S&P’s Modeling Was ‘Garbage In, Garbage Out, Lawyer Says

Standard & Poor’s ignored warnings that notes sold to Australian towns didn’t deserve a AAA rating and used faulty data to support its decision, a lawyer said.

“It was a simple case of GiGo - garbage in, garbage out,” said Noel Hudley, lawyer for a dozen Australian towns seeking to recoup investments that were wiped out when the notes’ value collapsed during the 2008 global financial crisis.

The towns claim they lost A$15 million ($15.6 million) of A$16 million invested in the Community Income Constant Proportion Debt Obligation Notes. They were unwound less than two years after the towns bought them as credit spreads increased and their cash value was exhausted, and the towns accused S&P of giving the notes the highest rating on pressure from a bank.

An S&P committee determining the rating on the notes had 31 results from tests run by analysts, with 68 percent of those findings not supporting a AAA rating, Hudley said today, on the first day of closing statements before Justice Jayne Jagot in Federal Court in Sydney.

The ratings company didn’t follow procedures that are a standard in the industry in developing the rating, Hudley said, citing evidence given by experts during the trial.

“You are the wuss for bending over in front of bankers and taking it,” Sebastian Venus, who had prepared an internal model for the notes at S&P, wrote to Derek Ding, an analyst responsible for rating the note, according to e-mail transcripts presented in court documents. “You rate something AAA, when it’s really A-?”

U.S. Downgrade

U.S. lawmakers accused ratings companies of mishandling their assessments of the mortgage-backed securities at the heart of the 2008 global financial crisis, and Congress sought to reduce their influence as part of the Dodd-Frank Act of 2010.

S&P stripped the U.S. of its AAA credit rating on Aug. 5. Instead of eroding the value of U.S. government debt, the rating cut sparked financial market turmoil that made Treasuries and the world’s reserve currency favorites among investors, with 10-year note yields dropping to a record low of 1.6714 percent just seven weeks later.

S&P, a unit of New York-based McGraw-Hill Cos., was sued along with ABN Amro Bank NV, the Australian affiliate of the Royal Bank of Scotland Group Plc, over the sale of the notes by towns that claim to have been misled by the ratings. Jagot will have to decide whether S&P owes a duty to the people who read their ratings.

The firm rated the notes AAA based on data supplied by ABN Amro Bank and under “significant pressure” from the bank, Hudley had said earlier during the trial, that began Oct. 4.

‘Serious Process’

The plaintiffs cited “selectively” from the hundreds of documents that were submitted, S&P said.

“Those e-mail exchanges also evidence the fact that S&P did not simply rubber stamp ABN’s opinion,” the company said. “Conflicting views are to be expected in the context of any serious process of analysis and consideration.”

The towns also sued Local Government Financial Services Ltd., a municipal financial adviser that bought the notes from ABN Amro Bank and resold them to the towns. LGFS also sued the bank, accusing it of breach of contract.

S&P said the councils didn’t properly review the investments and the ratings company blamed LGFS for failing to inform the councils of the risks.

LGFS, intent on offering new investment products to municipalities as it competed with Grange Securities Ltd., which later became a unit of Lehman Brothers Holdings Inc., took advantage of its relationship with the towns to sell them unsuitable investments, Hudley said today.

Fine Print

“The way it was marketed was to divert attention” from the fine print in the documents that warned of the risks of the investments, including that they could lose all their value, Hudley said.

The closing statements from the towns, LGFS, ABN Amro Bank and S&P are scheduled to take at least until March 30.

The AAA rating gave the purchasers confidence that they were buying a product similar to a AAA-rated bond, Guy Parker, LGFS’s lawyer said.

S&P, which has been issuing credit ratings for almost 100 years, conducted extensive testing of the notes and analyzed the models before a committee at the firm was satisfied they deserved a AAA rating, the company said of today’s case.

“Rating is an art, not a science,” S&P said. “There is no ‘correct’ procedure for ratings.”

The case is: Bathurst Regional Council v. Local Government Financial Services Ltd. NSD936/2009. Federal Court of Australia (Sydney).

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