Another Lawsuit Hits UBS

Already dealing with one investor lawsuit, Swiss bank UBS is facing allegations from Pursuit Partners that it marketed securities as investment grade that the bank knew were destined for junk status. Pursuit Partners, a Connecticut-based hedge fund, claims that it bought collateralized debt obligations (CDOs) from UBS last year when UBS knew that changes in Moody’s rating methodology for CDOs were imminent. Despite that information, UBS continued to market the CDOs to the hedge fund between July and October of last year as if the change would not occur.

CDOs are complex asset-backed securities that comprise various types of loans. They became popular during the U.S. housing boom as banks pooled mortgages into new investment products that were sold to a broad array of hedge funds and other institutional investors seeking robust returns.

The changes at Moody’s involved how the CDOs were valued. Previously, CDOs were priced at current market prices but as the market for securitized subprime mortgages collapsed and ratings agencies faced criticism over how they had rated CDOs, Moody's elected to change to a market-based formula focused on future prices rather than current prices. That change would result in the immediate drop of supposedly safe mortgage-backed securities into the realm of junk.

When Pursuit paid UBS more than $50 million for pieces of the CDO, the transaction was for investment-grade securities. When Moody's announced its new ratings formula on Oct. 10, 2007, the CDOs were immediately reduced to junk status. Although there was no change in the performance of the underlying mortgages, the ratings revision triggered a default clause in underlying derivatives contracts and Pursuit lost its entire investment. Pursuit also claims UBS took both sides of a derivatives contract, allowing it to liquidate the CDOs without sustaining a hit of its own.

Pursuit’s lawsuit also touches on allegations made in the previous lawsuit from German bank HSH Nordbank which accused UBS of pawning off toxic mortgage investments on unsophisticated buyers. In February, HSH Nordbank sued UBS for $275 million, claiming that it bought $500 million in complex mortgage-backed securities that Dillon Read, UBS’s now-closed hedge fund, later stuffed with troubled subprime loans as a way to reduce its own losses.