Structured finance documentation issues

Take an OTC market that has grown really, really quickly. It's a safe bet that there will be documentation difficulties. After all, documenting all of those trades is a lot of work. For credit derivatives it is a particular problem in that there have been several sets of ISDA definitions (including the 1999 definitions, the 2003 definitions and the 2005 supplement - and that's without worrying about pay as you go credit derivatives). Regulators have been worried about credit derivatives documentation for a while: see here for an FSA 'Dear CEO' letter about getting your docs signed and here for an earlier news story.

Now it seems that legal risk is starting to really bite. The FT reports that

[...] more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

For instance, in a number of cases it is not clear whether the assets should be sold (liquidation) or let to run off (acceleration). Moreover, even the rules to distribute the money post-EOD (who gets what) are unclear.

This is completely unsurprising. Desperate lawyers struggling to document the last trade before the next one closes make mistakes - anyone does if they are under enough time pressure. No one hired enough lawyers in the good times because there weren't enough lawyers: the market had grown faster than the skill base supporting it. What happens next will be insightful.