http://ftalphaville.ft.com/2012/11/06/1246821/working-together-on-the-cpdo-dream/
In the
prodigiously long and detailed judgement from Australia’s Federal Court on the CPDO affair, there is a story jumping out from behind the complexity of the product itself. It’s about the key role played by
former Standard & Poor’s employees who had left the rating agency to go to banks to help structure these products.
The judge found that S&P itself — rather than the individuals involved — had misled 12 local councils in Australia by awarding triple-A ratings to toxic structured debt. But as someone who has written about curious structured products, from
CPDOs to
rated CDO equity tranches, I have met a lot of the people whose names cropped up in this case. I was curious about what Judge Jagot would make of the raters who had effectively become in-house advisors.
Juan-Carlos Martorell and Michael Drexler were of this ilk, introduced in paragraph 73 of the judgement:
Mr Drexler and Mr Martorell, both former employees of S&P, were primarily responsible for managing ABN Amro’s dealings with S&P in respect of the rating of the CPDO.
This description of their role was supported by input from Jamie Cole, also an ABN Amro employee and colleague of the pair.
Additional characters in the cast inlude: Cian Chandler, an S&P analyst responsible for liaising between S&P quant teams, ABN Amro and other senior S&P peeps; and Perry Inglis, Cian Chandler’s boss.
I met all these guys apart from Drexler and found them — and their peers at other banks and agencies at the time — to be both intellectually honest and endlessly curious.
The judgement paints a picture of a hugely long and drawn out negotiation process between ABN Amro and S&P over the CPDO that’s the subject of the suit. By paragraph 128, the relationship dynamics take centre stage, with S&P struggling to make the leap from the last product the two sides worked on to the CPDO version of it. The models of the two parties were, at least initially, spitting out different answers.
The ridiculousness of it can perhaps be summarised by noting that a similar structured product paid an income of 50 basis points over Libor and attracted a single-A rating. Somehow that product had been rejigged into something that paid 200 basis points over Libor with a triple-A rating(!) — the CPDO.
Credit default swap markets were only trending towards lower and lower yields during 2006 when all this was going on. The chase for yield without comprising on the rating was in full-swing and CPDOs were positioned into place.
As for our characters, here’s Chandler writing to Inglis and other senior S&P bosses to update them on the discussions he had had with Drexler over at ABN:
He’s been insinuating that he was going to go over Sriram and Derek’s [two more junior S&P analysts] heads, so I wouldn’t be surprised if you get a call soon.
The length and detail in the back and forth between the rating agency and ABN is astounding — and is part of why the judgement runs to so many thousands of words. The discussions covered the assumptions that must be baked in order to get the outcome that was desired: a specific pay-out with a specific rating. Historic market volatility, what the long-term spread on the credit indices could be expected to look like, and how quickly spreads would revert to an assumed mean after diverting from it, were all part of this.
Clearly, a close working knowledge of how rating agency models and processes worked was a big advantage, especially when it came to getting a new product over the line. There were concerns in the months following this deal
about the way in which such ratings had been reached.
But it’s later on, after the CPDO was already being marketed, that an unforeseen problem crops up from the questions posed by a potential investor. And it’s at that point in time that the bank appears to really lean on its former S&P guys.
The problem was around the roll over of the credit derivatives indices that happened every six months. CDS buys you protection against default of a bond for typically five years — to maintain a near constant five-year price for credit default risk, the indices had to be rebooted regularly. The index compilers did it every six months. This process also ensured that the credit exposures that had become sub-investment grade could be removed.
Switching your own exposure from the old (or “off-the-run”) index into the new, “on-the-run” index, involved transaction costs. The CPDO modelling up to this point had not properly accounted for this.
Paul Silcox at ABN’s Exotic Credit Derivatives Group emailed his team (paragraph 217):
Potential issue I can see is that we mention it to S&P and they get all hung up on the roll cost and the modelling of it. However, if we don’t mention it then a client may ask about it on a call with S&P at which point things may be come a little ropey.
To which Cole responded (paragraph 218):
Yes I fully agree as discussed last week. JC/Mike best placed to know how S&P think – I had asked JC to think how best to approach them…
The next few paras may make for instructive reading. Martorell (aka “JC”) initially notes in a response (paragraph 219) that:
We should avoid S&P to overthink and open a can of worms.
A few days later Martorell gives a fuller analysis of the pros and cons of telling S&P about the issue, concluding that it is probably better to say nothing (paragraph 222, emphasis mine):
I think if asked by clients S&P wouldn’t want to look stupid that they haven’t thought about it. The diplomatic/ institutional S&P answer by an analyst will go typically as follows: “the model directly or indirectly captures the risks associated with CPDO” (ie stressed defaults, spread vol, low mean reversion, bid/ask, and structural considerations). All these mitigants are consistent with AAA standards.
Useful to have someone around who knows that.
