— John Godfrey Saxe, American poet and lawyer, 1869

Add bond ratings to that list.

The rating agencies have long managed to turn aside litigation by asserting they have a free-speech right to their opinions, whether or not they turn out to have been correct.

That makes a lot of sense in a world of uncertainty. Imagine if, say, a gambler could sue the sports section of this newspaper because our columnist’s Super Bowl forecast turned out to be wrong.

But after the financial crisis, that legal protection may be starting to break down.

This week in Australia, a federal judge found that Standard Poor’s was liable for issuing the top investment-grade rating of AAA for a product she described as a “grotesquely complicated” piece of financial engineering. In her opinion — which at 623,000 words was about 20 percent longer than “Les Misérables” — Judge Jayne Jagot meticulously traced how S. P. came to issue a top rating, concluding that no “reasonably competent ratings agency” would have awarded it.

The ruling, if it stands on appeal, would cost the rating agency only about $14 million, a relatively insignificant amount. But the danger to the firm’s reputation — and the fact that the ruling could prompt other suits — potentially could be much greater.

The ruling concerned a structured finance product developed in 2006 by the Dutch bank ABN Amro, known as a C.P.D.O., which stands for constant proportion debt obligation. In reality, it was not a debt obligation at all. The bank took money from the investors, borrowed more, then wrote credit-default swaps against a basket of corporate bonds.

It was a gamble, and a particularly risky one in that it effectively called for increasing the amount wagered if one bet lost money, on the theory that over time everything would work out. If the losses kept rising, however, the investor could lose as much as 90 percent of the initial investment.

In the end, that is exactly what happened.

In her ruling, Judge Jagot quoted from an ABN Amro document that compared the investment with a “casino strategy” of doubling your bet every time 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.’ ”

Had those who were gambling understood what they were doing, we should have no particular sympathy for them. If you want to bet that the Washington Redskins, with a current record of three wins and six losses, will somehow get to the Super Bowl, go right ahead. You must know that your chances of winning are very low.

But the buyers of C.P.D.O.’s did not understand what they were doing. It appears that those investors, including an agency that managed investments for Australian local governments, and some of those governments themselves, did not bother to go into details. They relied on S. P., which was retained and paid by the bank to rate the security and gave it a rating of AAA. That meant the agency thought that there was less than a 1 percent chance of losing money.

There was a lot of that going on in those heady days. In rating structured finance products, the agencies developed models based on past performance during the credit boom, and assumed that the past was prologue. That has been criticized, in hindsight, as the equivalent of studying the weather patterns during a prolonged drought and concluding there will never be a severe rainstorm.

But Judge Jagot said that was not what happened in this case. In this case, she said, inconvenient aspects of the past were simply ignored. S. P. did not bother to develop its own model at all before it began giving out AAA ratings to the C.P.D.O. offerings developed by ABM Amro. Instead, it simply adopted the bank’s model. Nor did the agency bother to verify the assumptions in the model.

The judge goes through a list of those assumptions, concluding that in many cases they were far more optimistic than history justified. She said that S. P. did conclude that one ABM Amro assumption, regarding market volatility of credit-default swaps, needed to be adjusted, but that it did not bother to do so. Had it made the adjustment, she says, there was no way that even the bank’s model would have justified the AAA rating.

The judge quoted from ABN Amro e-mails voicing concerns that S. P. analysts might realize they had ignored one possibly significant issue, and concluding the bank should not bring it up, at least not with any specificity. “We should avoid S. P. to overthink and perhaps open a can of worms,” wrote Juan Carlos Martorell, a senior member of ABN Amro’s Structured Credit Marketing Group and a former employee of S. P.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2012/11/09/business/judge-in-australia-finds-flaws-in-sps-triple-a-rating-strategy.html?partner=rss&emc=rss