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Financial Crisis Suit Suggests Bad Behavior at Morgan Stanley

February 1, 2013

Financial Crisis Suit Suggests Bad Behavior at Morgan Stanley


On March 16, 2007, Morgan Stanley employees working on one of the toxic assets that helped blow up the world economy discussed what to name it. Among the team members’ suggestions: “Subprime Meltdown,” “Hitman,” “Nuclear Holocaust” and “Mike Tyson’s Punchout,” as well a simple yet direct reference to a bag of excrement.

Ha ha. Those hilarious investment bankers.

Then they gave it its real name and sold it to a Chinese bank.

We are never going to have a full understanding of what bad behavior bankers engaged in in the years leading up to the financial crisis. The Justice Department and the Securities and Exchange Commission have failed to hold big wrongdoers to account.

We are left with what scraps we can get from those private lawsuits lucky enough to get over the high hurdles for document discovery. A case brought in a New York State Supreme Court in Manhattan against Morgan Stanley by a Taiwanese bank, which bought a piece of the same deal the Chinese bank did, has cleared that bar.

The results are explosive. Hundreds of pages of internal Morgan Stanley documents, released publicly last week, shed much new light on what bankers knew at the height of the housing bubble and what they did with that secret knowledge.

The lawsuit concerns a $500 million collateralized debt obligation called Stack 2006-1, created in the first half of 2006. Collections of mortgage-backed securities, C.D.O.’s were at the heart of the financial crisis.

But the documents suggest a pattern of behavior larger than this one deal: people across the bank understood that the American housing market was in trouble. They took advantage of that knowledge to create and then bet against securities and then also to unload garbage investments on unsuspecting buyers.

Morgan Stanley doesn’t see the narrative as the plaintiffs do. The firm is fighting the lawsuit, contending that the buyers were sophisticated clients and could have known what was going on in the subprime market. The C.D.O. documents disclosed, albeit obliquely, that Morgan Stanley might bet against the securities, a strategy known as shorting. The firm did not pick the assets going into the deal (though it was able to veto any assets). And any shorting of the deal was part of a larger array of trades, both long and short. Indeed, Morgan Stanley owned a big piece of Stack, in addition to its short bet.

Regarding the profane naming contest, Morgan Stanley said in a statement: “While the e-mail in question contains inappropriate language and reflects a poor attempt at humor, the Morgan Stanley employee who wrote it was responsible for documenting transactions. It was not his job or within his skill set to assess the state of the market or the credit quality of the transaction being discussed.”

Philip Blumberg, the Morgan Stanley lawyer who composed most of the names, meet the underside of a bus, courtesy of your employer.

Another Morgan Stanley employee sent an e-mail that same morning, suggesting that the deal be called “Hitman.” This might have been an attempt to manage up, because “Hitman” was the nickname of his boss, Jonathan Horowitz, who helped head the part of the group that oversaw mortgage-backed C.D.O.’s. Mr. Horowitz replied, “I like it.”

Both Mr. Blumberg and Mr. Horowitz, now at JPMorgan, declined to comment through representatives at their banks.

In February 2006, Morgan Stanley began putting together the Stack C.D.O. According to an internal presentation, Stack “represents attractive business for Morgan Stanley.”

Why? In addition to fees, another bullet point listed: “Ability to short up to $325MM of credits into the C.D.O.” In other words, Morgan Stanley could — and did — sell assets to the Stack C.D.O., intending to profit if the securities backed by those assets declined. The bank put on a $170 million bet against Stack, even as it was selling it.

In the end, of the $500 million of assets backing the deal, $415 million ended up worthless.

“While investors and taxpayers all over the world continue to choke on Wall Street’s toxic subprime products, to this day not a single major Wall Street executive has been held accountable for misconduct relating to those products,” said Jason C. Davis, a lawyer at Robbins Geller who is representing the plaintiff in the lawsuit. “They are generally untouchable, but we are pleased that the court in this case is ordering Morgan Stanley to turn over damning evidence, so that the jury will get to see what Morgan Stanley really knew about the troubled nature of its supposedly ‘higher-than-AAA’ quality product.”

