The concept of prudence is often included in the legal documentation underpinning structured finance transactions such as securitisations and collateralised debt obligations.
Its purpose is to recognise that not every eventuality can be covered contractually and to limit flexibility to safeguard the best interest of all parties.
In practice, this is a useful tool as it allows lenders to continue treating customers fairly by leaving room for things like further advances and equity transfers but ensures they continue to evaluate risk prudently to protect investors.
Until now the validity of prudence as a measure of action has not been tested, but as soon as the losses started to mount it became a matter of time before court action ensued.
HSH Nordbank’s action is likely to be the tip of the iceberg as increasing numbers of investors scrutinise transaction documents in an attempt to mitigate losses.
The impact of the crisis so far has been an issue of supply and demand. If mortgages were meat pies, all that has happened is that a number of customers got food poisoning, blamed the pies and stopped buying them. As a result, the pie industry has declined dramatically, forcing some manufacturers out of business.
But the next stage of the crisis is beginning to emerge, with blame being apportioned and the poisoned customers seeking redress.
Stretching the analogy further, people are also looking at the pie-making process to work out what went wrong. Is it the piemaker or something in the machine that made the pies?
In the case of securitisations and CDOs, the machines were supplied by investment banks that built complex structures to issue securities. Lenders supplied the ingredients in the form of loans, but these were processed into the securities on which investors gorged.
In one sense, the movement towards legal action is positive in that it represents a step forward in the process of working out how to move on from the initial crisis’ paralysing effects.
But the implications of HSH Nordbank’s action are wideranging. The media coverage of the bank’s legal claim suggests it is focussing on a lack of prudence on the part of UBS rather than any structural problems with the securitisation machinery.
But now the case has started the ball rolling it’s possible we will see standard securitisation concepts such as bank-ruptcy remoteness tested in the courts before long.