AAA Rembrandt

http://www.futureofcapitalism.com/2010/06/aaa-rembrandt

Bloomberg News has a dispatch about an Australian local government that is suing after buying a "constant proportion debt obligation, or CPDO," named "Rembrandt," which, according to the Bloomberg article "lost 93 percent of its value in two years."

The article is remarkable on at least two fronts. First, the forthrightness with which the news article takes a side in the debate over the regulation of derivatives:

Over the last decade the financial industry justified the rapid growth in products such as CPDOs, collateralized debt obligations and credit-default swaps by arguing that they were sold to qualified investors who understood the risks and were able to bear them. Their view was echoed in July 1998 Senate testimony by then-Federal Reserve Chairman Alan Greenspan, who said that "regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."

A decade later his assessment was proven wrong when some of the industry's most sophisticated participants, including Citigroup Inc. and American International Group Inc., were bailed out of bad bets on contracts whose risks they underestimated. By using government funds and cutting interest rates, politicians and central bankers laid the cost on taxpayers, savers and people living on fixed incomes.

First of all, it's debatable whether AIG was a bailout or a seizure. If it was a bailout, why weren't the AIG shareholders allowed to vote on it?

Second of all, contrary to the claim of the Bloomberg news article, the mere existence of a bailout or a seizure doesn't prove the case for regulation. Maybe the firms that made bad bets on derivatives should have been allowed to manage through their problems without government intervention.

Third, were the government interest rate cuts really designed just to help people who made bad bets on lightly regulated derivatives, or were they a broader effort aimed at helping everyone from homeowners to job-seekers?

Fourth, both Citi and AIG were highly regulated institutions by a variety of regulators, including the SEC, the New York state attorney general's office, the New York banking and insurance regulators, federal banking regulators, and others.

Fifth, not even AIG or Citi management or a lot of sophisticated shareholders saw these risks. Even if more regulators and regulations had existed, it's not clear that they would have successfully prevented a crisis or a failure.

The second front on which the Bloomberg article is remarkable is that the seller of the AAA-rated "Rembrandt" security to the Australian local government was "ABN Amro Holding NV, a Dutch bank later split up and sold to banks including Edinburgh-based Royal Bank of Scotland Plc." The Bloomberg article doesn't mention it, but these are the same guys the SEC alleges were defrauded by Goldman Sachs for selling them a similar AAA-rated security whose value declined. Again, the Bloomberg article doesn't mention it, but doesn't it change the optics of the SEC suit against Goldman if the supposed victims of the Goldman fraud were going around selling similar stuff -- AAA-rated securities that then lost significant value -- on their own, to other buyers?

Low down in the story, the Bloomberg article reports, "The Rembrandt CPDO offered investors AAA rated notes that paid 1.9 percentage points above Australia's three-month bank- bill swap rate, or about 8.25 percent at the time." This sentence is so poorly written and edited that it's unclear whether the Rembrandt rate was 8.25% or 10.15% (8.25+1.9), but either was it was a high yield at the time for a AAA-rated security, or, for that matter, for any investment, and if the people buying it didn't realize they were taking on some additional risk for the higher return, they realize it now.

by Ira Stoll  |  Jun 21, 2010 at 9:07 am Related Topics:  AIG, Capital Markets Regulation, George Soros, Goldman Sachs, SEC receive the latest by email: subscribe to the free futureofcapitalism.com mailing list