Why might Morgan Stanley have bet against the deal? Did its traders develop a brilliant thesis by assessing the fundamentals of the housing market through careful analysis of the public data? The documents suggest something more troubling: bankers found out that the housing market was diseased from their colleagues down the hall.

Bankers were getting information from fellow employees conducting and receiving private assessments of the quality of the mortgages that the bank would purchase to back securities. These reports weren’t available to the public. It would be crucial information for trading in securities backed by those kinds of mortgages.

In one e-mail from Oct. 21, 2005, a Morgan Stanley employee warned a banker that the mortgages Morgan Stanley was buying from loan originators were troubled. “The real issue is that the loan requests do not make sense,” he wrote. As an example, he cited “a borrower that makes $12K a month as an operation manger (sic) of an unknown company — after research on my part I reveal it is a tarot reading house. Compound these issues with the fact that we are seeing what I would call a lot of this type of profile.”

In another e-mail from March 17, 2006, another Morgan Stanley employee wrote about a “deteriorating appraisal quality that is very flagrant.”

Two of the employees who received those e-mails joined an internal hedge fund, headed by Howard Hubler, that was formed only the next month, in April 2006. As recounted in Michael Lewis’s “The Big Short,” Mr. Hubler infamously bet against the subprime market on Morgan Stanley’s behalf, a fact that Morgan Stanley’s chief financial officer conceded in late 2007. Mr. Hubler’s group was supposed to be separate from the rest of Morgan Stanley, but the two bankers continued to receive similar information about the underlying market, according to a person briefed on the matter.

At no point did they receive material, nonpublic information, a Morgan Stanley spokesman says.

I struggle to see how the private assessments that the subprime market was imploding were immaterial.

Another of Morgan Stanley’s main defenses is that it couldn’t have thought the investment it sold to the Taiwanese was terrible because it, too, lost money on securities backed by subprime mortgages. As the Morgan Stanley spokesman put it, “This deal must be viewed in the context of a significant write-down for Morgan Stanley in 2007, when the firm recorded huge losses in its public securities filings related to other subprime C.D.O. positions.”

This is a common refrain offered by big banks like CitigroupMerrill Lynch andBear Stearns to absolve them of any responsibility.

But does losing money wipe away sin?

Yes, Mr. Hubler made his bets in what turned out to be a deeply disastrous way. As part of a complex array of trades, he bet against the middle slices of subprime mortgage C.D.O.’s. He bought the supposedly safe top parts. The income from the top slices helped offset the cost of betting against the middle slices. But when the market collapsed, the top slices — called “super senior” because they were supposedly safer than Triple A — didn’t hold their value, losing billions for Mr. Hubler and Morgan Stanley. Mr. Hubler did not respond to requests for comment.

So Morgan Stanley lost a great deal of money.

But let’s review what the documents suggest is the big picture.

In the fall of 2005, bank employees shared nonpublic assessments of how the subprime market was a house of tarot cards.

In February 2006, the bank began creating Stack in part so that it could bet against it.

In April 2006, the bank created its own internal hedge fund, led by Mr. Hubler, who shorted the subprime market. Among the traders in this internal shop were people who helped create Stack and other deals like it, and at least two employees who had access to the private due diligence reports.

Mr. Hubler’s group had no investment position in Stack, according to the person briefed on the matter, but it sure looks as if the bank saw what was coming and tried to position itself for a subprime market collapse.

Finally, by early 2007, the bank appeared to realize that the subprime market was faring even worse than it expected. Even the supposedly safe pieces of C.D.O.’s that it owned, including its piece of Stack, were facing losses. So Morgan Stanley bankers set to scouring the world to peddle as a safe and sound investment what its own employees were internally deriding.

Morgan Stanley declined to comment on whether it made money on its Stack investments over all. But it looks to have turned out well for the bank. In Stack, it managed to fob off a nuclear bomb to the Taiwanese bank.

Unfortunately for Morgan Stanley, it had so many other pieces of C.D.O.’s, so many nuclear warheads, that it couldn’t find nearly enough suckers around the world to buy them all.

