Rating agencies score a failing grade

Standard & Poor’s took a beating in an Australian court last week after a judge found that the rating agency had been “misleading and deceptive” in its rating of a particular structured finance product.

A standard defence for credit rating agencies in these kinds of actions is to plead the First — or, in other words, argue that their ratings are opinions protected by freedom-of-speech laws.

In most cases, courts have agreed and found that investors have a responsibility to conduct their own due diligence — and should not rely on credit ratings to determine whether an investment is suitable. That may yet be the outcome in Australia.

In response to the controversy, we asked our readers last week if the agencies should be legally liable for their opinions.

More than three-quarters said that they should, in a strong show of support for the Australian court.

S&P stresses that this is only one decision, which it is appealing, and that it has won numerous other cases around the world.

But in this instance the court’s verdict was certainly damning. Judge Jayne Jagot described the product, known as a constant proportion debt obligation or CPDO, as “grotesquely complicated” and found that S&P had “no rational or reasonable basis” for the some of the assumptions it used to arrive at its rating.

It also exposed some embarrassing details of the rating process, including a flood of internal emails that describe a “crisis in CPDO land” and show the agency scrabbling to justify its rating on ABN Amro’s Rembrandt product amid tightening credit spreads in late 2006.

Apart from some choice language, the email exchanges also show that S&P came under intense pressure after the sudden popularity of CPDOs — products that carried triple-A ratings and paid 200bp, at a time when credit indices were paying less than 50bp.

“When we first looked at this ABN trade, we said that there might be better ways to model things... but we would do it later,” wrote one analyst. “Now the trade caught on and we are locked in.”

ABN Amro had created the CPDO product in early 2006 and brought it to Australia later that year, when a local government agency bought A$55 million of the Rembrandt notes and sold roughly half of them to 13 councils and an insurer in New South Wales.

In October 2008, the CPDOs cashed out when their net asset value fell below 10%. The payment to the noteholders, after deductions, amounted to about 6% of the principal amount they paid.

The result was a binder full of legal actions. All parties are suing each other, and few heroes have emerged from any of it. Neither the government agency nor the councils realised they were breaching their own investment guidelines by buying the products in the first place, which led the councils to sue the agency that sold them the notes.

They are also suing ABN Amro and S&P, which are both suing each other, in addition to several other suits involving various other related parties.

More actions are in the pipeline. IMF Australia, a litigation finance firm, helped the councils to bring this case and has now agreed to fund a new action on behalf of another group of Australian councils.

IMF said in a statement that it will also move forward with cases in New Zealand, the Netherlands and the UK.

S&P continues to reject any suggestions that its ratings were inappropriate and is appealing the decision.