-- [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
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
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
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.

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