"Fundamentally flawed, unreasonable and irrational."

November 6, 2012 12:16 AM

"Fundamentally flawed, unreasonable and irrational." In 2006, ABN Amro created a new type of financial instrument, the constant proportion debt obligation (CPDO), and sold a number of them to 15 local councils in Australia. Standard & Poor's rated these CPDOs as AAA. The Federal Court of Australia has now determined that both ABN Amro and S&P are liable for the losses the councils suffered when the value of the CPDOs collapsed during the financial crisis; the councils lost 90 per cent on the deal. S&P's rating of the CPDOs was found to have been "misleading and deceptive". Felix Salmon provides some analysis.

Matt Levine opines that CPDOs (not to be confused with CDOs) were nothing more than an elaborate martingale bet and ponders S&P's bizarre ratings strategy: "the CPDO marketing pitch was basically 'we have constructed a magic trick, would you like some?'".

The 1,459 page ruling can be found here. The summary, the first 56 paragraphs, are somewhat accessible and make for an interesting read.

S&P plans to appeal the ruling; whether the ruling has any implications outside Australia remains to be seen. Of the dozens of cases brought worldwide against rating agencies in the aftermath of the financial crisis for the ratings advice they assigned to contentious financial instruments, this appears to have been the first to succeed.

posted by kithrater (28 comments total)

"Fundamentally flawed, unreasonable and irrational."
Sounds like an excellent description of everything Standard & Poor's has done in the last decade. Well, it left out "totally corrupt".
posted by oneswellfoop at 12:20 AM on November 6, 2012 [5 favorites]

I can't find a source for "Any sufficiently advanced financial instrument is indistinguishable from fraud", but whoever coined that line was a good'un.
posted by Pope Guilty at 12:27 AM on November 6, 2012 [11 favorites]

Kill -9 the rich.
posted by I've wasted my life at 12:52 AM on November 6, 2012 [5 favorites]

Accountability? In my derivatives market?

It's more likely than you think.
posted by hobo gitano de queretaro at 12:54 AM on November 6, 2012

Accountability? In my derivatives market?

It's more likely than you think.*

* Accountability levels may vary by legal jurisdiction. Accountability may go down as well as up. Not FDIC protected.
posted by jaduncan at 1:06 AM on November 6, 2012 [10 favorites]

For the sake of our non-Australian friends, the Federal Court is a superior court, the only appeal is to the Full Court, and only if there are substantial grounds will leave to appeal be granted.
posted by wilful at 1:06 AM on November 6, 2012 [2 favorites]

I must confess, when I read this in the SMH, an involuntary ripple of joy went through me. The icicle of fear this would have sent through the hearts of S&P, and Moody's et al is just a bonus, really.

The real value is the idea of holding agencies to account for their arrant nonsense - we just need a lawsuit in the other direction; the damage a baseless negative rating has resulted in. Mind you, I reckon that's pretty unlikely as they tend to only stamp something a turd when the whole market's already abandoned it.

Ratings' agencies seem to specialise in saying what just about anyone could with ten minutes research, or being some kind of anti-Cassandra: Everything they say is a lie, but everyone believes it anyway.
posted by smoke at 1:06 AM on November 6, 2012 [2 favorites]

"Derivatives-based trading strategies rely on computer simulations to test their performance under different market scenarios. These simulations typically expect the future to be like the past; the collapse of Long-Term Capital Management LP in 1998 is proof of the danger of using inductive reasoning to extrapolate general laws from particular observable instances."

This sums up much of the work I've seen from ratings agencies. It's like driving a car by looking in the rear-view mirror. "The road has been like this for 4 kilometres, just keep going!"
posted by smoke at 1:09 AM on November 6, 2012 [7 favorites]

The trouble with Standard & Poor's is that its practices are poor and, alas, standard.
posted by Skeptic at 1:13 AM on November 6, 2012 [11 favorites]

Ratings' agencies seem to specialise in saying what just about anyone could with ten minutes research, or being some kind of anti-Cassandra: Everything they say is a lie, but everyone believes it anyway.

