Investors around the world had their eyes fixed on the Federal Court of Australia yesterday as the first legal case against a credit ratings agency went to trial.
And the case brought by 12 NSW local councils, who quickly lost 90 per cent of their capital after buying the “grotesquely complicated” Rembrandt-structured finance products in 2007, contains some explosive evidence.
“Smart” investment bankers had “sandbagged” Standard & Poor’s, “bulldozing” the world’s most venerable ratings agency into delivering its premiere “AAA” credit rating for a high-risk, and ultimately disastrous, financial product.
Just as remarkably, documents submitted to the court show these investment bankers were surprised to find that S&P didn’t even bother to do its own research for an “independent” report on the Rembrandt notes.
Rather, the ratings agency virtually cut and pasted a chunk of ABN Amro’s own analysis of the notes - even though this was the very bank seeking the credit rating and trying to sell the notes.
According to an email presented in opening submissions, one employee of S&P chided another, writing, “You are the wuss for bending over in front of bankers and taking it… You rate something AAA, when it is really A-?”
The case was brought before Justice Jagot in a Federal Court room packed with 30 solicitors and barristers this morning.
Funded by IMF Australia, the class action by 12 NSW local councils is suing S&P, the investment bank ABN Amro and the reseller of the disastrous “Rembrandt” “constant proportion debt obligation (CPDO – a derivative cousin of the infamous collateralised debt obligation or CDO but even more risky and noxious).
ABN Amro - which is now called RBS after it was taken over by RBS Group in 2010 and is not to be confused with today's ABN Amro Clearing - concocted them, S&P was cajoled into delivering its AAA rating in late 2006, Local Government Financial Services (LGFS) bought them and on-sold them to the councils, despite it being also a financial advisor to the councils.
That was in 2007. Two years later, in the wake of the financial crisis, the councils were saddled with 90 per cent losses.
The $16 million lawsuit alleges the bankers, resellers and ratings agencies to the Rembrandt issue misled investors. They knew the Rembrandt notes were “grotesquely complicated” and high risk and therefore not suitable for conservative local government investment requirements.
Moreover, the councils – Corowa, Deniliquin, Bathurst, Parkes, Eurobodalla, Moree Plains, Murray Shire, Narromine Shire, Narrandera Shire, Oberon, Orange and City of Ryde - claim they were misled.
Not only did the raters and vendors know of the extreme risk but they did not properly disclose the risks to the councils. They were “fundamentally misled”. This product should “never have been rated AAA”, they claim. S&P was “negligent” and in breach of its duty of care to council investors.
Nevertheless, like many other CDOs and credit derivatives of its ilk – indeed much of the $1 billion in CDOs sold by Lehman Brothers Australia to councils, charities and churches before the financial crisis, the Rembrandt notes still managed to attract a AAA rating.
In late October 2006, according to the statement of claim, the two managing directors of S&P, Elwyn Wong and Perry Inglis (who was also the European Head of CDOs and Credit Derivatives for S&P) were discussing media coverage on the CPDO ratings:
“Wong told Inglis: Getting the usual headlines from trade rags - some valid concerns but mostly sensationalism as you would expect from these guys. Drexler is a smart and charming man. Cian and Sriram were, I think, sandbagged a little. The model was a work in progress when Kai and Norbert [2 former S&P senior ratings analysts] left and Drexler simply bulldozed it through ... I just heard through the rumour mill that Norbert declines to rate Drexler's deal.”
Drexler is Mike Drexler, a banker at ABN Amro and Cian and Sriram were among the S&P employees involved in the credit ratings process.
S&P would 'rate a cow'
As far as explosive evidence goes, this exchange rivals the notorious email which came to light during a US congressional inquiry into the role of ratings agencies in 2009. In that, one S&P staffer said to the other, “We’d rate a cow” if they paid us.
Nonetheless, there is some evidence of professional rigour on the part of S&P staff in the present case, even if it came after the fact, and well after the fee.
