‘Measure us by the outcome’

Continued from page 1 more likely to see their deliverer as the Commerce Commission, whose dogged pursuit of claims the marketing of Credit Sails was misleading and deceptive ultimately forced a cash payout.

Several investors have also voiced their appreciation for Marshall, an industry maverick whose outspoken, one-eyed support gave them hope of one day getting a result.

However you look at it, the key to getting money back was always going to be the involvement of giant French bank Credit Agricole, whose merchant banking subsidiary Calyon designed Credit Sails as a high-yielding product with an unusual capital protection structure.

Or was Credit Sails designed to fail?

This was a product created in the last throes of the boom, in early 2006. Investors were clamouring for yield and financial institutions were working out increasingly ingenious ways to provide it. Those ways included complicated loan structures and derivatives – collateralised debt obligations, or CDOs, synthetic CDOs and credit default swaps.

Credit Sails touted an interest rate of 8.5 per cent for six years and potentially more on maturity. It was also supposed to offer capital protection and its ability to repay 100 per cent of investors’ capital on maturity was rated AA by Standard & Poor’s – one of the highest ratings S&P can award and considered ‘‘very strong’’.

However, achieving this magical result required labyrinthine financial engineering and, as it turned out, unrealistic assumptions.

Normally, a capital protected product would use some rock solid zero coupon bond as a backstop. For example, a bond paying $100 in five years might cost $85 now, so your capital protection costs $85 and you use the other $15 for your high risk, high return strategy.

Credit Sails didn’t do that. Instead of buying a bond, it bought ‘‘Momentum Notes’’ issued by a Cayman Islands special purpose company. These notes were one side of a credit default swap – effectively an insurance deal covering someone else, possibly Credit Agricole, against default in a specially selected, AA-rated portfolio of 120 corporate bonds, known as the reference portfolio.

Credit Agricole would pay an insurance premium to Momentum, in exchange for all investors’ capital covering the default risk for six years.

Credit Sails offer documents said the default rate of the portfolio would have to be 7.6 times the historical average before the notes would suffer any loss.

What happened was way worse than that.

Starting with Lehman Brothers in September 2008, the portfolio experienced a string of catastrophic defaults as the decade’s debt-fuelled house of cards came crashing down. The other corporates causing the damage were United States subprime mortgage lender Washington Mutual, Icelandic banks Landsbanki, Glitnir and Kaupthing, and debt-laden US directories business Idearc.

But hey, who could have seen that coming? The global financial crisis was a seismic event, the most severe to hit the world since the 1930s. No wonder products like Credit Sails could not survive such forces.

Except maybe some people did see it coming. The nature of a credit default swap is insurance, so why insure a bond portfolio rated AA by S&P against default?

The long answer can be found in pungent detail in Michael Lewis’ book The Big Short.

Here’s a flavour: ‘‘Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans.’’

As we now know, several big, contrarian investors were betting on major defaults using derivatives. One was hedge fund Paulson & Co, who sought to bet against the US housing market in 2006 using a synthetic CDO called Abacus – a structure similar to the Momentum Notes – created by Goldman Sachs.

Paulson made an estimated US$1 billion (NZ$1.2b) from Abacus and investors on the other side of the deal lost the same amount. Goldman Sachs ended up paying a US$550m penalty to the US Securities & Exchange Commission, acknowledging it should have disclosed the role Paulson had played in selecting the reference portfolio and that Paulson was betting against the investors on the other side of the CDO.

Similar allegations were made by New York entity Loreley Financing, which lost a packet on synthetic CDOs arranged and marketed by Credit Agricole’s merchant banking unit Calyon.

‘‘Eager to churn out CDOs,’’ said Loreley, ‘‘Calyon allowed [hedge fund] Magnetar to secretly control the selection of collateral [for the CDOs] knowing that Magnetar would select only weak and poor quality assets and bet against the success of the CDOs by taking short positions and profit when the deals failed.’’

The case was settled out of court last year.

Whether something similar could have happened with Credit Sails we’ll never know.

In pursuing a case against Credit Agricole and Forsyth Barr for the losses on Credit Sails, the Commerce Commission did not allege the product was designed to fail. Rather, it alleged the companies marketed Credit Sails in a deceptive way and sold it despite knowing it was unsuitable for average investors.

However, it is interesting to note that of the six defaults causing fatal injury to Credit Sails, four were introduced into the portfolio after the investment statement was published in May 2006 and before the Credit Sails notes were issued the following month.

Two more Icelandic banks were added despite known problems in March 2006.

The June issue date marked the cut-off point for portfolio changes – thereafter it was designed to be fixed for the six and a half year life of the product. This design was known to increase risk, but, according to Paviour-Smith, it was requested by buyers of Credit Sails in New Zealand in order to mitigate ‘‘manager risk’’ – the chance of the portfolio being changed after listing.

Since it would surely have been a simple matter to require the manager to maintain an AA portfolio rating, this request seems plain stupid – unless, perhaps, having a static portfolio meant higher returns on the credit default swap.

Unfortunately the people who really know how Credit Sails worked are all at Credit Agricole – and they won’t talk.

Contacted last week, Herve Martin, managing director global markets at Credit Agricole CIB in Sydney, said: ‘‘I cannot make any comment. Thank you, goodbye.’’

Another secret is who paid what into the $60m compensation fund. But the most likely scenario is this – Credit Agricole was the counterparty on the CDS and took the money investors lost. The bulk of the $60m fund could therefore be simply a refund.

Ultimately, it is to their credit that Credit Agricole and Forsyth Barr stumped up cash compensation without battling the commission through a multiyear court case.

In paying out, they have admitted no fault and will never have to defend the design of Credit Sails against legal attack.

After the settlement last week, Paviour-Smith said: ‘‘I do not believe this was set up to fail.’’

And there we will have to leave it.