Millions at stake as credit crisis gets legal

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Wall Street is bracing itself for years of legal wrangles over who should shoulder losses on the complex derivatives at the heart of the credit crisis.

A court case pending in New York, involving Deut-sche Bank and UBS, among others, is the first to try to unpick who is owed what, now that American homeowners are defaulting on their mortgages in record numbers.

The mortgages have been used as collateral for a fiendishly complex array of derivatives, including collateralised debt obligations (CDOs), which have been sold to investors around the globe.

A New York state court is being asked to decide what should happen to a mortgage investment vehicle called Sagittarius CDO I, which had $985m (487m) in assets, but which said last month it would default on interest payments it owes on some of its bonds. The case is been seen as a harbinger of things to come as the credit crisis plays out in 2008.

Sagittarius, in common with other CDOs, has sold an array of different types of bonds backed by different types of mortgages. Some of the bonds pay a high interest rate to compensate for their increased risk, while others are much safer investments that would keep paying out unless the underlying mortgage loans run into serious difficulty.

The circumstances in which different tranches of CDO debt can renege on promises to pay interest are governed by long legal agreements, ripe for conflicting interpretations.

In this case, the bond insurer MBIA is claiming it should get first dibs on all of Sagittarius's future income putting it into conflict with Deutsche Bank, the vehicle's trustee, and other investors who include UBS. Already the disputed payments run into several million dollars and are increasing all the time the matter is unresolved.

Sagittarius is not the first case in which a CDO has got into trouble and led to a legal fight. In 2005, Barclays agreed to pay compensation to German state bank HSH Nordbank in a dispute over the management of several CDOs that halved in value.

With more than $1 trillion of CDOs outstanding, the sums that could ultimately be in dispute across the industry are bigger than anything previously before the courts. Chris Flanagan, credit analyst at JPMorgan Chase, told clients in a recent investment note: "If there's one safe prediction for 2008, it is that legal teams will be busy."