The Smartest Girls In The Room
By Bernard LaganDecember 3, 2012
The world’s best known ratings agency has been hit with a billion-dollar civil law suit from the United States Justice Department for misleading and deceiving investors leading up to the financial crisis. But it was an obscure Australian judge and hard-charging lawyer who exposed the juggernaut's illegal behaviour.
Amanda Banton might have stepped off the set of the television show that entranced her when she was a kid growing up out on the scrub far west of Sydney; LA Law was a mid-1980s drama set in a legal firm, which probed the social and cultural ideologies of the time — racism, gay rights — overlaid with the conflicts posed by the surging appetites of the firm’s gilded partners for money, power and flesh.
“I always had a fascination with being a lawyer. I watched all the good law programs,” recalls Banton, a tall, slender blonde who wears Max Mara, drives a high-powered black Mercedes convertible, and is partner in the rising Sydney law firm Piper Alderman. Its offices are announced by a cavernous, white, glass foyer 22 floors above the city’s Phillip Street legal and commercial nexus. Here, the fantasy with downtown Los Angeles both rises and falls: while LA Law’s cases typically revolved around the time’s fermenting social issues, Banton’s ascendancy in the law has been via the grind of unravelling insolvent companies, assembling painstaking cases alleging corporate misbehaviour and, lately, unpicking dense financial investments.
No longer for her, the law’s humdrum chores of enforcing contracts or litigating building disputes — her early career fodder. “I just couldn't do the run-of-the-mill stuff over and over. I like to be on the edge a little bit,” says Banton, a mother of two.
When Banton was a child her father battled with cancer, which set the family back. It meant they had to leave their farm near the hamlet of Dunedoo, near Dubbo in central New South Wales. She did an accountancy major and law at the University of Adelaide, ran the nation’s health budget within the Federal Department of Finance, then joined a national consultancy. In recent times Banton has become a go-to litigator for those who want to unravel the brain-frying complexities of perhaps the most labyrinthine financial investments ever dreamed up within the world of prediction markets: synthetic derivatives.
She was the architect of a class action that in September won a spectacular victory for 72 Australian local councils and community organisations — including a Queensland charity that helps disabled children — that had been suckered into investing in what turned out to be multi-million dollar financial time bombs sold by the now collapsed New York investment banking powerhouse Lehman Brothers. The investments blew up — along with Lehman’s — in the 2007 global Economic Meltdown and the council and community investors collectively did more than $200 million.
The Federal Court justice who heard the case, Steven Rares, found that Lehman’s had engaged in deceptive and misleading conduct and negligence when it effectively took the councils for financial patsies. The trial was the first in the world to examine the conduct of an investment bank in the creation and selling of the complex financial products known as collateralised debt obligations (CDOs), and has paved the way for the councils and charities to recoup $200 million in damages.
But a more impressive court victory for Banton was soon to follow in November — a triumph that would again startle the world’s financial markets, rock the international rating agencies and bring a diffident, offbeat and crack Sydney judge to the attention of the world’s financial press.
Justice Jayne Jagot is a lithe, angular woman who carries herself like the swimming champion she once was. Jagot — like Amanda Banton — did not begin her ascendancy from a background of law or privilege.
Jagot’s parents were both raised in London orphanages. They came to Australia in the late 1960s so that their own children might have the education and life chances they never had. Jayne Jagot grasped her opportunities; at 14 she was a NSW state swimming champion. Later, while studying law at the University of Sydney, she collected almost every academic prize. As a barrister, she specialised in environmental and planning law. According to those who know her, her pastimes tend to the cerebral. She loves language and literature and is a prodigious reader with a deep interest in subjects as diverse as World War I and neurophysiology. Jagot operates with a brisk efficiency in court. She is not a judge who scolds lapses by lawyers; rather she seeks a work-around.
These are two very different women — on different sides of the law. One is a reserved, bookish judge, the other an elegant, dogged lawyer. And when Banton took her second case involving the sale of complex investments — this time the work of the Dutch investment banking behemoth ABN Amro — to court in Sydney late last year, Justice Jagot drew the case.