In this case, ABN Amro created a model with certain assumptions that would produce results that would just qualify for a AAA rating from S&P. Any deviation from those assumptions would result in a non-investment-grade rating. With said model and assumptions in hand, they proceeded to browbeat, whine, and lie to S&P until they too ran the model with the exactly required assumptions.
posted by kithrater at 1:28 AM on November 6, 2012 [3 favorites]

Indeed, Kithrater, and I agree with both judge and journo, that it was monumentally, wilfully ignorant of S&P to do so given their so-called expertise, and the presumed qualifications of those working on it. But then, like so much consultancy work, it's amazing how the melody can change according to who's paying the piper.

Interesting too, to see such ferocity about assumptions with regards to our own dept of treasury in recent days. Thankfully, they have more of a spine.

I suppose you could draw parallels to climate science and assumptions as well.

I wonder if these debates are connected by more than the logical commonalities. You could make something about postmodernism; the deliberate blurring by PR with facts and "facts"; the acceptance of such atomisation - different truths for different settings - by a public used to it in so many discourses; the esoteric spheres of knowledge we now employ and their general incomprehensibility outside of specialists; the subtle languages - and discourses - that modern flimflam must cloak itself with.
posted by smoke at 1:37 AM on November 6, 2012 [1 favorite]

it was monumentally, wilfully ignorant of S&P to do so given their so-called expertise, and the presumed qualifications of those working on it

The ironic thing is that if S&P had done a worse job, they might have not be found liable. If S&P didn't know exactly what was in the models and just how crazy the CPDOs really were, then they might have avoided being found to have offered a deliberately misleading and deceptive opinion on rating the instruments. Strength via ignorance.

Interesting too, to see such ferocity about assumptions with regards to our own dept of treasury in recent days

NSW or Federal treasury?
posted by kithrater at 1:56 AM on November 6, 2012 [1 favorite]

If S&P didn't know exactly what was in the models and just how crazy the CPDOs really were, then they might have avoided being found to have offered a deliberately misleading and deceptive opinion on rating the instruments

Then they (still) would have been negligent to rate them AAA. From the summary:

S&P’s rating of AAA of the Rembrandt 2006-2 and 2006-3 CPDO notes was misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia ... because by the AAA rating there was conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was “extremely strong” and a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care when neither was true and S&P also knew not to be true at the time made
posted by the quidnunc kid at 2:04 AM on November 6, 2012

What a horrible case to have to hear. 1,459 pages, my god. I would have had to adopt some kind of exponential growth martingale dosage strategy for my ADHD meds to sit through a fraction of it.

The rule for ratings agencies seems to be "If you aren't paying for financial advice, you're not the customer; you're the victim". Maybe this decision (assuming it isn't overturned by the Full Court or the High Court, because you can bet S&P will take it as far as they can go) will force ratings agencies to either start doing their jobs properly or openly admit that they're really just marketing consultants and everything they say should be taken about as seriously as some guy on an infomercial channel talking about how a vibrating belt made him lose 45kg and gave him a belly made of sculpted granite. Ah, who am I kidding, they'll just make everyone sign some kind of indemnity.
posted by A Thousand Baited Hooks at 2:12 AM on November 6, 2012 [4 favorites]

What's interesting about this case isn't that the judge decided the ratings agencies work was misleading and deceptive, it is that she found them liable for the losses incurred by people who bought the CPDOs rated by them. That's a big deal.

Unfortunately there is a bunch of case law in the US that has established a precedent that the agencies are protected from lawsuits by the first amendment.

