigation funder IMF estimates Australian investors will eventually make $4 billion of claims as they seek compensation for failed products called collateralised debt obligations (CDOs), with rating agencies, banks and advisory firms the likely targets.

Hugh McLernon, the WA executive director of IMF, said it was not a question of if the CDOs were toxic, it was a question of how toxic they were.

"In my view, the great majority will fail before they come to the end of their term," Mr McLernon said.

IMF has gathered more than 50 investors, who originally paid a collective $400 million to buy CDOs, to pursue the rating agencies, among others, for compensation should legal obstacles relating to the fall of Lehman's local branch be cleared.

The City of Melville used to be advised by Lehman (formerly Grange Securities), and in turn, paid more than $20 million for a portfolio of CDOs.

It is holding seven CDOs that have experienced four or more credit events, which means the investments are moving towards default.

The HSBC Bank-arranged Blue Gum, Merrill Lynch-arranged Scar-borough and JP Morgan-arranged Torquay and Kakadu are most at risk.

Some other popular council investments, like the Merrill Lynch-arranged Helium, have already defaulted.

A CDO is a bundle of loans designed to pay regular income and repay capital on maturity; although the synthetic CDOs common in council portfolios gain credit exposure through credit default swaps.

One professional with intimate knowledge of the sector told WA Business News that he spent weeks trying to reconstruct the Federation CDO to see how it worked, but eventually gave up on the project.

CDOs are able to sustain a couple of credit events in their underlying entities - such as a bankruptcy - but when they experience more than seven or eight, they usually become worthless.