The Federal Court of Australia ruled Nov. 5 that S&P misled investors by assigning AAA rating to a highly complex structured finance vehicle. S&P and two other companies now have to compensate investors.
“A reasonably competent ratings agency could not have rated the [structure] AAA in these circumstances,” Justice Jayne Jagot found in her ruling, which could provide a precedent for other lawsuits against banks and rating agencies.
Twelve municipal councils in New South Wales, Australia, bought $16.6 million worth of so called “constant proportion debt obligations” (CPDO) from the financial adviser Local Government Financial Services (LGFS) in 2006. The notes were issued by ABN Amro Bank, now a subsidiary of Royal Bank of Scotland PLC. S&P assigned AAA rating to the bonds, which indicates a low probability of default.
LGFS was ordered to compensate the investors for the $16.6 million in losses, but the total will likely be higher, due to interest and legal costs. The Financial Times cites John Walker, a representative for the plaintiff, who says the total could be as high as $31 million. The court has ordered the parties to convene and agree on interest and legal costs within 21 days.
In turn, LGFS has sued S&P and ABN Amro to recoup that sum. According to the ruling, which implicates both parties, it is likely that LGFS will be successful in recouping the sum.
“We are disappointed with the court’s decision, we reject any suggestion our opinions were inappropriate and we will appeal the Australian ruling, which relates to a specific CPDO rating,” S&P spokesman Edward Sweeney said in a statement.
Complexity of Product at Heart of Ruling
The judge said in her ruling that the product was “grotesquely complicated” and impossible for investors to understand. ABN Amro and S&P both misled investors by providing “false” or “negligent” information with respect to the risk of the product.
Rating agencies and banks have always pointed to their disclaimers where risks of loss are stated, a defense that was now dismissed for the first time in Australia. Defendants use the same arguments in cases currently being heard in the United States.
The Connecticut attorney general for example sued S&P and Moody’s because of false representation of risks in 2010. The office declined to comment on the ruling in Australia and said that its case against the agencies was ongoing.
So what was so risky about these products and what did banks and rating agencies fail to portray accurately?
For the layman, CPDOs present themselves as a cocoon of different acronyms, all equally difficult to grasp. Let’s follow the money. The investors, in this case the counties in New South Wales, invested cash in an entity. This Special Purpose Vehicle (SPV) was founded solely to aggregate that cash and then invest it according to a specific plan. The investors hold bonds issued by the SPV that promise to pay a fixed return and which were rated AAA by S&P.
In the case of the CPDOs, the investing entity uses the money paid in by investors to invest in credit default swaps (CDS). These private insurance contracts protect investors from default of an underlying debt, such as a corporate bond.
The contracts normally runs for five years and every year the buyer of protection has to pay a certain percentage of the notional sum that he wishes to protect. For high-grade corporate securities, this premium has recently been in the range of 1 percent. So if you want to insure $100 of your General Motors bond, you have to pay the CDS issuer $1 per year. If General Motors defaults within the contract period, you get $100 from the CDS issuer.
In order to generate the return needed for investors, the entity would actually sell rather than buy protection, collecting the premium each year. To make things a little easier, the entity would sell protection on an index of different European and American corporate credits. To further increase potential gains, the contracts would not be held until maturity, but changed every six months at a different price.
This combination of price gains and premium payments made it possible for the entity to pay out a yield much higher than “risk-free” securities such as government bonds. S&P put the securities on the same level as AAA rated U.S. Treasuries.
Using “unjustifiably and unreasonably low assumptions” of market volatility, this rating was not warranted, according to the Judge Jagot. At the end, the CPDO named Rembrandt paid out a premium over LIBOR (the overnight interest rate that banks charge each other) of 2 percent.
No Risk No Fun
As the old investment adage says, there is no increased return without an increase in risk. Having sold protection at low levels in 2006 and 2007, risk premiums widened dramatically during the largely unanticipated 2008 crisis. A practical example would see the entity sell insurance for 1 percent in 2007 for example.
Six months later that same insurance would cost 3 percent because of deterioration in market conditions. To close out the contract, the entity would have to take a loss. With normal bond investments, this is not a problem if the underlying bond does not default and the investment is funded with 100 percent cash. This means one could hold the position until maturity and wait for a complete repayment, choosing not to change after six months.
In Rembrandt’s case however, the principal amount of the investors was “leveraged” 15 times. This means that with $100 that the investors paid into the entity, the entity engaged in CDS transactions worth $1,500 of underlying corporate credit. Such high leverage means that extraordinary market movements can wipe out the principal without an actual bankruptcy as gains and losses are magnified by 15.
The crisis of 2008 produced such market movements and the counties in Australia as well as many other investors in AAA rated securities lost all their money.
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