BUSINESS
11/05/2012 12:01 pm ET

Standard & Poor's Misled Investors On Shoddy Derivatives, Australian Court Rules

The only thing the credit-rating agencies lost in the financial crisis was their reputation, despite midwifing the disaster. Now they're at risk of losing a little bit more.

A federal judge in Australia has ruled that Standard & Poor's misled investors about the quality of derivative monstrosities called constant proportion debt obligations (CPDO) dubbed "Rembrandt" notes. These were created by the Dutch bank ABN Amro's wholesale banking unit, stuffed with credit default swaps on corporate debt and sold to local governments in Australia in 2006.

Standard & Poor's, like it does, slapped these goofy things with a "AAA" credit rating before they were shipped out the door. They promptly went kaput, losing 90 percent of their value in less than two years. As Quartz's Naomi Rovnick notes, the judge in the case said Standard & Poor's rated the CPDOs without doing its homework. Instead, it relied on mistaken assumptions given to it by ABN Amro. And even when it started to wonder if maybe it had been "gamed" by ABN Amro, it went ahead and gave future batches of the stuff AAA ratings anyway.

If this all sounds familiar, then you are probably thinking of the financial crisis, in which Wall Street stuffed murky derivatives full of subprime mortgages or credit default swaps or other garbage, all of which were rubber-stamped "AAA" by S&P, Moody's and Fitch with inadequate due diligence before they promptly blew up in everybody's faces, bringing global finance to its knees.

This history led to widespread mockery of and disgust with the rating agencies, along with occasional sporadic efforts to find ways to ignore the agencies forever. But it has been difficult for investors to sue the rating agencies for their role in the crisis, as they have defended themselves with the shield of the First Amendment: Hey, our useless ratings were just opinions, and we can't be sued over dumb opinions. Unfortunately for the rating agencies, there are no First Amendments in godless communist hellholes like Australia and Europe.

The Financial Times and Quartz suggest that the ruling in Australia, which was scathing in its treatment of S&P, could open the door for more lawsuits, particularly in Europe. The FT writes:

The 1,500-page ruling marks the first time a rating agency has stood a full trial over a structured finance product. The decision will be closely studied by rival rating agencies and also by investors and investment banks around the world.

S&P said it disagreed with the decision and planned to appeal. Royal Bank of Scotland, which now owns ABN Amro's banking unit that created the CPDOs, said it was still chewing on the decision.

Even if S&P and the other agencies are suddenly vulnerable to a flood of lawsuits, nothing much will have changed about the relationship between credit-rating agencies and investors. The agencies are still paid by the banks that issue debt and derivatives, not by investors. This means they have an incentive to rate as much stuff as possible and to rate it well. As one rating-agency employee told another in the lead-up to the crisis: "We rate every deal. It could be structured by cows and we would rate it."

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