This will get approximately no attention today, but a federal court in Australia ruled that Standard and Poor’s, the credit rating agency, lied to investors when they awarded their highest, triple-A rating to derivative securities that lost their value within two years of purchase. The court ruled for a series of local councils in Australia, which accused S&P of botching the credit ratings and duping them into purchasing the securities.
In a damning verdict, the Federal Court of Australia ruled S&P and ABN Amro had “deceived” and “misled” 12 local councils that bought triple-A rated constant proportion debt obligations (CPDOs) from an intermediary in 2006.
The court said a “reasonably competent” rating agency could not have given a triple A rating to the securities, which were described as “grotesquely complicated”. S&P and ABN’s wholesale banking arm, which is now owned by RBS, also published information and statements that were either “false” or involved “negligent misrepresentations”, Justice Jayne Jagot found.
The 1,500-page ruling marks the first time a rating agency has stood a full trial over a structured finance product.
Further rulings of this type in this very new area of case law would be devastating to the rating agencies. They would also be correct. Rating agencies, paid by the banks whose securities they rate, simply failed to model the potential for a collapse in value of a basket of securities, particularly mortgage backed securities during the housing bubble. This led a host of investors to trust the ratings and buy the products, only to have their values collapse. While the banks got bailed out, the investors did not; they were collateral damage in the financial crash. And when I say “investors” I also mean municipal and union pension funds.
Those who want to defend the system argue that investors should have done their own due diligence before deciding on purchasing these structured finance products. The Australian court didn’t agree. They argued that the rating agencies are culpable for their work, and that their failures amounted to fraud. Rating agencies have never been held accountable for the ratings they assign, and this ruling, if replicated, would completely upend that expectation. The first place we could see further action from investors would be in Europe. The US has seen some case law in this area, and by and large the rating agencies have gotten off scot-free, using both disclaimers in their written materials and Constitutional protections on freedom of speech, believe it or not. There are some outstanding cases, however.
But Mr. Market certainly took notice of this ruling, dropping the stock of S&P’s parent company, McGraw-Hill, over 5%. Other rating agency stocks fell as well. And that’s appropriate, because the money that Standard and Poor’s will now have to pay the local councils in Australia outstrips the money the councils lost on the securities. There’s massive exposure here.
McGraw-Hill plans to appeal the ruling.
UPDATE: Felix Salmon has a lot more context on this case. Not only did S&P use the banks model for determining the safety of this product, they used the banks’ assumptions as well. They basically threw in whatever numbers would spit out a triple-A rating, irrespective of reality. There’s ample reason to attribute negligence to S&P in this case, and the judge, in a massive ruling (nearly 1,500 pages), backed up her reasoning.