The CPDO thing is kind of amazing. They were literally the last grasp of the credit bubble. When they were issued I remember FT Alphaville using them as kind of a running joke about the excesses of the structured credit market.
posted by JPD at 3:48 AM on November 6, 2012 [3 favorites]

JPD, the decision mentions the US caselaw at paragraph 2803:

Ohio Police & Fire Pension Fund concerned the rating of certain mortgage backed securities. The claims were brought under the Ohio Securities Act. The United States District Court noted a distinction drawn in the US authorities between immunity from liability for the rating for informational purposes of publicly-held companies (said to flow from the US Constitutional guarantee of freedom of speech) and liability for a rating the product of the issuer-pays model meant only for a select few investors. It also noted that courts in the US have declined to extend the immunity to the latter ratings, at least at the motion to dismiss stage. The claims failed under the terms of the Ohio Securities Act. The present case involves a rating the product of the issuer-pays model meant for a group of investors in the identified tranches of the CPDO notes.

I haven't read the whole judgement, but several bits I have read suggest that the reasoning behind S&P's liability is only really relevant to ratings produced for the purpose of selling investments to small, identified groups of investors.
posted by A Thousand Baited Hooks at 4:04 AM on November 6, 2012 [1 favorite]

Good to see S&P getting a kicking for once.
posted by GallonOfAlan at 4:20 AM on November 6, 2012

Unfortunately there is a bunch of case law in the US that has established a precedent that the agencies are protected from lawsuits by the first amendment.

I'm appalled that the difference between free speech and paid speech is ignored by the court. I didn't realize that Citizen's United was just one layer of crap littering the law.
posted by CheeseDigestsAll at 5:38 AM on November 6, 2012 [3 favorites]

This is the perfect retort to anyone claiming government "should be run like a business."
posted by tommasz at 5:44 AM on November 6, 2012 [2 favorites]

Sometimes people ask me what I'm reading and my answer sounds ludicrous even to me. I can't wait to answer, "the first 56 pages of an Australian court's ruling in a structured finance ratings related case against S&P." I can't even imagine the looks I'll get.
posted by putzface_dickman at 5:48 AM on November 6, 2012 [2 favorites]

I'm pretty much at the point where any time I hear about "a new financial instrument", I know it's going to end in tears (at best) or fraud (most of the time).

Seriously, why do people get involved with these things? If you have to resort to jiggery-pokery in the financial markets for something to seem to be worth your investment dollar, then you should probably just stay away from investing.
posted by hippybear at 5:53 AM on November 6, 2012 [1 favorite]

Unfortunately there is a bunch of case law in the US that has established a precedent that the agencies are protected from lawsuits by the first amendment.

I'm appalled that the difference between free speech and paid speech is ignored by the court. I didn't realize that Citizen's United was just one layer of crap littering the law.

I think the difference is that they can't be held liable if they publish their ratings in public. If I buy magic beans because I went to their website and find that they are rated AAA, that's on me. But if I pay them for their advice and they screw up, they probably can be held liable unless the contract indemnifies them. Or if the magic bean seller pays for their rating as an imprimatur of goodness, and they screw it up, they are liable.
posted by gjc at 6:04 AM on November 6, 2012 [1 favorite]

I've been waiting for them to perp walk these fraudulent mofos out of their offices since 2008, not this, but still good.
posted by sfts2 at 9:45 AM on November 6, 2012 [1 favorite]

So I downloaded the ruling and have spent some time trying to decipher what it means. After this time well spent I have come to the following confusions:

1. People from S and P need to do the perp walk
2. The judge is much much smarter than I
3. I hope this ruling is widely disseminated
posted by jason says at 9:51 AM on November 6, 2012 [1 favorite]

*conclusions (stupid autocorrect)
posted by jason says at 10:20 AM on November 6, 2012

This makes me all the angrier at an acquaintance saying, "You should have done your own research," to people who took a 50% loss on their "professionally managed" 401(k)'s when the market tanked.
posted by ob1quixote at 10:24 AM on November 6, 2012 [3 favorites]

“ABN Amro knew they were aiming for a particular rating and employed two former Standard & Poor’s employees so they could mine the rating and basically reverse engineer what they needed for the inputs to produce a AAA rating,”
That's pretty blatant.
posted by unliteral at 3:52 PM on November 6, 2012

[Tangent: smoke, you might appreciate this: Is Climate Denialism Post-modern?]
posted by harriet vane at 10:57 PM on November 6, 2012 [1 favorite]