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Australian CPDO court ruling unlikely to inflict wider damage on rating industry

Ramifications of Rembrandt CPDO ruling may be more muted than the market expects.


The decision by Australian Federal Court Judge Jayne Jagot to find rating agency Standard & Poor’s liable for investor losses in connection with a transaction it rated during the structured credit bubble has shaken one of the rating agencies’ fundamental shibboleths – that they provide opinions rather than investment advice and therefore cannot be held liable for their determinations.

The ruling itself stems from a recent case (Bathurst Regional Council vs LGFS Pty) brought by 12 local councils in New South Wales against municipal adviser Local Government Financial Service (LGFS). In 2006 the councils invested A$18.5 million ($19.3 million) in a constant proportion debt obligation (CPDO) structure called Rembrandt 2006-3 that LGFS had bought from ABN Amro.

CPDOs sold unfunded CDS on corporate debt indices such as the iTraxx in Europe and the CDX index in the US. Because these indices are rolled over every six months, the CDS were closed out and new transactions entered into when the indices were rebalanced. At this point the difference in spread from the last roll – which will be multiplied by the extent to which the structure is levered – was applied to the structure. Thus, if corporate spreads fell – as they did – the impact on the structure was devastating. Once the markets imploded in 2007 it did not take very long for CPDO deals – some of which were levered as much as 15 times – to implode as well. The Australian councils incurred an A$16 million loss on their A$18.5 million investment.

Judge Jagot deemed that Standard & Poor's had engaged in “misleading and deceptive” conduct by rating the Rembrandt 2006-3 deal triple-A, concluding that a “reasonably competent” rating agency would never have given such a rating. S&P said in a statement: “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.”

However, this is an area where the rating industry has ample previous form.

In early 2007, Moody's discovered that the rating model it had been using to rate certain CPDO notes contained an inadvertent coding error, which resulted in the rating being set between 1.5 and 3.5 notches higher than it should have been. However, when the error came to light in 2007 the agency did not downgrade the $1 billion of CPDO notes in 11 separate deals that were incorrectly rated. A member of the European rating committee emailed at the time: “To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug.” The SEC investigated the issue in 2010 but did not pursue a fraud enforcement action against the agency.

Judge Jagot found against S&P in the November 5 judgement largely on the basis that S&P’s rating methodology was flawed. The agency does seem to have relied heavily on ABN Amro’s own model and ABN Amro’s inputs to determine the rating – using higher spreads and lower volatility assumptions than it should have.

In its CPDO rating methodology S&P assumed that spreads would revert towards 40 basis points over the first year and 80bp for the subsequent nine years of a 10-year CPDO deal. It assumed a volatility of spread movement of 25%. As the court ruling points out, the fact that the CPDO performed better when the long-term average spread increased was counter-intuitive because increasing spreads are a reflection of increased risks in markets. At least one person within S&P considered that ABN Amro, whether intentionally or not, had effectively “gamed” the model it knew S&P would apply to rate the CPDO. It is informative to note that the ABN Amro executives primarily responsible for liaising with S&P over the rating - Juan-Carlos Martorell and Michael Drexler - were both former employees of the rating agency.

In protracted exchanges in the testimony it emerges that S&P became aware that the initial portfolio spread of 32bp would be insufficient to generate a triple-A rating, something that certainly seems to have caused internal dispute at the agency. In a colourful but ill-tempered email exchange between Derek Ding, a quantitative analyst at S&P jointly responsible for the modelling of the CPDO for rating by S&P and Sebastian Venus a quantitative analyst, primarily responsible for the day-to-day development of S&P’s own model for rating CPDOs, the controversial nature of the rating methodology is very apparent.

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