ABN Amro

Over the last 6 years, much has been made about how banks lost their way when it came to putting themselves ahead of customers in the lead up to the financial crisis. How customers were screwed over in the quest for profits. How moral compasses were broken. Responding to outrage over the marked shift in how business is done, banks have commissioned studies, investigated claims, and promised to change. Up until this week, though, a bank CEO had yet to perform a play about how his firm had found its way through the wisdom of a fictional brothel owner. Thankfully, Gerrit Zalm took it upon himself to fill that void. Read more »

Have you finished reading Judge Jayne Jagot’s 43,000-page opinion in the Australian CPDO case yet? Good, because we’ve got to move on to other things.1 Like: what does it all mean?

One obvious thing that it could mean is “nothing,” or at least not very much. The case involved $30 million of damages, and there seems to be an Australian class action coming that might involve more damages, but it seems unlikely that CPDOs are going to track S&P across the globe to haunt its bovine dreams. Euromoney points out some of the many barriers to suing, though it adds:

In the case of CPDOs, however, of which around $5 billion were issued, there might be impetus for investors to follow the Australian councils’ lead. The firm that funded their litigation, IMF Australia, is believed to be examining the viability of further claims in Europe (CPDOs were largely arranged by European banks and sold in Europe).

Here in America, though, S&P seems safer. Here’s the FT:

Floyd Abrams, an attorney for S&P, says: “It is highly unlikely that this Australian court opinion will have any significant impact elsewhere. The case does not involve mortgage-backed securities. And the ruling does not recognise – as courts in the US and elsewhere generally have – that ratings are opinions which are not actionable unless disbelieved by those that issued them.”

They also point out that the statute of limitations will protect most crisis-era ratings at this point. And here’s John Carney: Read more »

Oh man, CPDOs. CPDOs! Why was I not aware? This Australian court decision is like 3,000 pages long but it is riveting; if you built a CPDO, email me, I will buy you a drink and you can tell me all about it. My God it’s so beautiful.

The story is that ABN Amro invented a structured-credit monstrosity called a constant proportion debt obligation, got it rated AAA by S&P, and sold it to some people; it ended up in the hands of some Australian regional councils, and then it chewed their hands off. As well it might have! It was monstrous. Anyway the councils sued S&P (and others) and today they won their lawsuit, which is bad news for S&P, though they kind of deserved it.

To simplify enormously the CPDO deal was:

  • You are a ten-year pool of money
  • You make a levered investment in some 5-year investment grade credit indices
  • Every six months you roll that investment into the next 5-year index
  • If credit has widened, you have lost money and therefore lever your investment more, to try to make your money back
  • If credit has tightened, you have made money and therefore ratchet down your leverage, hoping to get out in one piece
  • If you keep winning you take more money off the table until you end up with your money in Treasuries for the remainder of the 10 years
  • If you keep losing you run out of money and just give up, with your investors losing everything

This is obviously a martingale gambling strategy and the analogy is made extensively in the opinion but don’t worry about that now. Worry about the purity of the ratings arb here. It is breathtaking. Here is the core trick of it: S&P rated structured credit products based solely on the probability that they would pay off less than 100% of their principal plus interest, and not at all based on the expected loss if that happened. A triple-A rating required a <0.728% probability of defaulting. What this means is that: Read more »