And so when the real collapse came, Morgan Stanley was left with billions of dollars in losses.

That hardly seems exculpatory.


Jesse Eisinger is a reporter for ProPublica, an independent, nonprofit newsroom that produces investigative journalism in the public interest. Twitter: @Eisingerj


Investor reactions following the settlement

December 18, 2012

We have kept names anonymous, but because you all have been so grateful with your words, we thought we would share some.  Feel free to add your own comments!


Yes – news of payout is very exciting and you and your team deserve a huge pat on back as without your insistent harassment of all those involved, I’m sure much would have been swept under the carper. You’ve kept everyone involved responsible in their duty to report on an ongoing basis, and assisted very much so in the various parties having to come to a monetary payout conclusion. Well done. We need more people like you in New Zealand keeping companies clean and honest.

Thank you sincerely for all the work and effort you have put into realising funds for the Credit Sails community. This will have been much appreciated by many I feel sure. I think I had really said goodbye to my investment so I anticipate the return of some capital owed with some delight!

Thank you for the update and the ‘best practice’ note.  You thank us for our support, but the thanks are more properly due to you and your team who have enabled us to have some hope of good news whereas left alone we wouldn’t have had any.  We truly appreciate your efforts; thanks.  Best wishes for the Festive Season.

For all the time & effort you have put into this. I really appreciate what you have done.

Thank you for the Credit Sales communication and for your diligent “beavering away” to achieve such a successful outcome. Congratulations on the ODT publication of today’s hard hitting resume of the impact on so many investors. There could be a case for a Prospectus/Investment Statement requirement to state that it is unwise to place any more than say 10% of an investor’s funds in any one investment.  We shall be in Wanaka Christmas/New Year & hope to have you round for a celebratory drink!

We would like to thank you and your team for the last three years negotiations on our behalf during the battle with Credit Sails and their associated firms.  Your team, together with the Commerce Commission,exceeded our wildest dreams and for this we can not express our appreciation enough.. We would like to wish you and yours a happy festive season and a  prosperous New Year.

You deserve a medal for this and our support of lesser importance.  I was rung this morning by Forsyth barr re this as if they had had had major impact.  Well done.

Thank you, I am delighted with your efforts on my behalf, especially keeping me so well informed.  I look forward to  receiving investment opinions and offers from Logic Fund Management in the future.

You little beauties!!!  Grateful thanks from a couple of oldies who had mistakenly expected an income stream that never eventuated.

Great news – thanks very much for your concerted effort.  It is much appreciated by us little guys !!   Please keep me on your database. I would like to show my support of you once the funds are received.  Kind Regards

Congratulations.  If you know where that Grant Waterhouse is; the man quoted by Tim Hunter; tell him I owe him a few beers for his famous quote about Chinese walls.  I would love to meet that man.  He has an attitude that I like.

I am sure that all investors appreciate the leadership in this matter – which has been key to the outcome. Great example of how investors can be become a community with the same objective.

Thank you both very much for your persistence and encouragement which I greatly appreciate. While it would have been good to have the perpetrators acknowledge culpability it is a very pleasing outcome.  I hope you enjoy a well deserved break and will hope to speak to you in the New Year.

Merry Xmas guys….Well done. Great news!!!! We hope you have a nice break and we will be in touch in the new year. Without you guys our money would have been lost and as loyal Southlanders we will look at putting some business your way in the future.  Once again well done!!!

Proficiat !  Delighted with the just received news the CC Credit Sails investigations have resulted in a NZ $60 m settlement , thanks to your ongoing and persistent drive to rescue our investments!  You have done a marvelous job , our heartfelt thanks.

I am very grateful for your efforts on behalf of all of us who bought these bonds.

Thanks to you and the team for all your hard work to achieve this very good result which was not without cost. I do think that you should allow the investors to make a voluntary contribution towards costs / salaries and I think 2.5% of funds received would be an appropriate guideline. If you are unable to consider this then perhaps in a later communication you could nominate a charity (ies) to whom donations could be made ( and these would be tax dedectible for investors as an added bonus!!l).  Again thanks for the Christmas present

If you ever pass through Waihi, please look us up. If it is the right time of the day we will share whiskey!  Well done, and all the best!

