Friday, November 9, 2012

Banks and Rating Agencies Behave Badly in Australia

Floyd Norris in today's New York Times Business section, tells the story of an Australian federal judge who ruled that investors in a CPDO (Constant Proportion Debt Obligation)  can sue Standard and Poors for assigning a AAA rating to a structured finance vehicle which seemed inherently unsuitable for any qualified institutional buyer.

This is from issuer ABN AMRO's draft marketing materials cited in the Australian court's judgment:
What is the CPDO?

  • A CPDO is a fixed income instrument with cashflows that have a high and rated likelihood of payment
  • A CPDO aims to pay the stated coupons by taking leveraged exposure to a notional portfolio of credit indices. It comprises of exposure to a Credit Index Portfolio and a cash deposit
  • The Credit Index Portfolio aims to generate sufficient returns to enable the coupon payments to be made
  • The Target Portfolio Size of the Credit Index Portfolio is set such that the present value of the expected income from the Credit Index Portfolio is linked to the difference between the present value of the coupons and principal due under the Note and Note NAV
  • Once the current Note NAV equals the present value of the payments due under the Note, the Credit Index Portfolio will be unwound and no further credit exposure taken ...

The Floating Rate Notes were issued in the amount of Aus $45 million.  The notes are not backed by ABN AMRO or any other institution. ABN AMRO sold the Notes to its client, an Australian workers' compensation fund.

According to the issuer,
"The CPDO is suitable for investors who:
– Seek to take high grade exposure in a form that has not had value eroded by movements in correlation as has occurred in the CDO market
Require high rating of principal and coupon payments, but without the necessity of principal protection
– Wish to diversify their current structured credit portfolio
– Require liquidity for structured products."

Let's start by saying that ABN AMRO should not have marketed this product to its customer in any case. The prospectus should have had much more meaningful and transparent risk disclosures.  Standard and Poors didn't seem to have any reasonable basis for rating these securities AAA.  Even though in the court document, there is a convoluted battle among experts on what an AAA rating means (better than AA relatively) or doesn't mean (the highest absolute rating or lowest risk), there is a pretty telling statement in the prospectus which says,
"The probability of receiving the rated coupons and principal at maturity is benchmarked to the default probability of an S&P bond with the same rating and tenor."
On this definition, and given all of the email exchanges and witness testimony, a rating of AAA seems beyond reason.

However, it also seems clear that the client probably violated their own statutory investment policy guidelines for selecting and evaluating this investment.  So Floyd Norris' comment below is equally unreasonable:
"But the buyers of C.P.D.O.’s did not understand what they were doing. It appears that those investors, including an agency that managed investments for Australian local governments, and some of those governments themselves, did not bother to go into details."
The investment process laid out in the judgment has steps and particular measures which should disallow investing inappropriately, i.e. without understanding the investment's suitability and risk profile. To suggest that they "did not go into details" is a failure in their duty of loyalty.  Investors should not be protected by the government for being lazy, or for failing to exercise due care and diligence in accordance with their own published, statutory guidelines.

We've written about the failure of the rating agencies during the 2004-2006 runup to our own credit crisis.  Nothing was done to hold them accountable.  The investment banks have moved on to sunnier earnings and increasing management compensation after drinking at the public trough.

The investors should be compensated if the investments were (1) not suitable for their clients, (2) marketed with incomplete, misleading or false claims about their risk-return profiles, and (3) the expected performance of the Notes under reasonable scenarios did not warrant a AAA rating, according to SandP's own internal standards.

Institutional investors should not, however, receive government help to generate recoveries for their own greed, laziness or stupidity.

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