Bond market has ability to adapt
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Tuesday, November 6, 2012
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by Louise Bowman
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 Amros 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 Moodys, 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
The decision by the Federal Court of Australia to find
Standard & Poors (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.
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 judges 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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