The hearing would take 13 weeks, involve 40,000 documents, 17 different parties and a brace of lawyers in Jagot’s muffled, faux wood-panelled court room above Queen Square in Sydney. She would eventually write a judgment longer than the 587,287 words of Tolstoy’s War and Peace. Its effect would be as profound within the shrouded world of the international financial-ratings agencies as Tolstoy's work was on literature.
This case dealt with a new issue for Justice Jagot — one that had never before been examined in a court anywhere in the world. How was it that the New York-based global rating agency Standard & Poor’s had decided that arguably the most complex financial investments ever created were worth the gold standard of financial ratings, the coveted AAA? Their decision flagged to investors the world over that these new deals had only a minuscule chance of failing; more precisely, the rating meant there was supposed to be a 99.3 per cent chance that they were bulletproof.
A computer model had supposedly simulated their performance 100,000 times.
In reality, the global financial crisis of 2007 rendered these investments treacherous. But there is little that is real about what Justice Jagot came to call the grotesquely complex investments that ABN Amro was selling around the world — including to naïve council officers in Australia.
The story that unravelled in Sydney was an engrossing account of what went on in the back rooms of the London and New York financial districts where a global bank, desperate to get its investments on the market with the lure of a gold-standard rating, dealt with the world’s leading rating agency. The Sydney Court hearing — because it forced the production of some 40,000 documents, including emails — would shine light where none had shone.
Before we look, we must first go far back in time to understand the genesis of what it was that ABN Amro was pushing. These were highly sophisticated derivatives.
While they might sound like the creation of the elite who labour within the financial houses of London and New York, a derivative is simply a contract whose value relies on the worth of an asset — say a stock, a chunk of gold, a barrel of oil. The secret to understanding them is that those who buy and sell derivatives are not buying the asset, they are betting on its future value. They are gambling on time.
Crude contracts to sell commodities in the future at set prices have been found inscribed on clay tablets from Mesopotamia that date from 1750 BC. In the 13th century, English monks made futures deals with traveling merchants, to sell wool 20 years in advance. In 17th century Holland, when tulip prices began to soar, a frenzied round of buying and selling tulip futures lead to a market crash. Some traders — such as the English monks — used derivatives to control risk; they locked in the future price of their wool. Others, like those who bet on Holland’s soaring tulip prices, saw the chance for windfall profits.
The marvel of derivatives is that they can do two seemingly opposite things: they are a way for investors to reduce risk, and they can create a good deal more risk, with the potential for enormous profit or crushing loss. It all depends on the skill and knowledge — and motives — of those who trade in them.
Naturally, as the world moved beyond trading in commodities — whipped along by technological change and globalisation — traders and investors began using derivatives to protect themselves from exchange-rate swings and currency fluctuations. No one could have imagined the scale of these new prediction markets; by 1994 the total amount of interest-rate and currency derivatives in the world — that is, bets on the future of exchange rates and interest rates — was assessed at USD12,000 billion. This amount is larger than the whole of the US economy.
As Gillian Tett, a Financial Times journalist, vividly chronicled in her absorbing 2009 book, Fool’s Gold, about the economic meltdown in 2007 the time bombs were set on Florida’s fabled Gold Coast at a sugar-pink Boca Raton hotel in the American summer of 1994. That's when several dozen young bankers from the investment banking firm JP Morgan converged from New York, London and Tokyo for a weekend of wild partying and gazing into the future. How to create the next big thing to spur on the explosion in derivatives? Was there a new innovation that might keep the incredibly profitable deals cranking?
The idea they hit on was to use derivatives to trade the risk linked to an entirely new area; corporate debt and bonds (loans made by investors to a corporation). Why not create a derivative that would make it possible for banks to bet on whether a company might default on its debts in the future?
It was an idea the young tsars of JP Morgan thought would be good for the world’s financial system; if you could really insure banks and other lenders against the risk of loan defaults, might that not open the flood gates for mountains of cash into the world economy?