Thanks for your report. i think I should applaud your firm for its efforts in pursuing a very reluctant share broker and others so that a reasonable conclusion was reached.  I note that Paviour-Smith still claims that he has worked over three years to obtain satisfactory return for investors.  How gullible does he think investors are ?  I wish you success in pursuing the SCF preferential share issue. I am just thankful that I said to FB & Co “No thanks’ when they tried to sell me that issue.

Compliments of the season to you and your staff.  And best wishes to you in your next mission.

We write thanking you and all the team at Logic Management for the successful outcome with Credit Sales. This will have been a very exhausting 2-3 years for you all on our behalf.  How we ever bought into this product, with hindsight, still eludes us. But the offer, to just a select few, of the chance to buyback really grates.  Correspondence from Forsyth Barr on this matter has been nil, other than an earlier letter saying “challenging times” and “bad luck”. Without your persistence to get this matter before FMA, none of us would have received any repayment.  We would welcome the opportunity to stay on your database and, in time, review some of our investment options. Once again, thanks – and Happy Christmas to you all.

Thank you very much, this is very good news. All your hard work has certainly paid off because without the pressure you put on, the commerce commission would have done nothing. Thank you very much. I am certain you will have a very Merry Christmas and will have a very successful new year. Thank you again from my wife and myself, you can be very proud of yourselves.

Credit Sails deal too late for some

December 18, 2012

Credit Sails deal too late for some

Otago Daily Times

By Dene Mackenzie 

Greg Marshall.

Greg Marshall.
The $60 million resolution of the Credit Sails debacle had come too late for some investors, Wanaka finance professional Greg Marshall said yesterday.Mr Marshall, of Logic Fund Management, has spent three years chasing a resolution of the fund. Credit Sails were sophisticated debt securities marketed and sold to the New Zealand public in 2006 with the prospect of 8.5% interest income and capital protection.

The Commerce Commission said $91.5 million was raised through the offer. Credit Sails failed in 2008 and the notes were now virtually worthless, it said in a statement.

”The $60 million resolution has been very much welcomed by Logic Fund Management and the investors for whom we have been fighting for over the course of the last three years,” Mr Marshall said.

”However, this has not happened quickly enough for those victims of one of the dodgiest deals in recent history.”

Some investors had died and others had been ”significantly impacted” by the loss of life savings, he said.

”This will always leave a lump in our throat.”

Following an agreement with the Commerce Commission, Credit Agricole CIB (formerly Calyon) and Forsyth Barr had paid $60 million which would be held in a trust account from which payments would be made to eligible investors.

The companies had not admitted liability and did not accept the commission’s views on the matters.

Mr Marshall said the manner in which the parties had been ”dragged kicking and screaming to a resolution” should, in the opinion of Logic Fund, result in additional damages.

”They had ample opportunity to ‘fess up. But instead, in the case of Forsyth Barr, they advised their preferred customers to get out in July and October 2007, and subsequently in our opinion were active in hindering our campaign to redress investors.”

Asked why his firm had carried out the campaign to get the money returned to investors from the failed fund, Mr Marshall said the work was carried out pro bono because he and others in Logic Fund had the ability to understand the issue and the tenacity to go after a resolution.

Questions remained unanswered, he said. They included why Credit Sails notes were removed from customers’ accounts for ”nil value” in 2010 and whether or not those notes were being returned to customer accounts now, he said.

Online criticism about Forsyth Barr was harsh and unmoderated. Mr Marshall said there was no surprise in that. He was particularly angry at Forsyth Barr claiming it had worked hard for three years to get the money back when he believed the firm had done nothing at all.

”People will see through that for what it is. We had clients who were told nothing would ever come from that investment and those `guys in Wanaka’ had no show.”

Many people had lost their life savings. There were big losses from investors such as the Dunedin Orphans Club, the Taieri A&P Society, the Southern Hospice Trust and the Methodist Community Trust, Mr Marshall said.

