Mining the Australian CPDO decision

By Felix Salmon
November 9, 2012

Now that the election is over, there’s a bit of time to revisit that very important CPDO decision I wrote about on Monday. There’s a lot of material to be mined here, and the Internet is slowly delving its way into it: I particularly love, for instance, the way that Daniel Davies started tweeting out noteworthy paragraphs.

But first there’s Paul Davies, who does a great job of explaining the revolving-door aspect to the case. You know how banks will hire regulators, at multiples of their former salary, and turn the former gamekeepers into poachers? Well, exactly the same thing happens to S&P: it pays better than the US government, but not nearly as well as the structured-credit department at ABN Amro. And thus a whole slew of S&P alumni ended up at the Dutch bank, putting together deals precisely designed to be the absolutely worst possible product in the world which could still, somehow, get a triple-A rating. In order to do that, you need people who know how the ratings sausage is made — and the easiest way to do that is to simply hire them.

S&P was well aware of what ABN Amro was doing, of course, but they had no incentive to frown on its behavior. For one thing it was good news for staffers that there was a healthy bid out there for their services; for another, ABN Amro paid S&P itself huge amounts of money to rate these deals. Everybody won — except the credulous investors who thought that ratings were honest, arm’s-length things.

Matt Levine points out that conceptually, the CPDO is “the perfect ratings arbitrage”, because the rating just tries to calculate the probability of default, without regard to the recovery value given default. As a result, the CPDO was specifically designed to have a recovery given default of very near zero, since that would increase the yield on the instrument without increasing the default rate. (This is exactly the same reason why it was S&P, rather than Moody’s, which downgraded the US from triple-A last year.)

Louise Bowman, meanwhile, finds this email exchange, between a couple of S&P quants:

Mr Venus: I am done with the whole CPDO – wish I was never involved in that whole mess that was made.

Mr Ding: What a wuss.

Mr Venus: 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.

Mr Ding: primarily me and the banker…so what? I would not mind if they put my name on that article, grow up kid.

Mr Venus: 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 [Inglis] that you made a mistake with your analysis.

But the smartest lines, still, come from the judge, Jayne Jagot. For instance, she spends a lot of time demolishing the S&P argument that the investors didn’t understand what they were buying, and therefore that it was the investors’ fault, not S&P’s fault, that the investors lost money. Jagot demonstrates clearly that the investors knew full well that they didn’t understand the CPDOs, and that it wasn’t necessarily stupid of them to invest anyway:

The notion that it was necessarily imprudent of the councils to invest in a product they did not understand, on analysis, is specious. It is a superficially attractive catchphrase which does not withstand scrutiny. An investor who obtains expert advice and relies on an expert rating is not imprudent merely because the investor does not understand the investment. So in this case the councils’ lack of understanding and their knowledge of their own lack of capacity to understand was the reason for relying on the expert advice and recommendations of LGFS and the expert opinion of S&P embodied in the rating.

The fact is that in the fixed-income world, investors almost never understand what they are buying. A bond is a set of predictable cashflows, with a sting in the tail: it has some unknowable probability of default. Different analysts can try to calculate that probability by different means, but in reality bond investors simply don’t have the time or the expertise to do that for every bond they buy. That’s where ratings come in handy: they’re a way for bond investors to outsource a lot of the hard work they don’t have the time or the human capital to do themselves. And the ratings agencies know it: as Jagot says, “S&P is paid to assign a rating for a structured financial product for one purpose only.”

And then there’s the bigger picture: the fact that Jagot was able to deliver this magnum opus of an opinion at all. It’s clearly the product of vast amounts of work, and a positively enormous amount of lawyering on both sides. The victims, in this case, were relatively small Australian municipalities: how did they manage to afford to fight this court case this far?

The answer is, they didn’t: all of the legal fees were paid by a litigation funder called IMF (Australia), which will take a cut of any proceeds. They write:

Litigation finance is a critical mechanism to enable cases to be brought and litigated against large corporations, banks and other powerful institutions, often by small and mid-sized companies and entities.

The Australian Federal Court’s finding yesterday — in favor of local municipalities — that S&P’s AAA ratings were “misleading and deceptive” could never have been achieved without litigation funding support from IMF (Australia), Bentham’s parent.

I have no problem at all with companies like IMF funding these lawsuits. It’s incredibly hard for investors to successfully sue big financial-services companies like S&P, and litigation funders help to level the playing field. Even if they end up getting paid no money at all, they have at least caused Jagot’s wonderful opinion to see the light of day. And that alone is a massive public service.


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I always like to pay experts to tell me to make my own informed decision and that I cannot trust whatever they are advising me. A brilliant use of money and resources …

Posted by Frump | Report as abusive

An idea I’ve been rolling around my head for a while, which would require some implementation details that I’m missing, is that rather than use ratings for whatever regulatory purposes we currently use them for, we cap the returns on assets, taxing the overage at 100%. If you’re holding assets in a bucket that is currently required to be investment grade, you’re allowed to decide whether they are investment grade yourself, without relying on a ratings agency, but once you have made that declaration to your regulator, your regulator can tell you what kind of current return one can expect on investment grade assets; if it’s 6%, and you get an 8% return, 2% of the asset goes to the IRS.

The idea here is that, when you say they are trying to construct “the worst possible” instrument with a particular rating, you’re assuming a degree of market efficiency; what they’re really trying to get isn’t the product most likely to implode, but the product with the highest yield, and the markets are efficient enough that these are reasonably close. I want to use that for regulatory purposes. Indeed, once you get your investment-grade bucket to 6%, you have no incentive to increase yield (which you lose), but you do have an incentive to decrease risk (which you keep); to the extent market inefficiencies can be found, your incentive is to use them to reduce risk rather than chase yield.

If someone develops a security that generates 18% returns and gets S&P to stick a AA- label on it, I’m not betting on S&P.

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