The idea — and it wasn’t all JP Morgan’s — came to be known as credit derivatives.
A disaster in an Alaskan Sound a few years before the Boca Raton conference would become an early illustrator of their capacity. In the early 1990s, the American oil giant Exxon was facing a USD5 billion fine arising out of the 1989 Exxon Valdez oil spill, an environmental disaster in Alaska’s Prince William Sound. Exxon desperately needed a huge line of credit to cover the fine. But banks were reluctant to lend to Exxon, despite the likelihood that Exxon would pay it back, simply because such a vast line of credit would eat up the bank's available funds for lending to others and would push bank credit limits.
The investment bankers came up with an innovative solution: JP Morgan provided the line of credit to Exxon but transferred the risk of Exxon defaulting to the European Bank for Reconstruction and Development. It did this by paying the Euro bank a hefty annual fee in return for the Euro bank agreeing to cover any default by Exxon. The deal took the pressure of JP Morgan’s internal credit lines; it was no longer exposed to a default.
The great leap in credit derivatives — the credit default swap — was born.
But how to turbo-charge this creation? How to develop it from a cottage industry of swapping the risk of one loan at a time? The answer lay in pooling, or bundling, large numbers of loans into packages. The beauty of this idea was that the risk of some of the dodgier loans defaulting would be spread over the whole bundle; thus, if some loans did default, the loss would be covered by profits made on the rest of the loans.
The business soared. Scores of differing and exotic products, based on bundled credit-default swaps, were showered upon investors. The challenge for the bankers creating and selling these products was to stay ahead of each other — to constantly innovate.
And that leads us back to ABN Amro and how it came to create, in 2006, the mother of all derivative products. It was this monstrously tangled creation that Amanda Banton’s legal team would later unpick, lay out before a Sydney court and convince Justice Jayne Jagot that not only had the Australian local councils who readily handed over millions been bamboozled, but that the world’s most prestigious ratings agency, Standard & Poor’s, had been negligent and had misled investors who relied on its gold-standard rating to assess the products.
Juicy email chains that ABN Amro’s hard-charging London-based bankers and Standard & Poor’s New York-based pressured ratings analysts never thought would emerge were dredged up and put into evidence before Justice Jagot. They would disclose the application of heavy pressure on the rating’s agency, by the bankers, for a coveted AAA rating and, later, deep recriminations inside Standard & Poor’s over the issuing of that rating.
One senior Standard & Poor’s analyst, regretting his involvement in rating ABN Amro’s product, railed in an angry email to a colleague: “You are a wuss for bending over in front of bankers and taking it.”
In late 2006 the Dutch-based ABN Amro global investment bank began to offer corporations and public utilities around the world an extraordinary trick of financial conjuring. This complex golden egg would pay investors an interest rate of up to 2 per cent more than they could get from a rock-solid government bond. Most amazingly, it looked just as safe. ABN Amro’s product came with the top drawer, AAA rating from Standard & Poor’s. The premium rating immediately opened up the products to a wide pool of investors who are often barred from holding assets with less than stellar credit ratings; investors such as pension funds, public utilities — local councils in Australia — could all buy in.
This new product set the international money world alight. Risk magazine, the sophisticated investment bible noted for its modern art covers, gushed over it, quickly awarding the innovation its “deal of the year” award. Euromoney listed it as one of 2006’s top six deals.
This extremely attractive little goldmine came with an ugly moniker; ABN Amro called it a Constant Proportion Debt Obligation (CPDO). Its technique, explained here in its most crude form, was simple enough: It scooped up investors’ money, leveraged it up (borrowed more money on it) and poured the cash into sophisticated versions of those credit default swaps that we referred to earlier — it laid massive bets that baskets of corporate debt wouldn’t sour.