Smaller investors, where $5000 to $10,000 made all the difference to their lives, had lost their money.

Two Dunedin women had lost their entire savings through Credit Sails and had ended up in psychiatric care. An elderly woman in Balclutha had lost her money and was told there was no hope of seeing any of it again.

”And I have lost count of the people who died. People blamed themselves. They wouldn’t go out or meet people. They just holed up at home.”

Logic Fund was now turning its attention to the collapse of South Canterbury Finance and the loss of $120 million of investors’ funds in the SCF preference shares.

”It seems to be a stunning coincidence that the company that promoted and sold these preference shares is the same one who organised Credit Sails. We will be shortly reaching out to the SCF investors to commence a campaign for redress,” Mr Marshall said.

He paid tribute to the Commerce Commission which he said showed tenacity and courage to achieve the result on behalf of Credit Sails investors.

Relief and anger from Credit Sails investors

December 18, 2012

Relief and anger from Credit Sails investors


18 December 2012 

There was relief mixed with anger from Credit Sails investors this morning as they learned one of New Zealand’s largest sharebrokers and a giant French bank had agreed to pay $60 million in compensation for their losses.

“I’m obviously very pleased,” said Dunedin investor Andrew Cunningham. “I’ll take the money and I’ll never deal with those people again.”

Retired businessman Grant Waterhouse, who stands to recover more than $100,000 of a $150,000 investment, said news of the payout was reward for the heartache.

“It’s just good,” he said. “Despite the fact these pricks don’t admit liability, the fact they’ve coughed up $60m has got to say something.

“And it’s good they’ve been held to account. They would have just squirmed their way out of it if the Commerce Commission hadn’t got the bit between their teeth.”

Credit Sails was a complex derivative product put together in 2006 by French investment bank Calyon, a subsidiary of Credit Agricole, and lead managed in New Zealand by broker Forsyth Barr.

Its key selling points were AA-rated capital protection and a high interest rate of 8.5 per cent, but two years later the securities were worthless after a series of defaults decimated the structure.

Estimated losses for investors were about $70m.

After a two-year investigation, the Commerce Commission said it believed the marketing of Credit Sails was likely to breach the Fair Trading Act, and representations that it was capital protected were “misleading and deceptive”.

Credit Agricole and Forsyth Barr have agreed to pay $60m into a compensation fund but do not accept liability or accept they broke the law.

The commission’s investigation and settlement followed a vociferous campaign on investors’ behalf by Wanaka-based fund manager Greg Marshall, principal of Logic Funds.

“I feel quite good – a little bit proud,” he said. “It was a long road I can tell you.”

He had talked to about 100 clients about the settlement so far, he said, including a Southland couple in their 80s who had put the proceeds of a farm sale into Credit Sails.

“They were dancing on the table,” said Marshall. For many investors, news of the payout was “a life-changing event”.

It was nevertheless disappointing that the institutions behind Credit Sails had not accepted responsibility.

“The most powerful words are ‘that’s my fault, I’m sorry”, and they still don’t appear in this. ‘We pay $60m but we disagree’? Please.”

Cunningham said the only other thing he’d like to see would be resignations at Forsyth Barr, “but I suppose they’ll manage to crawl under a few stones until the dust settles.”

Waterhouse said the firm had fed him “bullshit” about Chinese walls between the advisory and investment banking sides of the business. “You can quote me on this – the Chinese walls were about as thick as the condoms they used to shove it up the shareholders arses.”

Commerce Commission secures $60m for investors in failed Credit SaILS product

December 17, 2012

Commerce Commission secures $60m for investors in failed Credit SaILS product

18 December 2012

The Commerce Commission has reached a settlement with five companies that concludes its investigation into the failed investment product Credit SaILS. As part of the settlement, the companies have agreed to create a settlement fund of $60 million to be distributed to investors who lost money when Credit SaILS failed in 2008.

The companies involved in establishing the fund were Forsyth Barr Limited, Forsyth Barr Group Limited, Credit Agricole Corporate and Investment Bank, Credit Sail Limited and Calyon Hong Kong Limited.

