Leveraged finance

Leveraged finance

The threat to corporate America

Leveraged finance

Leveraged finance

Between a rock star and a hard place

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.


When Venus declared: “I am done with the whole CPDO – wish I was never involved in that whole mess that was made,” Ding retorts “What a wuss.” Venus then replies “I am not responsible, I just helped build an internal model. You are the wuss for bending over in front of bankers and taking it...You rate something AAA, when it is really A-? You proud of that little mistake?”

When this exchange was revealed in court, S&P stated: “Those email exchanges also evidence the fact that S&P did not simply rubber-stamp ABN Amro’s opinion. Conflicting views are to be expected in the context of any serious process of analysis and consideration.”

CPDOs were hands down the most contentious of the structured credit products to emerge from the boom and many in the market were sceptical about their triple-A status. CreditSights said at the time that “while the strategy is very simple and surprisingly robust when modelled...there are a number of things that give us grounds for unease.” The structures were developed by ABN Amro as a rated version of constant proportion portfolio insurance but were swiftly copied by many other banks. The fact that the deals could pay 200bp over mid-swaps for triple-A risk immediately drew suspicion; rating agency Fitch, which did not rate any CPDOs, correctly argued that there was insufficient historical performance data on the iTraxx and CDX to model deals for 10 years. However, even CPDOs' harshest critics said that the structure probably deserved to be investment grade – just not triple-A.

But they subsequently proved to be a graphic illustration of the risk amplification that staggering leverage embodied. In a paper published in 2010, Michael Gordy and Sren Willemann at the Federal Reserve described them thus: “In its complexity and its vulnerability to market volatility, the CPDO might be viewed as the poster child for the excesses of financial engineering in the credit market... For both S&P and Moody’s, the rating of CPDOs was driven by models that assigned effectively zero probability to reaching the levels of spreads actually realized in the CDS markets in late 2008. This spike in spreads would, to the best of our knowledge, have triggered default and large losses for every CPDO note that had managed to survive to that point. All the issues in question had been rated AAA at origination in late 2006 or early 2007.”

The decision by the Federal Court of Australia to find Standard & Poor’s (along with ABN Amro – since acquired by RBS – and LGFS) liable for the local council losses has been seized upon as a precedent for wider legal action against the rating agencies in connection with highly structured products. But investors expecting a flood of cases might be disappointed.

Free speech

Rating agencies have long been excoriated for their role in the credit crisis. But the fact that their ratings are credit opinions has always offered protection under the first amendment to the US constitution – the guarantee of free speech. Roughly 50 cases have been brought against the rating agencies since 2007 but the majority have been dismissed on this basis. Their defence is that investors buying on rating have failed to conduct their own due diligence in relying on an credit opinion for an investment decision.

The Australian judge’s ruling in this case was probably swayed by the complexity of the deal in question. Although local councils losing money on derivative transactions they do not understand has a long and rich history it would be tough to expect them to have fully understood the CPDO. It is therefore unlikely that the reasoning applied in this case can be taken and applied to more vanilla mortgage-backed deals that also turned out to have been rated on overly optimistic assumptions. Questions were raised over the rating methodologies of CPDOs from the moment they were devised, whereas even the worst-performing sub-prime MBS was based on securitization technology that had been tried and tested for decades. The length of the Australian ruling (1,500 pages) gives some idea as to how complex the deal was.

Another factor mitigating against many new legal actions is the length of time that has now elapsed since the collapse of the structured credit market. In the US the statute of limitations runs for a year after the date of breach but in cases alleging deliberate misrepresentation it can run for three years (see CDO litigation: Casino banking victims face last roll of the dice Euromoney February 2011).

In the case of CPDOs, however, of which around $5 billion were issued, there might be impetus for investors to follow the Australian councils’ lead. The firm that funded their litigation, IMF Australia, is believed to be examining the viability of further claims in Europe (CPDOs were largely arranged by European banks and sold in Europe). But as to this ruling opening the door to a flood of litigation against the rating agencies – much as many investors might like it to – this might be a conclusion too far.

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