CLOThe hey-day for exotic bets on credit risk spanned most of the first decade of the 21st century. The popping of the housing bubble in 2008 did it in. People lost homes that they bought with debt they couldn't repay; and plenty of investors watched in horror as the value of the junk they'd bought — collateralized debt obligations, mortgage-backed securities, and credit-default swaps — went to zero or worse.

Yet some folks made money. A LOT of money. The vendors whose services made the exotic bets possible sure did. That would include the banks, the deal lawyers, and the firms that acted as trustees. Pretty much everybody did fine until the bubble burst. See, e.g., Michael Lewis, The Big Short.


A ruling by the Second Circuit today highlights the importance of timing.

Franklin Advisers sued for a "contingent" fee from a $600 million collateralized loan obligation. Franklin claimed that it earned the fee under the CLO's trust indenture for beating a 12 percent gain target. The district court and Second Circuit panel agreed, holding that the cashing out of the CLO in 2007 — shortly before the bubble burst — constituted an event that entitled Franklin to the bonus. Bank of New York Trust Co. v. Franklin Advisers, Inc., No. 12-0168 (2d Cir. Aug. 1, 2013) (applying New York law).

The CLO side claimed, oddly, that the court should construe the trust indenture against trustee Franklin. The panel said no, that rule applies only if the party in question drafted the contract language in question. Franklin, as trustee, didn't even sign the indenture, the court noted.

Blawgletter observes that Franklin very likely hired and directed the law firm that wrote the indenture. The panel describes the firm as "deal counsel". We think that matters as much as or more than the identities of the formal parties to the indenture.

We also point out that Franklin would likely have earned no contingent fee had the CLO's shareholders not voted to redeem their shares in early 2007. In the ordinary course, the CLO would not have matured until Aug. 28, 2013 — a few weeks from now. Because its assets "in the main, were leveraged, secured loans made to below-investment-grade borrowers", the CLO probably wouldn't have lasted until maturity as defaults cascaded through the portfolio and the value of the assets plummeted. Timing is everything.

Bonus:    Goldman Sachs's Tourre Fabrice lost his civil trial in a case that the Securities and Exchange Commission brought against him for helping GS hype a CDO that went bust. The jury found that he committed securities fraud.