The Bankwatch

Tracking the consumer evolution of financial services

Beware Rolled Down Benefit (RDB) and other obtuse terms; S&P ruled incompetent by Aussie Court

One of the sad facts of the banking crisis, is that the derivatives markets remain quite opaque and too complicated for most to understand.  Enter the Federal Court of Australia.  Judge J. Jagot has taken the time to understand in this 1,376 page ruling and not just understand but to explain. 

There is another lesson here when attempts are made to hide behind newly created terms.  This reminds be of Groupon and their attempts to bypass accounting profit and loss realities using new terms thatexcluded marketing from their expenses.

The result is a damning ruling against Standard & Poors, as well as ABN Amro. Federal Court of Australia.

Here Felix Salmon of Reuters has taken the time to digest the ruling and summarise the outcome.

Hero of the day, CPDO edition

Put it all together, and you get a very shocking view of S&P. Here’s the list:

  • S&P used the wrong model input for starting spread.
  • S&P used the wrong model input for volatilty.
  • S&P used the wrong model input for average spread.
  • S&P completely ignored ratings migration.

If S&P had just got any one of these things right, the CPDO would never have gotten that triple-A rating. If it had got them all right, the CPDO would almost certainly not even have been investment grade, let alone triple-A.

Basically S&P did little or no diligence of their own, accepted ABN Amro assumptions willy nilly, and the result was a meaningless AAA rating.  Some aspects of the instrument that S&P rated are ponzi in nature.  They developed a concept called roll-down benefit or RDB, which somehow involved rolling in benefit of 7% from periodic shift in the investment.  As Felix explains:

Every six months, the CPDO would exit its existing positions, and buy new positions in the index maturing six months later. In general, bonds which mature later have higher yields, so S&P assumed that on average, the new index would yield 7bp more than the old index. And that was an utterly crucial assumption. Never mind the triple-A rating: without the RDB, the CPDO couldn’t even get an investment-grade rating. It wouldn’t even be triple-B.

This ruling will have ramifications for courts in US and UK, but more importantly it has ramifications for common sense in investment evaluation.

Written by Colin Henderson

November 5, 2012 at 17:33

Posted in Uncategorized

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