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Opinion

Structured finance: The empire strikes back

CDO Wells Notice has serious ramifications for S&P.

"I have thought for a while now that if this company suffers from an Arthur Andersen event, we will not be brought down by a lack of ethics as I have never seen an organization more ethical, nor will it be by greed as this plays so little role in our motivations; it will be arrogance."

This statement made in a July 2007 email from Ian Bell, the head of European structured finance ratings at Standard & Poor’s, could turn out to be remarkably prescient. It seems incredible that it has taken until September 22 this year for a credit rating agency to be faced with a regulatory enforcement action over its rating of a CDO.

However, on that date what is called a Wells Notice was delivered to Standard & Poor’s over its rating of a $1.6 billion hybrid CDO known as Delphinus CDO 2007-1.

This time it is not the murky skullduggery of the alleged portfolio-picking influence of hedge fund managers that is under scrutiny – although the deal in question was structured for Illinois-based hedge fund Magnetar Group, which has been involved in several of the CDOs that have been fingered for such activities (see Casino banking victims face last roll of the dice, Euromoney, February 2011). This time it is the basic rating practices of a rating agency that are being addressed by the regulators.

Delphinius was downgraded mere months after it was issued. Both Moody’s and S&P rated the senior tranches of the deal triple-A in July and August 2007. By the end of 2008, though, these had been fully downgraded to junk status.

Email evidence obtained by the SEC shows that the structure was rated using dummy assets, which were subsequently substituted with assets of inferior quality.

This led an analyst to comment: "The concern is that the deal would’ve never passed – and actually would’ve been worse – if they included the assets that they claimed are dummies." The substituted assets were mostly triple-B rated sub-prime as opposed to the dummies, which included more single-A assets.

Despite the analysts’ concerns, S&P managers did not question the rating of the bait-and-switch deal and let it through.

It is sorely tempting to see this Wells Notice as a measure of payback by the SEC for S&P’s decision to downgrade US treasuries over the summer. However, the investigation pre-dates that decision by some considerable time. It is interesting to note, however, that Moody’s also rated the deal triple-A but has received no such notice.

Even if, as Bell asserts, it is arrogance rather than a lack of ethics that drove S&P’s CDO ratings activity, the SEC investigation is the last thing that McGraw Hill needs as it comes under increasing pressure to split S&P off from its education business. And the agency has certainly triggered the ire of many in Congress as a result of its downgrade of the sovereign.

But arrogance is not scarce on Capitol Hill either, so at least they are talking each other’s language: indeed Bell observed in his email that in responding to a teleconference question concerning the timing of the CDO downgrades in 2007 the agency "did sound like the Nixon White House".

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