Wednesday, July 15, 2009

Calpers Sues Over Ratings of Securities

Whaaa, whaaa, whaaa!
From the New York Times:
The nation’s largest public pension fund has filed suit in California state court in connection with $1 billion in losses that it says were caused by “wildly inaccurate” credit ratings from the three leading ratings agencies....

The lawsuit, filed late last week in California Superior Court in San Francisco, is focused on a form of debt called structured investment vehicles, highly complex packages of securities made up of a variety of assets, including subprime mortgages. Calpers bought $1.3 billion of them in 2006; they collapsed in 2007 and 2008....

...Calpers maintains that in giving these packages of securities the agencies’ highest credit rating, the three top ratings agencies — Moody’s Investors Service, Standard & Poor’s and Fitch — “made negligent misrepresentation” to the pension fund, which provides retirement benefits to 1.6 million public employees in California.

The AAA ratings given by the agencies “proved to be wildly inaccurate and unreasonably high,” according to the suit, which also said that the methods used by the rating agencies to assess these packages of securities “were seriously flawed in conception and incompetently applied.”...

...While the lawsuit is not the first against the credit rating agencies, some of which face litigation not only from investors in the securities they rated but from their own shareholders, too, it does lay out how an investor as sophisticated as Calpers, which has $173 billion in assets, could be led astray.

The security packages were so opaque that only the hedge funds that put them together — Sigma S.I.V. and Cheyne Capital Management in London, and Stanfield Capital Partners in New York — and the ratings agencies knew what the packages contained. Information about the securities in these packages was considered proprietary and not provided to the investors who bought them....MORE
Got that? We have a FIDUCIARY saying they bought stuff they didn't understand.
And weren't allowed to see.
"Hey Mister, I've got a magic box that will turn your dollar bills into C-notes!"
I'm pretty sure a smart young paralegal could draft the brief against CalPERS in about fifteen minutes.
We had some related thoughts in the March post "David Viniar, CFO of Goldman Sachs Blows Smoke at Journalists on AIG":
...David Viniar, CFO of Goldman Sachs, basically suggested that since nobody knew that AIG was a house of cards, nobody had any reason to suspect anything. “AIG was a triple-A rated company, one of the largest and considered one of the most sophisticated in the world,” he said. And in a response to a question on how Goldman allowed its exposure to AIG to get as large as it did, Mr. Viniar describes positions made in 2006 and early 2007 as if it was a different age, a more innocent time, when magical dwarves ruled the land, before the ring of power had been forged.

“It was a very long time ago,” Mr. Viniar says. “AIG at the time was one of the largest, strongest companies in the entire world, and they were very sophisticated, or appeared to be, a very sophisticated counterparty.” The firm later scaled back trades — by the end of 2007, according to Mr. Viniar....

My question is, "If Goldman Sachs were still a partnership, would they have entered into these transactions in the same size?"

The answer, of course, is no.

If partners equity were at risk, there is no way that they would have depended on ratings agencies to ascertain the strength of their counterparty.

Junior partners would be expected to run honey traps on AIG employees.

Lower level employees would hone their dumpster-diving skills.

Whatever it takes to gain competitive intelligence and safeguard the partnership's capital.

See also: "The optimal design of Ponzi schemes in finite economies"

Reading Mr. Viniar's words, I am reminded of his statement on market moves in August, 2007:

“We were seeing things that were 25-standard deviation moves, several days in a row”
Several folks, when they finally quit laughing, pointed out how blatently Mr. V was spinning.
Most however underestimated how infrequent 25SD events are, the most common guess being once in 100,000 years. Tee hee.
In a snappy little eight page paper "How Unlucky is 25 Sigma" we see that at 7 Sigma the odds are:
...The reader will note that as k gets bigger the probabilities of a k-sigma event fall
extremely rapidly:
• a 3-sigma event is to be expected about every 741 days or about 1 trading day
in every three years;

• a 4-sigma event is to be expected about every 31,560 days or about 1 trading
day in 126 years (!);

• a 5-sigma event is to be expected every 3,483,046 days or about 1 day every
13,932 years(!!)

• a 6-sigma event is to be expected every 1,009,976,678 days or about 1 day
every 4,039,906 years;

• a 7-sigma event is to be expected every 7.76e+11 days – the number of zero
digits is so large that Excel now reports the number of days using scientific
notation, and this number is to be interpreted as 7.76 days with decimal point
pushed back 11 places. This frequency corresponds to 1 day in 3,105,395,365
The authors go on to describe the problems involved in computing numbers on the cosmological scales required for 25 standard deviations. A good read, both for the statistically challenged and for pros like Viniar, a very highly paid PR guy, in addition to his CFO duties.