The First Amendment Defense Fails (In Australia)
It's about damn time....
The New South Wales councils, including Bathurst and Corowa, brought a class action against S&P, investment bank ABN AMRO and Local Government Financial Services (LGFS).
The councils claimed they were misled into losing almost $16 million in the financial crisis, saying S&P led them to buy complex investments called constant proportion debt obligation notes (CDPOs), which the agency had given a AAA rating.
Today's ruling found that rating was misleading and deceptive.
Federal Court Justice Jayne Jagot described the ABN AMRO products as "grotesquely complicated" and said that the LGFS breached its fiduciary duty to the councils by not properly investigating the products.
She said S&P had been "sandbagged" while ABN AMRO "simply bulldozed the rating through".
Now it may be fine and well for someone to opine and be entitled that opinion.
But S&P, Moody's and other NRSROs do more than just "opine." They hold out their opinions as
expert opinions, and more-so they lobby for and are the beneficiary of laws and regulations that in many cases
require their ratings before some entity can purchase a given security.
Never mind that while there is certainly a valid First Amendment argument that one has the absolute right to free speech
it is also well-within the boundaries of the law that one does not have a shield against knowingly false speech.
In other words there is a huge difference between being wrong and knowingly being wrong, either through willful blindness or deliberate falsehood.
This, incidentally, is the same issue I have with a number of the investment banks, who created products at the behest of some client who wanted to take a short position
and then marketed them as good long investments without disclosing that the reason they existed was that someone wanted the other side -- in other words, that they were created by someone expecting them to fail.
This weekend I had an interesting conversation with a "registered investment advisor" (but not for my account; off-the-record) and our conversation turned to the markets. He and I are on decidedly opposite sides when it comes to what we think is going to happen, and his closing argument was simply "you're wrong."
Ok, we shall see. My retort of course is "sold to you!" and that's what makes a market -- two people with opposing ideas of what value is. One of us will be right and one of us will be wrong.
But neither of us has a fiduciary duty to the other; in the case where I was his paying client things change. In that case there is a fiduciary duty.
S&P, Moody's, Fitch and others argue that they have no such duty. I disagree; if your models are going to be required before someone can buy something, effectively going from a voluntary advisory position to that of a
mandatory rating, then I argue that you have a fiduciary duty to those who rely on those ratings -- because without those consumers of your product, whether you're paid by them or not,
you are out of business.
and......
http://www.abc.net.au/news/2012-11-05/councils-to-recoup-gfc-loses-after-court-ruling/4353000?section=nsw
Ratings agency Standard and Poor's says it will appeal against a landmark ruling which will allow 13 local councils to recoup losses they suffered during the 2008 financial crisis.
The New South Wales councils, including Bathurst and Corowa, brought a class action against S&P, investment bank ABN AMRO and Local Government Financial Services (LGFS).
The councils claimed they were misled into losing almost $16 million in the financial crisis, saying S&P led them to buy complex investments called constant proportion debt obligation notes (CDPOs), which the agency had given a AAA rating.
Today's ruling found that rating was misleading and deceptive.
Federal Court Justice Jayne Jagot described the ABN AMRO products as "grotesquely complicated" and said that the LGFS breached its fiduciary duty to the councils by not properly investigating the products.
She said S&P had been "sandbagged" while ABN AMRO "simply bulldozed the rating through".
The three financial agencies have each been ordered to pay one-third of the amount lost by the councils, plus interest.
That means the councils will recoup about $30 million.
Piper Alderman partner Amanda Banton, who represented 12 of the 13 councils taking action, said the decision was a major blow for ratings agencies.
"No longer will rating agencies be able to hide behind disclaimers to absolve themselves from liability," she said in a statement.
But in a statement, S&P says it is disappointed with the court's decision and intends to appeal.
Claimants and their losses:
- Bathurst Regional Council: $1 million
- Cooma Monaro Shire Council: $1.86m
- Corowa Shire Council: $933,225
- Deniliquin Council: $466,613
- Eurobodalla Shire Council: $466,612
- Moree Plains Shire Council: $1.9m
- Murray Shire Council: $933,225
- Narrandera Shire Council: $1.86m
- Narromine Shire Council: $466,612
- Oberon Council: $933,225
- Orange City Council: $1.4m
- Parkes Shire Council: $2.8m
- City of Ryde: $933,225
"We reject any suggestion our opinions were inappropriate, and we will appeal the Australian ruling, which relates to a specific CPDO rating," the statement read.
Landmark ruling
Class action funder IMF Australia says the ruling is likely to have global ramifications, particularly in Europe where more than $2 billion worth of CDPOs were issued.
"This has been a long time coming," IMF executive director John Walker told The World Today.
"It not only involves or assists people in New South Wales, it also potentially can be relied upon by people around the world.
"It fundamentally arose by rating agencies and investment banks looking after their own interests and potentially being a material cause of the global financial crisis. I don't say that lightly.
