Ruling on ratings has big implications

by | Nov 6, 2012 | Business

THE Federal Court’s Justice Jayne Jagot has accepted the evidence from 12 New South Wales councils – who claimed they had been duped into buying a toxic financial product – that the ratings agency Standard & Poor’s was little more than a lapdog for merchant bankers.

The ruling means the councils will recover about $30 million in losses following failed investments in complex synthetic derivatives known as constant proportion debt obligations, or CPDOs, that were arranged by ABN Amro, rated AAA by S&P and sold by Local Government Financial Services (LGFS) in 2006.

This judgment was a long time coming. The financial crisis, from which the world economy has yet to recover, was caused in part by the sale of toxic and highly leveraged derivatives. Investment banks created this deceptive rubbish and the ratings agencies lent their imprimatur.

In the aftermath of the crisis in 2009, a Congressional inquiry in Washington heard testimony, which came to light in an email between S&P employees, ”We’d rate a cow”, if it was paid for.

It has taken three years but finally a court has ruled what most people had suspected, that the ratings agencies have a duty of care to investors, that their AAA ratings should have mattered, and yes, not only that they would rate a cow for money but they did rate a cow.

That cow was a ”Rembrandt” CPDO. S&P had assigned the instrument its top rating, AAA. Yet it was a highly leveraged and risky financial product and it blew up 90 per cent of its value six months after the councils had purchased it.

The Federal Court’s finding that S&P was negligent has tremendous implications. It will reverberate around the globe, perhaps exposing the ratings agencies to a slather of lawsuits here and abroad.

The essential problem in the system has been exposed, and now judged by a court. That is, that the ratings agencies are private companies whose shareholders benefit if the stock price rises. They are paid by the banks to rate their products. The more ratings they apply, the more profit they make.

And so, during the debt-fuelled boom, the agencies’ standards declined.

These CPDOs were even more leveraged and risky than your average CDO (collateralised debt obligation) and there were about €5 billion worth of them issued globally, the vast majority of which defaulted during the financial crisis.

It will now be far more difficult for ratings agencies to hide behind disclaimers to absolve themselves from liability. The court’s finding acknowledges that investors are entitled to and indeed do rely on credit ratings and can expect them to be based on reasonable grounds.

It remains to be seen whether the findings will open the floodgates for actions against credit rating agencies in relation to other structured products such as CDOs. Logically, CDOs are also in the gun. Most enjoyed the top rating, most blew up.

The CDO market was much larger than the CPDO market – by the end of 2006, the size of the global market was close to $2 trillion, much of which was lost in the financial crisis.

Now that a legal determination of liability has been made against S&P, disgruntled investors may start undertaking investigations into the reasonableness of the ratings issued for the CDO products.

Much of the investigative work has already been undertaken. Both the US Securities and Exchange Commission and the US Senate Permanent Subcommittee of Investigations have issued reports on the conduct of ratings agencies and both have concluded that ratings were inaccurate and that the failures of credit rating agencies were essential cogs in the wheel of financial destruction.

The judgment against ABN Amro should also serve as a warning to all investment banks that issued structured financial products throughout the market.

In this case, ABN Amro supplied S&P with incorrect data to be used in the ratings process. It knew that the product should not have been rated AAA and yet knowingly allowed investors to be deceived.

Then there are the implications for financial advisers. This is the second Federal Court decision in six weeks to confirm that an investment advisory relationship can exist in the absence of a written agreement.


Michael West

Michael West

Michael West established to focus on journalism of high public interest, particularly the rising power of corporations over democracy. Formerly a journalist and editor at Fairfax newspapers and a columnist at News Corp, West was appointed Adjunct Associate Professor at the University of Sydney’s School of Social and Political Sciences. You can follow Michael on Twitter @MichaelWestBiz.

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