Credit SaILS were sophisticated debt securities marketed and sold to the New Zealand public in 2006 with the prospect of 8.5% interest income and capital protection. $91.5 million was raised through the offer. Credit SaILS failed in 2008 and the notes are now virtually worthless. On the information available, the Commission estimates the total loss for those eligible for a share of the settlement fund is around $70 million.

The Commission has reached the view that Credit SaILS was marketed and sold in a way that is likely to have breached the Fair Trading Act, in that:

  • the representations that Credit SaILS were ‘capital protected’ were misleading and deceptive
  • Credit SaILS were marketed to the average investor
  • Credit SaILS were highly complex and unsuitable for the average investor
  • and the companies who marketed and sold Credit SaILS ought to have known that the product was unsuitable for the average investor.

The companies have not admitted liability and do not accept the Commission’s views on these matters.

“In our view there were sufficient grounds to file legal proceedings under the Fair Trading Act against the companies who promoted and sold Credit SaILS. While the Commission could have issued proceedings, those proceedings would likely have been lengthy, costly and with no absolute certainty of a successful outcome,” said Dr Mark Berry, Chair of the Commerce Commission.

“We believe that a settlement fund of $60 million, available to investors from March next year, is an excellent outcome. We expect this settlement to restore eligible investors to around 85% of their original investment in Credit SaILS. We place high priority on seeking redress for businesses and consumers and we are pleased we are able to achieve this outcome for the investors,” said Dr Berry.

More than 3,000 investors bought Credit SaILS. Most of these were retail investors with a limited understanding of complex financial products like Credit SaILS. A significant number of investors are now over 70 years of age.

Under this settlement, investors will now receive about $850 for every $1,000 they invested in Credit SaILS. Without this settlement, investors could expect to get about $20 from their $1,000.

“It is crucial in relation to complex financial products that investors are provided with accurate information, particularly about the risks of a product. We believe these mostly elderly investors bought Credit SaILS because they were told that their capital was protected,” said Dr Berry. “Consumers must be able to rely on representations made.”

Eligible investors are defined in the settlement agreement as including anyone who purchased Credit SaILS before 1 November 2008 and who still hold those notes, and anyone who purchased Credit SaILS before 1 November 2008 who has sold the notes at any time for less than 85 cents per note.

A trustee will be appointed to distribute the settlement fund to eligible investors. Investors do not need to contact the Commerce Commission or the companies – the trustee will write to all investors shortly.

The Commission’s investigation has included liaison with the Financial Markets Authority, which is aware of the Commission’s settlement and has agreed not to take action against the companies in light of this settlement.

The settlement deed and further information about the settlement, including more details about the settlement offer and the pay-out process, are available on the Credit Sails Investigation page.

Media interviews:

Dr Mark Berry, Chair of the Commerce Commission and Mary-Anne Borrowdale, General Counsel, Competition are both available for media interviews. Please contact through the Media Contacts at the end of this release.


Credit SalLS were marketed as secured fixed interest New Zealand Dollar denominated debt securities on the following basis.

  • Credit SaILS were issued on 15 June 2006 and are scheduled to mature on 22 December 2012.
  • The issue price was $1 per note.
  • The minimum investment was $5,000.
  • The offer was available to members of the public.
  • 91.5 million Credit SaILS were issued.

Credit SaILS were a complex debt security involving an investment in separate securities called Momentum Notes, which acted as the collateral for Credit SaILS. The performance of Credit SaILS was therefore contingent on the performance of the Momentum Notes.

Marketing of Credit SaILS

Between April and June 2006, the companies had various roles in marketing and selling Credit SaILS to New Zealand investors.

The companies participated in marketing Credit SaILS through:

  • the Credit SalLS lnvestment Statement and Combined lnvestment Statement and Prospectus for Credit SalLS
  • other documents prepared by the companies for the purpose of marketing Credit SaILS
  • and representations made by investment advisors acting on behalf of Forsyth Barr and other New Zealand-based investment advisory firms.

More than 3,000 investors purchased Credit SaILS.