"So much of these synthetic derivatives created huge credit risks outside regulated markets that were really outside the control of our regulators."
He says his organisation is looking into funding further litigation in Australia, New Zealand, The Netherlands and the UK.
"Here we have Standard and Poor's, which is a live breathing ratings agency that has a business that everybody in the financial markets relies upon. And we're looking to sue Standard and Poor's in those four jurisdictions," he said.
City of Ryde spokesman Roy Newsome says he is delighted with the ruling.
"Parties that we relied upon for their advice and their due diligence obviously didn't prove to be correct," he said.
Les Finn from Parkes Shire Council says they can now move forward.
"We'll be able to shift our focus now onto getting some services back on the ground, rather than servicing debt," he said.
The ruling
follows another in September against the now collapsed Lehman Brothers, which was found to have breached legal duties when it sold toxic derivatives to a group of charities, councils and church groups who collectively lost about $250 million.
And as the Bankers lost their first attempt to dismiss the FHFA Mortgage lawsuit , one may ask is the tide slowly turning ???
JPMorgan Chase & Co. (JPM) lost a bid to have a U.S. judge dismiss lawsuits filed by the Federal Housing Finance Agency against 16 U.S. banks over mortgage-backed securities.
JPMorgan,
Bank of America Corp. (BAC) and
Citigroup Inc. (C) were among the lenders sued last year for allegedly misleading Fannie Mae and Freddie Mac about the soundness of loans underlying billions of dollars of residential mortgage-backed securities. JPMorgan served as the lead underwriter for 30 out of the 103 securitizations at issue in this case.
U.S. District Judge Denise Cote in Manhattan today rejected a bid to throw out the FHFA’s complaint, overruling arguments that the agency lacked factual support that the loans underlying the securitizations weren’t underwritten in accordance with the guidelines set out in the offering documents.
“The agency’s reliance on this information is not, as the defendants allege, an effort to argue ‘fraud by hindsight’; rather the amended complaint suggests that these market events are telltale signs of defects that were present in the securitizations all along, albeit, unbeknownst to the public,” the judge wrote.
“FHFA may be wrong of course; a jury will decide,” Cote said. “But the claim is not an implausible one.”
‘Total Collapse’
Cote said that the plaintiffs’ amended complaints includes allegations of a “total collapse in credit ratings” and claims the banks had made false statements of material facts in registration statements, which “directly caused Fannie Mae and Freddie Mac to suffer billions of dollars in damages.” The plaintiffs also claim the loans underlying the securities experienced defaults and delinquencies at a much higher rate than they would have if the loan originators had adhered to underwriting guidelines.
Cote cited evidence provided by the plaintiffs in the amended complaint that included statements or two “confidential witnesses” who were personally involved in the origination and underwriting of JPMorgan’s EMC unit.
She also said the plaintiffs included testimony from witnesses who described being pressured by supervisors to approve loans in disregard of their expressed concerns about potentially fraudulent documentation and cited other evidence provided by plaintiffs involving Washington Mutual Inc.
‘Wild West’
“As one appraiser who did business with WaMu during the relevant period described the bank’s origination practices: ‘It was the Wild West ... if you were alive, they would give you a loan, Actually, I think if you were dead, they would still give you a loan,’” Cote said in her ruling, citing the witness’s statements.
WaMu, based in Seattle, filed for bankruptcy on Sept. 26, 2008, the day after its banking unit was taken over by regulators and sold to JPMorgan Chase & Co. for $1.9 billion.
The defendants argued the plaintiffs had failed to provide sufficient evidence to support their claims.
Fannie Mae and Freddie Mac have operated under U.S. conservatorship since 2008, when they were seized amid subprime mortgage losses that pushed them toward insolvency.
Cote did narrow the case, dismissing some claims alleging violations of the Virginia Securities Act as well as fraud claims regarding the owner-occupancy and loan-to-value ratio of the securities for which New York-based JPMorgan served as lead underwriter.
Amended Complaint
She cited the amended complaint filed by the plaintiffs, including statements made by JPMorgan Chief Executive Officer Jamie Dimon criticizing the quality of loans originated by Chase Home Finance LLC, a unit of the bank. The judge said the amended complaint also mentioned the $5.3 billion settlement JPMorgan reached this year with state and local authorities.
Joe Evangelisti, a spokesman for JPMorgan, declined to comment on the ruling.
Also sued by the FHFA were Barclays Plc (BARC), Nomura Holdings Inc. (8604), HSBC Holdings Plc (HSBA), Societe Generale SA (GLE),
Morgan Stanley (MS),
Ally Financial Inc. (ALLY), Royal Bank of Scotland Group Plc, Credit Suisse Group AG (CSGN), Deutsche Bank AG (DBK) and
First Horizon National Corp. (FHN)
No comments:
Post a Comment