Using leverage in the derivatives galaxy is akin to the property speculator who borrows money to buy multiple homes; he or she will be more exposed to ever greater losses if house prices fall — and reap windfall gains if they increase. In the case of the CPDO, it was programmed to keep leveraging its bets upwards — up to a maximum of 15 times the initial amount invested — to compensate for any deterioration in its investment in credit-default swaps.
This was akin to a casino doubling strategy for a gambler; the gambler tosses a coin and doubles his bet each time he loses and keeps repeating that until he wins. The goal was to win before losing everything. The maths underpinning this play says that most of the time the strategy will eventually bet the gambler out of his hole. The CPDO was programmed to keep increasing its bets until it won its gamble.
As ABN Amro itself described the strategy: “Taking on of leverage when you under perform is similar to the... casino strategy” of doubling your bets when you lose; “if you hit a losing streak your net worth can become very low, however most of the time you will be able to ‘bet yourself out of the hole’ ”.
But what if, as no investor imagined possible back in 2006, the CPDO still continued to lose even after doubling its bet 15 times?
The holes would become huge and the Australian councils that had invested in the CPDOs would watch in horror as their cash burned. The Moree Shire Council in northern New South Wales, for example, had handed over $2 million. They would be left with just $133,000. The investments had automatically cashed out — terminated — when their worth hit a pre-determined low point; a depth that was never supposed to have been reached.
A group of 10 quants — quantative analysts — most working for ABN Amro’s European exotic derivatives team had designed the CPDO. But it was a race against time to put it on the market to cash-flooded investors and public utilities with idle millions. Word would quickly leak out about ABN Amro’s new product; rival banks would soon be frantically trying to copy it; and, ABN Amro feared, competitors might even try and beat them onto the market.
But for the CPDO to have the widest possible appeal to corporate government and, in particular, big not-for-profit organisations, it had to be seen as virtually risk-free. The top AAA credit rating was crucial. The bankers turned to New York and Standard & Poor’s, which traces its lineage back to 1860, when its founders put together the first comprehensive financial data on US railroads.
ABN Amro now set about urgently persuading Standard & Poor’s to rate its product AAA. In this, the bank had handsome advantages: two of its key executives involved with the creation of the CPDO happened to be former Standard & Poor’s analysts. One was Michael Drexler, New York-based, bright, blunt and supremely confident. The second was Juan Carlos Martorell, who seemed well attuned to how Standard & Poor’s would react to the bank’s various strategies. In one email produced in the Sydney Court hearing, Martorell wrote: “We should avoid S&P to overthink and open a can of worms.”
Drexler and Martorell would also have had a good idea of the methodology by which Standard & Poor’s would rate Amro’s new product.
The two bank executives knew much about their new product that Standard & Poor’s did not. They knew — because their bank had already used its internal computer modelling to find out — under what market conditions their CPDO would fail the AAA test. Indeed, amid the flurry of emails that ensued was one from a senior Standard & Poor’s analyst, Derek Ding, informing his colleagues that ABN Amro had, “found a way to game our criteria”.
Herein lies one of the revelations in the case that most astounded Justice Jagot, Standard & Poor’s did not initially develop its own computer model to simulate the operation of the bank’s financial product — it accepted the bank’s own simulation. It used computer coding written by the bank — a scenario which generated gleeful astonishment inside ABN Amro amid its desperate efforts to ensure that Standard & Poor’s awarded its new product the gold-standard rating.
When he learned that Standard & Poor’s was using his bank's own computer model and code to test the bank’s new product, Paul Silcox, a London-based ABN Amro executive, emailed the bank’s man in New York, Michael Drexler:
Silcox: Of course I still have the code but was seeing if my suspicion of them (Standard & Poors) using that code was true. Evidently, it is. Is it normal for ratings agencies to allow banks to build their own models for Standard & Poors to use to rate them?
Drexler: No! It is not normal and highly weird. An opportunity, however.
Unbeknown to Standard & Poor’s, the bank realised there was a bug in the computer code incorrectly inserted by a Standard & Poor’s analyst that made it more likely to rate the product AAA. There is no evidence that the bank alerted the ratings agency to the bug.
