Judge 1 – Rating Agency 0
by Economics Correspondent Sean Whelan @seanwhelanRTE
Bathurst is a small town 200km west of Sydney that is best known (to me at least) as the home of the Bathurst 1000 motor race. It is not known as a place that has its finger on the pulse of the GLOBOXX index. But why should it? After all a regional council’s job is looking after local services, promoting the local university, helping out with the local, internationally famous, motor race.
No, keeping an eye on the GLOBOXX index (which itself is a composite of two other indices, the CDX and iTraxx, which measure the market in Credit Default Swaps – a sort of insurance against default commonly used by buyers of government or commercial bonds) is best left to the nerds who work at credit ratings agencies.
Or so one would have thought. Yet a judge in Australia has found that one of the very biggest ratings agencies, Standard and Poor’s, didn’t keep an eye on the Globoxx index. Instead of working out some important numbers for itself, it used numbers supplied to it by a client, ABN Amro, a Dutch bank that had just invented a brand new financial product called a Constant Proportion Debt Obligation (CPDO).
And on the basis of these numbers – and a few other improbable assumptions – awarded this newly minted product a triple-A rating, the highest there is. And on that basis, Bathurst Regional council, and a dozen other small local authorities in Australia invested $16 million these CPDOs. And lost 90% of their money when the instruments blew up a year later.
I won’t try and explain how these CPDOs were supposed to work – I’m not sure I can – but there is a link below if you really, really need to know. Suffice to say that the CPDO was a very risky product that, thanks to the Triple A rating it got from S&P, was bought by local authorities looking for somewhere safe to stash their financial surpluses, but still earn more than the bank was offering.
Now Bathurst council and the others might just get their money back, because they have won a court case against the people that sold them the CPDO’s (Local Government Financial Services Pty), and ABN Amro and – most significantly – S&P.
And the best part is that the case taken by little Bathurst (population 33,000) proved with numbers that S&P got it badly wrong. It wasn’t just an “opinion” that didn’t turn out right – it was several glaring mathematical errors, any one of which, had they been caught, would have rendered it impossible to give the product Bathurst bought a Triple A rating.
The summary of Federal Judge Jayne Jagot’s judgement runs to ten pages. The full judgement – more than 600,000 words, comes close to 1,500 pages. Here is the summary of the summary – paragraph 53
“S&P’s rating of AAA of the Rembrandt 2006-2 and 2006-3 CPDO notes was misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia”.
“ABN Amro was knowingly concerned in S&P’s contraventions of the various statutory provisions proscribing such misleading and deceptive conduct, and also itself engaged in conduct that was misleading and deceptive…”
S&P’s problem, according to the judge, was that it didn’t do its own sums. She reports in great detail how ABN Amro structured its CPDO products to try and get a Triple A rating (as they had hired two former S&P employees, this was not too difficult).
ABN’s own modelling found they would not get AAA ratings unless one of the parameters used – the volatility of the Globoxx index – was much above 15%. This was the key number they suggested to S&P – in five communications.
S&P’s could have performed their own calculation to discover what the true rate of volatility in the Globoxx index was. If they did, they would have found it to be 29%. A number, Judge Jagot says, ABN already knew. Indeed she says S&P had previously rated a similar product using a volatility assumption of 35% for the same index!.
But at any of these levels, the ABN CPDO would not get a AAA rating. So S&P used the number ABN had given them – 15%. The judge said that an “averagely competent” ratings agency would have done its own calculation.
The volatility question wasn’t the only issue. Of the five key inputs to the model used by S&P to test the CPDO, two were described by the Judge as “unjustifiably and unreasonably optimistic and had not proper rational foundation”. Two other inputs were defensible in themselves, but S&P did not use a “stress case scenario” to see what would happen if things took a turn for the worse. If it did they would not have been able to award AAA status. A fifth parameter – default cases – was stress tested.
The Judge decided “S&P’s modelling and assignment of the AA rating was not such as a reasonably competent ratings agency could have carried out and assigned in all the circumstances”.
The CPDO was a fiendishly complex instrument, described by the Judge as “an extraordinarily complicated bet on the future performance of two CDS indices over a period of up to ten years.
Of crucial importance was the starting spread. The money investors put into a CPDO was then invested in a “synthetic” basket of corporate debt. The lower the yield on that debt, the less money the CPDO could make. When these CPDO products were marketed the spread on corporate debt was low and falling.
When S&P first rated the product, the starting spread was 36 bps, which reflected the average spreads at the time. But a few months later, when the second and third CPDOs were assessed, the spread had dropped to 31 bps, then 29 bps.
According to the judge, ABN Amro knew that a spread below 35 bps meant the AAA rating was “borderline”, but didn’t tell S&P when it came to rate the second and third CPDO’s.
S&P didn’t check what the actual spreads were – they assigned the AAA rating to the second CPDO product using the same spread as earlier (36 bps). If they had used the actual spread of 31 bps, they would not have been able to issue a AAA rating.
Local Government Financial Services (LGFS) in Australia bought $40 million of this product, based on the AAA rating from S&P. They later sold on $16 million of the product to the local authorities, including Bathurst. They too put their faith in the AAA rating. A further €10 million of the second CPDO was sold on to StateCover, a workers compensation insurer.
Within a few months of the CPDOs being sold, the global financial crisis started, and immediately the CPDOs were in trouble. By February 2008, S&P rated the second and third CPDOs – the ones the Australians bought – at BBB+. The net asset value in them was 40%. Local Government Financial services lost $16 million when it sold its holdings of the CPDO’s (it could not hold anything rated lower than A).
The judge said ABN and S&P must pay them compensation for this sum, 50% each. The local authorities lost 90% of their money, plus fees and charges. The judge ruled that LGFS, ABN and S&P must pay them back the missing 90%. ABN and S&P also have to compensate LGFS for the settlement it made with StateCover.
The significance of this ruling is that a ratings agency is being held liable for wrongly assigning a triple A rating to a product. Lawyers say the ruling establishes that ratings agencies have a duty of care to the ultimate buyers of financial products, not just the companies that invent them, the clients of the ratings agencies
The organisation that funded the litigation in Australia is sending an executive to Europe at the weekend, to speak to investors from Britain, Germany France and Holland who bought about €800 million worth of CPDOs. In all they think European investors bought some €1.6 billion worth of CPDO products.
More cases may follow. And not just for CPDOs. Given the scale of losses to investors on other AAA rated products that blew up on investors (notably mortgage backed CDOs), this might be the opening of a floodgate to claims against the ratings agencies. Standard and Poors is appealing the judgement.
Link to the judgement – warning: very long! Do not print unless you really need to! http://www.austlii.edu.au/au/cases/cth/FCA/2012/1200.html