Failure of Credit SaILS

Between 15 September 2008 and 31 March 2009 six individual reference entities named in the Momentum Reference Portfolio (a portfolio upon which repayment of the Credit SaILS principal amount was dependent) experienced adverse credit events.

The total losses from these credit events resulted in the full amount of the Momentum Notes investment being lost, meaning that none of the principal amount of Credit SaILS would be returned to investors upon maturity. On 12 May 2009 Credit Sail Limited issued a public announcement that Credit SaILS would be redeemed at zero, plus the holder’s pro rata share of the residual monies, amounting at the date of the announcement to $11.66 plus interest for every 1,000 Credit SaILS held.

Rembrandt ruling in Australian CPDO case puts heat on S&P

November 11, 2012

Rembrandt ruling puts heat on S&P

November 5, 2012

Michael West

Sydney Morning Herald 

“ABN simply bulldozed it (the rating) through.” The rating of the Rembrandt notes as AAA had been “sandbagged a little”.*

The Federal Court’s Justice Jayne Jagot has accepted the evidence from 13 NSW councils – who claimed they had been duped into buying a toxic financial product – that the ratings agency Standard & Poor’s was little more than a lap dog for slick merchant bankers.

Investors are entitled to and indeed do rely on credit ratings and can expect them to be based on reasonable grounds.

The ruling means the councils will recover about $30 million in losses following failed investments in complex synthetic derivatives known as constant proportion debt obligations, or CPDOs, that were arranged by ABN Amro, rated AAA by S&P and sold by LGFS in 2006.

This judgement was a long time in the coming. The financial crisis, from which the world economy has yet to recover, was caused in part by the widespread sale of toxic and highly leveraged credit derivatives. Investment banks created this deceptive rubbish and the rating agencies lent their imprimatur.

In the direct aftermath of the crisis in 2009 a Congressional inquiry in Washington heard testimony, which came to light in an email between S&P employees, “We’d rate a cow”, if paid for.

Duty of care for investors

It has taken three years but finally a court has ruled what most people had suspected, that the rating agencies have a duty of care to investors, that their AAA ratings should have mattered, and yes, not only that they would rate a cow for money but they did rate a cow.

That cow was a “Rembrandt” CPDO (Constant Proportion Debt Obligation). S&P had assigned its top rating, AAA. Yet it was highly leveraged and highly risky financial product and it blew up 90 per cent of its value six months after the councils had purchased it.

The Federal Court’s finding that S&P was negligent has tremendous implications. It will reverberate around the globe, perhaps exposing the ratings agencies to a slather of lawsuits here and abroad.

The essential problem in the system has been exposed, and now judged by a court. That is, that the ratings agencies are private companies whose shareholders benefit if the stock price rises. They are paid by the banks to rate their products. The more ratings they apply, the more profit they make.

And so, during the debt-fuelled boom the agencies’ standards declined.

These CPDOs were even more leveraged and risky than your average CDO (collateralised debt obligation) and there were approximately 5 billion euros worth of CPDOs issued globally, the vast majority of which defaulted during the height of the financial crisis.

It will now be far more difficult for rating agencies to hide behind disclaimers to absolve themselves from liability. The Court’s finding this morning acknowledges that investors are entitled to and indeed do rely on credit ratings and can expect them to be based on reasonable grounds.

S&P cannot express its opinion, knowing that investors rely upon it, get paid for that opinion and then disclaim liability.

Floodgates opened?

It remains to be seen whether the Court’s finding that S&P engaged in misleading and deceptive conduct in assigning its coveted-AAA rating to the CPDO will open the flood gates for actions against credit rating agencies in relation to other structured products such as CDOs. Logically, CDOs are also in the gun. Most enjoyed the top rating, most blew up.

The CDO market was much larger than the CPDO market – by the end of 2006, the size of the CDO global market was close to $2 trillion, much of which was lost to the global financial crisis.

Now that a legal determination of liability has been made against S&P, disgruntled investors may start undertaking investigations into the reasonableness of the ratings issued for the CDO products.

