Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

On rating Rembrandts

No, this post is not about the masterpieces of the Dutch painter Rembrandt van Rijn, but about the Rembrandt CPDO (Constant Proportion Debt Obligation) notes created by the Dutch bank ABN Amro in 2006. The Federal Court of Australia ruled last week that:

S&P’s rating of AAA of the Rembrandt 2006-2 and 2006-3 CPDO notes was misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia … because by the AAA rating there was conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was “extremely strong” and a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care when neither was true and S&P also knew not to be true at the time made. (Summary, Para 53)

The judgement is indeed very long – Felix Salmon says that Jayne Jagot’s judgement “runs to an astonishing 635,500 words, or almost 1,500 pages: it’s literally longer than War and Peace”. I agree with Felix that the judge does a remarkable job of understanding this complex instrument and the analyzing the intricacies of rating it. She has obviously benefited from the testimony of numerous experts, but she still deserves full credit for the clarity of her analysis of the key drivers of the performance of a CPDO. The court is thus able to arrive at a cogently argued conclusion that “S&P’s modelling and assignment of the AAA rating was not such as a reasonably competent ratings agency could have carried out and assigned in all of the circumstances.” (Summary, Para 27)

There is a wealth of information in the judgement about the modelling of CPDOs, but from the point of view of legal liability of the rating agency, there are three crucial hurdles to overcome:

  • Investors have a responsibility to perform their own credit assessment.
  • The court cannot become the regulator of rating agency methodology.
  • Rating agencies do not insure investment performance.

The court deals with each of this with forcefully, but I am sure there will be a great deal of debate whether the views of the court are correct. On the investors’ responsibility to perform their own credit assessment: the court says:

I consider the proposition that a prudent person must not invest in any product they do not themselves understand problematic. It suggests that a prudent person could never take and rely on advice. It suggests that a prudent person who had been advised that a particular investment should be made must reject the advice if they themselves are capable of understanding the advice but incapable of understanding the way in which the investment operates. It is the equivalent of saying that only people who truly understand the principles of flight should be allowed to travel by plane. It seems to me that the rigidity of the proposition is a recipe for imprudence. Prudent people do not assume they know or can know everything. They do not assume that they are best placed to assess every fact, matter or thing. They do not assume that their own limitations dictate what can and cannot prudently be done. Prudence does not involve solipsism. (Para 1472).

Prudent people seek to identify others who are best placed and have demonstrated they can be trusted to assess relevant facts, matters and things. … All of the councils relied on: – (i) the belief that LGFS’s conduct had induced that LGFS, as specialists in local government financial markers and investments, had applied its expertise to the CPDO and assessed it to be a suitable investment for councils to make, and (ii) the belief that S&P had applied its expertise as a body specialising in assessing the creditworthiness of financial products and had concluded that this product warranted the highest possible rating of AAA in respect of interest and principal. The councils’ beliefs to this effect were reasonable in the circumstances and, indeed, were correct. For the councils to refuse to invest in these circumstances, by reason only of the fact that they did not understand how the product operated, does not accord with the dictates of prudence. (Para 1473).

On the issue of the court becoming the regulator of rating agency methodology, the judgement says:

It is also not the case that the councils “seek to place the Court in the untenable position of being the regulator of rating agency methodology”. This is an inaccurate description of the issues in this case. As will be apparent from the discussion and findings below this is not a case about alternative methods of rating, questions of reasonable qualitative judgment or whether one or other method or judgment is to be preferred or is superior to another. This is a case about what S&P did and did not do and whether any reasonable ratings agency could have so conducted itself. It is not a case about the appropriateness or otherwise of a rating. It is case about negligence and misleading and deceptive conduct. (Para 2482)

On the argument that rating agencies are not insurers, the court says:

The imposition of a duty of care in this case does not transform S&P into an insurer of investment performance. It does no more than ensure that S&P, if it chooses to earn money from holding itself out as having specialised expertise in ascertaining the creditworthiness of structured financial products, knowing that it can do so because many potential investors do not have or cannot practically access the same expertise, exercises reasonable care in the assigning of ratings to structured financial products. The criterion for potential liability in respect of such a duty of care is not the performance of the product. The performance of the product determines the potential for loss and thus completion of the potential cause of action. But breach of the proposed duty cannot be determined by reference to the performance of the product. As S&P correctly said the assigning of a rating of a structured financial product embodies a forward-looking opinion about creditworthiness assigned at a particular time. The ratings agency either did or did not exercise reasonable care at that particular time. (Para 2799)

But I am not a lawyer, and my interest is not in legal liability but financial modelling. I have been asking myself a more fundamental question – could this note have been rated at all (not a AAA rating but any rating at all)? The Australian court does conclude that the Rembrandts were securities and not derivatives for the purposes of the Corporations Act, but economically they are more derivatives than bonds. As the court put it: “However else it might be described, the CPDO was ultimately an extraordinarily complicated bet on the future performance of two CDS indices over a period of up to 10 years.” (Summary, Para 9). The risk in the Rembrandts is market risk rather than credit risk. Yes, the derivatives are credit derivatives, but the Rembrandts could be cashed out at a 90% loss of principal not because there were too many any defaults on the names underlying the credit derivatives, but because of the movement of the credit spread. Counter-intuitively, this could happen if the credit spread were too low rather than too high.

Another way of looking at it is that the Rembrandts were a bet that the risk premium embedded in the credit spread (more precisely the CDS spread) could be harvested in a “safe” manner. If the credit spread were say 1% while the expected default losses were only 0.20%, the notes would be expected to make 0.80% annually by selling CDS (before accounting for leverage which could be as high as 15:1). In finance jargon, the Rembrandts were betting that the risk neutral expected default loss (say 1%) is much higher than the real expected default loss (say 0.20%) and the balance is just a risk premium. The complexity of the CPDO structure is all about (a) making this a leveraged bet and (b) dynamically adjusting the leverage ratio to deliver a bimodal outcome where either the investor gets back full principal with a coupon 1.90% above the risk free rate or gets cashed out at a 90% loss of principal. To a finance theorist, there is something absurd about a risk free (AAA) instrument yielding 1.90% above the risk free rate. It is almost axiomatic that there is no risk free way of harvesting risk premia.

It appears to me that such instruments should not be rated at all. Analyzing the probability of loss in the Rembrandt makes no sense when it does not take into account the fact that the loss in case of default is 90% and not the much smaller losses in AAA corporate bonds. Comparing the loss probability of the Rembrandt with that of a AAA corporate bond over a ten year horizon is meaningless since unlike AAA rated corporate bonds which default only after several years, the biggest risk of loss in a CPDO like Rembrandt is in the early years when the leverage is very high. A 0.28% probability of loss over ten years might be consistent with a AAA rating, but a AAA rated corporate bond also has less than 0.01% default probability over the first two years and not 0.06% as one might expect if one tried to spread the 0.28% out equally over ten years.


One response to “On rating Rembrandts

  1. Pingback: Rembrandt: false engravings at the Rijksmuseum. Yareah magazine | Yareah Magazine. Arts and writing

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