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Gilt edged: law finally catches up with S&P on derivative junk rated AAA
by David Campbell on Nov 20, 2012 at 00:01
The court ruling that the ratings agencies have been dodging for five years finally arrived this month, courtesy of an Australian court, which found S&P culpable for losses on a credit derivative structure.
While the cost to S&P was small – A $30 million (£19 million) payable to a local authority which lost A$16 million on a ‘grotesquely complicated’ and erroneously AAA-rated structure known as a CPDO, or a constant proportion debt obligation – the potential precedent is huge.
At issue was not, as in previous cases, the question of whether a rating is advice or guidance. The judge instead ruled that the flawed rating process itself was criminally ‘misleading and deceptive’.
‘In the US and elsewhere, the ratings agencies have [previously] very successfully avoided liability by arguing on freedom of speech grounds,’ noted Matthew Barnes, credit manager at ACPI, and previously a member of a collateralised debt obligation (CDO) team at New Bond Street Asset Management.
S&P is to appeal the judgement. The potential ramifications were enough to send shares in S&P parent company McGraw-Hill down as much as 7.1% – its biggest fall since August 2011, according to Bloomberg – with shares in Moody’s also off in an otherwise rising market.
The danger for S&P is the authority of the judgement. Judge Jayne Jagot delivered her verdict over 1,500 pages, and probably became the world’s leading CPDO expert in the process.
‘The explanation unavoidably refers to complex concepts which are likely to be unfamiliar to those without specialist expertise in structured finance,’ she wrote, with considerable understatement.
Essentially the instrument, issued by ABN Amro made a 10-year maturity, 15 times levered investment in the spread available on a five-year investment grade index, rolling over every six months.
If the spread widened over each six-month period, the instrument booked profit; if the spread tightened, it used the leverage to double down on the position and hoped it came good next time.
More important than the actual mechanics of the structure, however, were the assumptions necessary to win the AAA rating – described by Reuters columnist Felix Salmon as ‘bonkers’.
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