It was not until March the following year (2007) that Standard & Poor’s got its own computer model up and running to test the financial products; by then it had already rated the first wave of the products AAA, including ABN Amro’s, using ABN Amro’s computer model.
An internal Standard & Poor’s document would later admit that if the first wave of the CPDO products had been rated using Standard & Poor’s own computer model, they would not have reached the AAA standard.
There was another revelation about the ratings agency’s testing of ABN Amro’s product that Justice Jagot would come to see as extraordinary. ABN Amro knew early on it had a big problem: its CPDO would fail to achieve a AAA rating if Standard & Poor’s insisted on assigning a high-volatility rating to the basket of credit defaults swaps on which the CPDO was betting.
Volatility, in financial terms, is a measure of how quickly an investment’s worth may change. A product with a volatility of 50 per cent is considered high risk since it has the potential to increase or decrease by up to half its value. Thus, the higher the volatility of the swaps on which the bets are being placed, the riskier the outcome, making it unlikely that the products would gain a AAA rating.
Somehow, the bankers had to jawbone Standard & Poor’s into cutting the high 35 per cent volatility measure they were going to feed into the bank’s computer model. That figure would spell disaster for their new product’s appeal to investors — particularly supremely cautious investors, such as local councils in Australia.
As London-based ABN Amro executive Jamie Cole succinctly put it to his colleagues in email: “Well we are completely screwed if they take this approach.”
ABN Amro believed a drop to 25 per cent or even 15 per cent was justified. But Standard & Poor’s wanted to stick with 35 per cent — that’s what they’d used in the past when rating similar products. And there was push-back from some in the ratings agency as the bank ratcheted up its pressure for the crucial volatility to be eased.
The bank’s Jamie Cole sent a stern email to the ratings agency saying that the 35 per cent figure was “overkill”, that they’d produce a ratings result that would not “look great” for the bank, “so I suggest we don’t look at these runs”, he wrote.
But Standard & Poor’s analyst Chian Chandler, initially at least, stuck to his guns, replying to Cole: “We need to do these runs to decide whether or not it is overkill."
Jamie Cole warned his colleagues within the bank that if the ratings agency persisted with the 35 per cent figure, then the results “will of course completely suck!!!”
Late on the night of May 26, 2006, the bank’s Carlos Martorell also chimed in, firing off an angry email to Standard & Poor’s. Martorell was deeply affronted that the ratings agency was persisting with the high-volatility figure and he disclosed the pressure he and Drexler were under from their masters in the bank to get the CPDO on the market.
He wrote: “To be honest, this final process comes as a big surprise. Our quants have been working with your quantative team for three months… Both groups have worked long hours. The [Standard & Poor’s] base case scenario… seems to be arbitrary, unrealistic and erratic.”
It was in this email that Martorell included a line that would cause the ratings agency to capitulate to the bank on the vexed issue of volatility. He wrote: “The historical volatility of this portfolio is less than 15 per cent. 2.5 years of history.”
How the ratings agency came to capitulate to the bank on volatility would become riveting for Justice Jagot. This was the change, more than any other, that resulted in ABN Amro’s CPDO winning a AAA rating which should never have been given.
And it happened because ABN Amro gave false information — albeit apparently unwittingly — to the ratings agency, which, incredibly, the ratings agency did not check. ABN Amro told Standard & Poor’s that historical data supported a much lower volatility — as low as 15 per cent. In fact, solid research would have revealed that the figure was much higher — 28 per cent.
Justice Jagot’s words on this issue — coming toward the end of her 1,222-page, 635,586-word judgment — are damning for the world's venerable ratings agency:
“The problem for S & P is that, for the reasons given, I am satisfied that in fact S & P used the volatility of 15 per cent because Mr Chandler (Chian Chandler, an S & P analyst) wrongly believed that to be the historical volatility of these indices. I am also satisfied that had Mr Chandler known the true position he could not and would not have reasoned as he did. Had he known (as he should have done if S&P had taken the basic step of analysing the indices for itself) that the actual volatility of the indices was 28 per cent, it is difficult to believe that he could have justified adopting a volatility for the CPDO below 35 per cent and impossible to believe that he could have justified adopting a volatility for the CPDO below 25 per cent.”
