ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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The Quiet Power of the Ratings System

Over the years, the ratings system and, therefore, the ratings fi rms have become a part of the regulatory framework in many countries which has given them enormous infl uence in the fi nancial system. But there is a basic confl ict of interest when a ratings fi rm is paid by an issuer to rate its offering. With an Australian court delivering a landmark judgment ruling that a ratings fi rm was guilty of "negligent representations", the stage is set for a number of court processes that will investigate the working of these powerful agencies.

In a landmark judgment, the Federal Court of Australia ruled in early November 2012 that one of the big three rating agencies, Standard and Poor’s (S&P), put out assessments of the safety of complex derivatives issued by ABN Amro and named constant proportion debt obligations (CPDOs) that were either “false” or “negligent misrepre­sentations”. When ABN Amro launched these instruments in 2006, the Financial Times (13 November 2006) defined a CPDO as a structured product that is “essentially a leveraged bet on the credit quality of a bunch of US and European investment-grade companies. It aims to generate income by selling protection on the two main indices of credit default swaps – which offer a kind of insurance against non-payment of corporate debt – the iTraxx Europe and the Dow Jones CDX.” These indices measure the performance of holding the respective credit default swap (CDS) contracts.

S&P had awarded its highest triple-A rating to ABN Amro’s CPDOs, implying that the probability of loss in the value of those instruments was negligible. But their value collapsed two years later. The Australian court held that S&P and ABN Amro had “deceived” and “misled” 12 local councils, which invested in these instruments, and suffered considerable losses. John Walker, the executive dir­ector of International Monetary fund (IMF) Australia, a litigation company that fought the case, is quoted by the Financial Times as estimating that the councils could receive as much as $16.5 million in damages. The judgment, some expect, would also strengthen the case for regulating the ratings agencies and make them financially responsible for their assessments.

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