Barclays Used Credit Ratings Loophole, San Marino Lawyer Says

Barclays Plc used “a loophole” in the way credit rating companies graded the default risk in structuring securities, allowing the bank to design notes that were riskier than their triple-A rating suggested, lawyers for an Italian bank said.

A lawyer for Cassa di Risparmio della Repubblica di San Marino SpA, or CRSM, told Judge Nicholas Hamblen in London yesterday that the way the British lender rated the notes at the center of a 92 million-euro ($122 million) lawsuit was “a scam.”

The collateralized debt obligations in dispute had been rated triple-A, suggesting that the risk of default was less than 1 percent, when the actual probability was more than 25 percent, CRSM lawyer George Leggatt said during closing arguments. CRSM is suing Barclays for fraudulent misrepresentation over the sale.

Barclays was “exploiting a loophole in the rating agency methodology that treated the historical default rate as the estimate of the probability of default for all names in the bracket with that rating without taking account of the fact that within any given rating at any given time some of those companies were much riskier than others,” Leggatt said. “What it actually does is to magnify the risk.”

Barclays, based in London, denies the allegations that it sold CRSM structured notes that misrepresented the risks.

‘Rules of the Game’

“The rules of the game” in the international capital and structured debt market “are well-known, well-understood by CRSM,” Barclays lawyer Andrew Baker said today. “CRSM was perfectly well aware of the basis upon which my client would wish to do any trade.”

CRSM approached Barclays in 2003 for funding for its units, the San Marino, Italy-based bank said in court documents. Barclays loaned 700 million euros on condition that CRSM would buy 450 million euros of structured notes including “highly complex and opaque” CDO instruments, CRSM said in court papers.

Selling the product based on a credit rating it knew didn’t accurately reflect the risk “crossed the line into misrepresentation and potentially deceit,” Leggatt said. “How could it genuinely be low-risk if at the same time Barclays was making 25 percent gross profit on the sale.”

CDOs are pools of assets such as mortgage bonds packaged into new securities. Interest payments on the underlying bonds or loans are used to pay investors.

The case is: Cassa di Risparmio della Repubblica di San Marino SpA v. Barclays Bank Plc, Case No: 08-757, High Court of Justice, Queen’s Bench Division.

To contact the reporter on this story: Lindsay Fortado in London at lfortado@bloomberg.net.

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net.

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