In May 2007, according to the statement of claim, two of the S&P analysts involved in the process, were debating who was responsible for the AAA rating:
“Mr Venus, who had prepared an internal model for the CPDO and who had expressed concerns during the rating process about the modelling results being inconsistent with the AAA rating, told Derek Ding:That thing is done by 3 people: Cian, Sriram and you. 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? It's nothing to do with growing up, it's about doing your job to a high standard. If you want to talk about growing up, you should admit to Perry that you made a mistake with your analysis.”
Highly complex product
Elsewhere, the plaintiffs claim that “ABN Amro substantially drafted S&P’s 'presale' report for the CPDO, which purported to describe S&P’s analysis of and conclusions concerning the CPDO.
“That report was the template for the subsequent post-sale report issued by S&P concerning the Rembrandt Notes. At one point, an ABN Amro employee expressed surprise that ABN Amro was to prepare the presale report asking, quite saliently, 'Isn’t this S&P’s job?''
“The product should never have been given a AAA rating”, argue the councils.
Rather than being an investment in a share or bond involving a reputable counterparty, the CPDOs were merely ''a bet'' on the direction of two ''credit default swap'' indices – a bet on an index of other bets, if you like.
The CPDO was a highly sophisticated, high-risk structured credit derivative, the performance of which depended upon events occurring in two “credit default swap indices”, which in turn depended upon events affecting the companies which were included in those indices and in credit markets generally.
'Old casino strategy'
The bankers, says the statement of claim, requested S&P assign a rating to the CPDO and “subsequently exercised real and substantial influence over S&P’s rating processes, taking advantage of S&P’s lack of understanding of the product or willingness to disregard fundamental shortcomings in its rating methodologies for the CPDO in order to achieve the outcome ABN Amro sought”.
Worse, the product was designed to be leveraged as much as 15 times in order to enhance its return. It was “extremely high risk” said a submission by one of the council plaintiffs.
“While that leverage had the potential to generate higher income, it also had the potential to generate massive losses in a short time.
“One of the creators of the product, David Poet of ABN Amro shared the same view, likening the product to 'the old casino strategy' in which 'if you win, start again. If you lose, double your bet' with the result that there was 'a chance of losing the lot'.
“In response to those statements, Jamie Cole of ABN Amro, said 'perhaps we go and flog this for all its worth' and then asked S&P to rate the product.''
Indeed, the stetement of claim includes an email from another ABN banker to Mike Drexler asking “is it normal for rating agencies to allow banks to build their own models for S&P to use to rate them?”.
Drexler’s response was: “No! It is not normal and highly weird. An opportunity, however.”
ABN did whatever it could, says the statement of claim, to “provide S&P with the most optimistic data and assumptions possible about the likely performance of the CPDO and to persuade S&P to assign the Rembrandt Notes a AAA rating”.
Ratings agencies on edge
The case is far more sensitive for the ratings agency than the bankers.
Investment bankers are well known for rapaciously flogging any financial product. It had been the supposed role of the ratings agency, however, to deliver independent and reliable advice to investors.
Yet some years before, S&P and its rivals Moody’s and Fitch had capitulated to the temptations of their own conflicted business model, that is, that they get paid by the rating. The more ratings, the higher their profits.
It had always run counter to their own prosperity to maintain their standards!
By the time of the financial meltdown in 2008, standards were appalling. Once, only sovereigns could attract a AAA rating. Now, high-risk derivatives could get one.
Although the likes of US pension funds have attempted to sue the agencies - indeed the Californian giant “Calpers” fund has been trying to get a case to trial for two years - this is the first case in the world to get to trial.
In the US, the First Amendment protections for free speech have assisted the agencies in deflecting claims - so far at least. After all, they contend their ratings are “just an opinion”.
The importance of this lawsuit is that a successful claim could set a precedent for further actions for bogus ratings in Australia, and indeed worldwide.