Much of the investigative work has already been undertaken. Both the SEC and the United States Senate Permanent Subcommittee of Investigations have issued reports on the conduct of rating agencies and both have concluded that ratings were inaccurate and that the failures of credit rating agencies were essential cogs in the wheel of financial destruction.

The judgement against ABN Amro should also serve a warning to all investment banks who issued structured financial products throughout the market. Although a rating is not a representation of the bank, the bank can still be found liable for passing on those ratings in circumstances where they know the rating was not based on reasonable grounds.

In this case, ABN Amro supplied S&P with incorrect data to be used in the ratings process. It knew that the product should not have been rated AAA and yet knowingly allowed investors to be deceived.

Implications for financial advisors

Then there are the implications for financial advisors. This is the second Federal Court decision in the space of six weeks to confirm that an investment advisory relationship can exist in the absence of a written agreement.

Today’s decision, together with the recent findings by Justice Steven Rares in the Lehman Brothers proceedings, confirms that the existence of an advisory relationship is determined on a case by case basis. It swings on the relationship between the investor and the adviser.

No written agreement is necessary. Such advisory relationships, if established, bring a fiduciary duty. The adviser will have to fully and accurately disclose all matters that could reasonably be considered relevant to an investor’s decision to invest and institutions who consider themselves mere sellers of financial products may now find themselves embroiled in litigation for failing to fulfil their obligations as financial advisers.

LGFS (the investment adviser) was found to owe duties to the councils to disclose all factors which were material to the decision to invest in the Rembrandt Notes. LGFS was negligent and guilty of misleading and deceptive conduct in failing to fully and accurately disclose all the material risks the councils, who LGFS knew reposed trust and confidence in them and relied on them to adequately explain the structure and risks.

LGFS were also found to be in breach of their fiduciary duties to the councils by failing to disclose that they had a significant financial interest in selling the products to the councils. LGFS had bought the $40 million issue of the product and would be forced to hold it on its own books if it would not on-sell them.

The proceedings were filed by the applicants in the Federal Court of Australia in September 2009. The 13-week trial commenced before Justice Jagot in October 2011 and concluded in March this year.

S&P says it plans to appeal the ruling.

“We are disappointed with the court’s decision, we reject any suggestion our opinions were inappropriate,” the ratings agency said in an emailed statement.

*These are quotes from internal emails that emerged during the hearings of the case and were mentioned  by Justice Jagot in her ruling.

Bloomberg: Goldman Fails to Dismiss Basis Capital’s Timberwolf Suit

October 25, 2012

Goldman Fails to Dismiss Basis Capital’s Timberwolf Suit

By Edvard Pettersson 
October 20, 2012 

Goldman Sachs Group Inc. (GS) lost a bid for dismissal of a lawsuit by Australian hedge fund Basis Capital Funds Management Ltd. over the sale of securities known as Timberwolf and Point Pleasant.

New York Supreme Court Judge Shirley Werner Kornreich in an order yesterday denied Goldman Sachs’s request to throw out Basis Capital’s fraud, negligent misrepresentation, unjust enrichment and recession claims. The judge agreed to dismiss the breach of contract claim and a claim for breach of implied covenant of good faith and fair dealing.

The suit, filed a year ago in Manhattan by Basis Capital’s Basis Yield Alpha Fund, accuses New York-based Goldman Sachs of “knowingly making materially false and misleading statements and omissions” in connection with the securities.

The claims relate to Point Pleasant, a collateralized debt obligation based on subprime residential home mortgages, and two credit default swaps that referenced securities from a similar CDO known as Timberwolf.

Basis Capital accuses Goldman Sachs of marketing new CDO investments in early 2007, after the company had already determined that the value of securities in that market “would likely go into sharp decline in the near future,” and used the new CDOs as a vehicle to short the market.

Basis Capital is seeking to recover the $67 million in compensatory damages and $1 billion in punitive damages, according to the lawsuit.

Michael DuVally, a Goldman Sachs spokesman, declined to comment on the ruling.

The case is Basis Yield Alpha Fund (Master), 652996/2011, New York State Supreme Court (Manhattan).