The Justice added a scathing paragraph to make clear her view of Standard & Poor’s competence:
“Having regard to this material, the ultimate conclusion about which I am satisfied is that no reasonably competent ratings agency could have considered any analysis on the basis of a volatility of 15 per cent a proper or reasonable foundation on which to rate the CPDO.”
By late November 2006, barely four months after ABN Amro’s CPDO product had been sold to excited investors — including Australian councils, which poured in millions — there were growing recriminations inside Standard & Poor’s that would quickly shift to blame and bitterness. It was becoming clear that the product’s AAA rating might be difficult to defend; the financial press was questioning how the AAA rating had been achieved.
In late October 2007 a Standard & Poor’s London executive, Perry Inglis, emailed his New York office requesting a discussion about “a crisis in CPDO land”. He implies that the AAA rating was based on something other than the computer-modelling results.
Inglis writes: “This is analytical bs at its worst. I now[sic] how those ratings they came about and it had nothing to do with the model!”
Later that day Elvyn Wong, a senior analyst with Standard and Poor's, emailed Inglis suggesting that ABN Amro’s Michael Drexler — who had previously worked for the ratings agency — had bulldozed Standard & Poor’s into giving the bank’s product the top rating.
He wrote: “Drexler is a smart and charming man. Cian and Sriram (both Standard & Poor’s analysts) were, I think, sandbagged a little. The model was a work in progress when Kai and Norbert left and Drexler simply bulldozed it through.”
By May 2007, the financial press had began to more closely examine how it was that the ratings agency had awarded the CPDO the top rating, and reported that government regulators were also examining the issue. The Financial Times reported that Standard & Poor’s would have been paid up to USD 1.7 million for rating ABN Amro’s product.
The pressure inside Standard & Poor’s New York office spilled over into a bitter exchange between two of the most important participants in the whole saga — Sebastian Venus who was building the ratings agency’s own computer model to test CPDOs and Derek Ding who’d been involved in testing the first CPDOs for Standard & Poor’s, using the bank’s computer model.
Venus: I am done with the whole CPDO — wish I was never involved in that whole mess that was made.
Mr Ding: What a wuss.
Venus: That thing is done by 3 people: Cian, Sriram and you. I am not responsible, I just helped build an internal model. You are the wuss for bending over in front of bankers and taking it.
Ding: primarily me and the banker... so what? I would not mind if they put my name on that article, grow up kid.
Venus: You rate something AAA, when it is really A-? You proud of that little mistake? It’s nothing to do with growing up, it’s about doing your job to a high standard. If you want to talk about growing up, you should admit to Perry [Inglis] that you made a mistake with your analysis...
Ding: We stressed the hell out of the credit loss, and it will cover other things... all the analysis is subjective anyway, you never know how the market will work out in the next 10 years? Any downgrade yet?
Venus: Yes, there are downgrades all the time. And you say “stress the hell”, you have been saying that for 6 months, but you didn’t even quantify it. It takes a long time to analyse that thing, maybe one year, and you rate it within a few months, claiming that something rated AAA paying L+2% will not get any attention...
Thirteen Australian councils sank $16 million dollars of spare cash into the ABN Amro CPDO investments. The investments kept losing their bets and eventually cashed out — the banker’s term for failing.
The councils got just $1.1 million back.
Justice Jagot found that Standard & Poor’s was negligent, as it owed a duty of care to investors and did not have reasonable grounds for assigning the AAA rating. Most significantly, the court found that Standard & Poor’s could not hide behind its disclaimers which say the AAA rating was merely an opinion.
The effect of the judgment — in Australia at least — is to make international ratings agencies directly liable to investors for their ratings.
That is a world first.
Standard & Poor’s has rejected the judgment and defended its rating methodology.
It is appealing the decision.