-- [B] Investor group sues CSFB, Dresdner over Ecuador derivatives -- By Felix Salmon, BridgeNews New York--Aug. 24--Credit Suisse First Boston (CSFB) and Dresdner Bank AG allegedly structured Ecuadorean credit derivatives that had no place in a retail portfolio with the knowledge and intention that retail investors would buy them, according to a lawsuit filed in Frankfurt on behalf of some of the holders of the bonds. The synthetic instruments, issued in 1997, expired worthless after Ecuador defaulted on its debt in 1999. Holders of Ecuador sovereign bonds, in contrast, saw their debt restructured into new bonds. Dresdner Bank would not immediately comment on the allegations, while a spokeswoman for CSFB, the global investment banking unit of Zurich-based Credit Suisse Group, said that "we believe that the lawsuit has no merit." * * * The suits are a test case, the investors' lawyer, Franz Braun, of German law firm Rotter Rechtanwaelte, told BridgeNews from Germany. Should they be successful, other investors in the Dresdner and CSFB instruments, as well as investors in similar bonds issued by other banks, could seek to retrieve some of their losses, he added. He said he now represents more than 30 investors. The CSFB and Dresdner Bank instruments were valued at 375 million Deutsche marks ($172 million). When similar instruments from institutions such as Merrill Lynch & Co. Inc., JP Morgan & Co. Inc. and HSBC Trinkaus are included, the total value of the instruments is estimated at 1 billion Deutsche marks ($458 million). The test cases are seeking compensation of 140,000 Deutsche marks ($64,000) from CSFB and 132,000 Deutsche marks ($61,000) from Dresdner Bank. In early 1997, when these notes were issued, there was much more appetite for emerging-market risk than there is now. Emerging-market spreads were narrowing to all-time lows near 300 basis points over Treasuries, and yield-hungry European investors were looking at increasingly high-risk instruments, especially high-yielding Ecuadorean PDI Brady bonds. But the currency (dollars), the coupon (just 3.5%) and the size (minimum $250,000) of the PDIs bonds were not appealing to investors, say sources in some of the banks that structured such deals. So investment banks, including CSFB and Dresdner, stuctured a deal that turned the low-coupon, low-price PDI bonds into high-coupon, high-price synthetic instruments. The dollar coupon from PDI bonds was swapped into Deutsche marks at a rate fixed at issue, and paid out as a higher coupon on the new bond. Because the amount of the new bonds was less than the PDIs on which they were based, they could pay out a higher coupon. The PDIs were trading cheaply in the secondary market--around 60 cents on the dollar--so the new bonds could pay out even more. And because the cash coupon on the PDIs increased over time while the coupon on the new bonds went down, the initial dividend was jacked up even further. All told, the 3.5% coupon on the PDIs turned into a coupon of as much as 14.25% on the new notes. The structure behind the bonds was extremely complicated: most emerging-market bond traders and institutional investors avoid synthetic issues precisely because they're so difficult to understand. Not only did the structure involve a foreign exchange swap and an interest-rate swap, there weren't any physical PDI bonds underlying the new notes. Everything was structured with the aid of credit derivatives--instruments that typically pay out a predetermined amount of money in the case of certain credit events. Regardless of whether the new bonds were actually sold as synthetic PDIs, they were certainly pitched as Ecuadorean sovereign risk. But there is a crucial difference between Ecuadorean debt and the new structured instruments: the former is a claim on the Ecuadorean government, which has been restructured into new 12-year and 30-year global bonds. The latter, on the other hand, expired worthless within days of Ecuador defaulting in September 1999. The bonds have been bought back at zero cost by the issuer, and the bondholders have been left with nothing at all. The bond prospectus for the CSFB bonds is very long and written in very technical language. Nevertheless, the front page states in bold type that "the performance of the Notes will differ significantly from a direct investment in the Reference Securities (PDIs)... the prevailing market value of the Notes will not correspond to the aggregate of the prevailing market values of each Reference Security." "Each Partial Reference Amount payable following a Credit Event may accordingly amount to zero," the document states. The prospectus continues: "The Notes are only intended for highly sophisticated and knowledgeable investors who are capable of understanding and evaluating the risks involved in investing in the Notes and who are required to read 'Investment Considerations.'" But some of the investors who wound up holding the bonds were neither sophisticated nor knowledgeable. "A lot of very small investors went into this without realizing the risk," says a U.K.-based investor who spoke on condition of anonymity. "I think a lot of people have been wiped out." The small investors, scattered throughout Europe, who ended up buying the notes were not financially sophisticated at all, they and their lawyers say. They never saw the prospectus, with its bold-type warning. One of them alleges that the banker who sold him the bonds never had a copy. They didn't even know what a credit derivative was, let alone that they were buying one, they say. Says one of the U.K. investors: "I thought I was buying Ecuadorean sovereign debt issued by Ecuador. I've only recently found out that Ecuador Synthetic Sovereign Instruments is a subsidiary of Credit Suisse. My understanding was that the bonds I bought were the equivalent of the dollar PDIs. I didn't hear the name Credit Suisse." One of the plaintiffs in the test case bought some of the Dresdner Bank bonds directly from Dresdner Bank, according to Braun at Rotter Rechtanwaelte. However, Credit Suisse did not sell its synthetic instruments to any retail investors, according to sources inside and outside the bank. Nevertheless, the bonds were denominated in units of 1,000 Deutsche marks and 10,000 Deutsche marks, making it easier to sell into retail. It also could not be confirmed whether a German language version of the prospectus was made available to prospective customers there. "One should be able to prove that CSFB and Dresdner were counting on private investors investing in these bonds" despite knowing that these securities were unsuitable for such investors, says Braun. The law firm issued a press release when it filed the suit on Aug. 19, alleging that "several rules including those of German criminal law had been violated because the lead managing banks took unfair advantage of the fact that investors didn't have the faintest idea of what was really going on." Braun is suing the lead managers of the bonds because under German law it is very difficult to go after the brokers who actually sold the investors their bonds. "In England and in America there are very hard selling restrictions, so they (CSFB and Dresdner) went to Germany," he says. Braun notes that CSFB and Dresdner seem to have got the best of both worlds. In England, it would be illegal to sell such securities to retail investors, while in Germany it would be illegal to structure such instruments in the first place. So the banks structured the instruments under English law, and then sold them to brokers who in turn sold them on to their retail clients in Germany, Braun says. Braun speculated that the first hearings in the case might take place in three to five months' time, and that if it goes to the German high court, the case could take four or five years in total. Sources at Dresdner and CSFB say they are awaiting delivery of the claims by the Frankfurt court system before they can respond to the allegations. End (Back) to felixsalmon.com