US to Sue S&P for Fraud over Pre-Subprime Crisis on Mortgage Ratings
S&P – Standard & Poor’s has said it will be sued by US authorities over ratings the company gave to derivatives in the run-up to the financial crisis, reported The Telegraph. The Department of Justice (DoJ) late Monday filed civil fraud charges against the nation’s largest credit-ratings agency, S&P (Standard & Poor’s), accusing the firm of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis struck. Shares in S&P’s parent company, McGraw-Hill, slumped 13.8% to $50.30 in New York following the disclosure. Senate investigations have already raised questions about the role S&P and the two other major rating agencies – Moody’s and Fitch – played in the worst financial crisis since the Great Depression. Critics allege the agencies awarded excessively high credit ratings to certain bonds because of the lucrative fees they received from the investment banks that then sold sell them to investors. The suit, filed in federal court in Los Angeles, is the first significant federal action against the ratings industry, which during the boom years reaped record profits as it bestowed gilt-edged ratings on complex bundles of home loans that quickly went sour. The high ratings made many investments appear safer than they actually were, and are now seen as having contributed to a crisis that brought the financial system and the broader economy to its knees, as reported in the New York Times. More than a dozen state prosecutors are expected to join the federal suit, and the New York attorney general is preparing a separate action. The Securities and Exchange Commission has also been investigating possible wrongdoing at S&P
From September 2004 through October 2007, S&P “knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors” in certain mortgage-related securities, according to the suit filed against the agency and its parent company, McGraw-Hill Companies. S.&P. also falsely represented that its ratings “were objective, independent, uninfluenced by any conflicts of interest,” the suit said. S&P, which was first contacted by federal enforcement officials three years ago, said in a statement earlier Monday in anticipation of the suit that it had acted in good faith when it issued the ratings. “A D.O.J. lawsuit would be entirely without factual or legal merit,” it said, adding that its competitors had given exactly the same ratings to all the securities it believed to be in question. Settlement talks between S&P and the Justice Department broke down in the last two weeks after prosecutors sought a penalty in excess of $1 billion and insisted that the company admit wrongdoing, several people with knowledge of the talks said. That amount would wipe out the profits of McGraw-Hill for an entire year. S&P had proposed a settlement of around $100 million, the people said. S&P also sought a deal that would allow it to neither admit, nor deny guilt; the government pressed for an admission of guilt to at least one count of fraud, said the people. S&P told prosecutors it could not admit guilt without exposing itself to liability in a multitude of civil cases. It was unclear whether state and federal authorities were looking at the other two major ratings agencies, Moody’s Investors Service and Fitch Ratings.
First ever action against the ratings industry since the crisis:
S&P said on Monday that a “lawsuit would be entirely without factual or legal merit”. Charges from the DoJ would be the first time authorities in America have taken action against the ratings industry since the crisis. However, it would not be the first time S&P has been accused. In November, an Australian judge ruled that S&P had engaged in “misleading and deceptive” practices when assigning top ratings to certain derivative products. S&P said it disagreed with the judgment. The credit rating agency insisted on Monday that US prosecutors would be wrong “in contending that S&P ratings were motivated by commercial considerations and not issued in good faith”. A spokesman for Moody’s declined to comment. A spokesman for Fitch, Daniel J. Noonan, said the agency could not comment on an action that appeared to focus on Standard & Poor’s, but added, “we have no reason to believe Fitch is a target of any such action.”
The case against S&P is said to focus on about 30 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of mortgage bonds, which in turn were composed of individual home loans. The securities were created at the height of the housing boom. S&P was paid fees of about $13 million for rating them. Prosecutors, according to the people briefed on the discussions, have uncovered troves of e-mails written by S&P employees, which the government considers damaging. The firm gave the government more than 20 million pages of e-mails as part of its investigation, the people with knowledge of the process said.
Since the financial crisis in 2008, the ratings agencies’ business practices have been widely criticized and questions have been raised as to whether independent analysis was corrupted by Wall Street’s push for profits. A Senate investigation made public in 2010 found that S&P and Moody’s used inaccurate rating models from 2004 to 2007 that failed to predict how high-risk residential mortgages would perform; allowed competitive pressures to affect their ratings; and failed to reassess past ratings after improving their models in 2006. The companies failed to assign adequate staff to examine new and exotic investments, and neglected to take mortgage fraud, lax underwriting and “unsustainable home price appreciation” into account in their models, the inquiry found.
Ratings agencies continue to create an even bigger monster:
“Ratings agencies continue to create an even bigger monster — the C.D.O. market,” one S&P employee wrote in an internal e-mail in December 2006. “Let’s hope we are all wealthy and retired by the time this house of card falters.” Another S&P employee wrote in an instant message the next April, according to the Senate report: “We rate every deal. It could be structured by cows and we would rate it.” The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors who would buy the securities were not involved in the process but depended on the rating agencies’ assessments.
Although the three agencies tend to track one another, each has its own statistical methods for assessing the likelihood of a bond default. That has led to speculation that S&P analysts knew their method yielded unrealistic ratings, but issued the ratings anyway. In its statement on Monday, S&P said it had begun stress-testing the mortgage-backed securities it rated as early as 2005, trying to see how they would perform in a severe market downturn. S&P said it had also sent out early warning signals, downgrading hundreds of mortgage-backed securities, starting in 2006. Nor was it the only one to have underestimated the coming crisis, it said — even the US Federal Reserve’s open market committee (FOMC) believed at the time that any problems within the housing sector could be contained. The Justice Department, the company said, “would be wrong in contending that S&P ratings were motivated by commercial considerations and not issued in good faith.”
Ratings agencies have till now successfully defended themselves:
For many years, the ratings agencies have defended themselves successfully in civil litigation by saying their ratings were independent opinions, protected by the First Amendment, which guarantees the right to free speech. Developments in the wake of the financial crisis have raised questions about the agencies’ independence however. For example, one federal judge, Shira A. Scheindlin, ruled in 2009 that the First Amendment did not apply in a lawsuit over ratings issued by S&P and Moody’s, because the mortgage-backed securities at issue had not been offered to the public at large. Judge Scheindlin also agreed with the plaintiffs, who argued the ratings were not opinions, but misrepresentations, possibly the result of fraud or negligence. The federal action will be the first time a credit-rating agency has been charged under a 1989 law intended to protect taxpayers from frauds involving federally insured financial institutions, which since the financial crisis has been used against a number of federally insured banks, including Wells Fargo, Bank of America and Citigroup.
Novel approach by US against Ratings Agency for injuring the taxpayer:
The government is taking a novel approach in this instance by accusing S&P of defrauding a federally insured institution and therefore injuring the taxpayer. The government is expected to cite the demise of Wescorp, a federally insured credit union in Los Angeles that went bankrupt after investing in mortgage securities rated by S&P Wescorp will be showcased as an example of the contended fraud, and as a way to bring the case in California, people with knowledge of the proceedings said. The suit was filed in Federal District Court fore the Central District of California. By bringing a civil suit, as opposed to a criminal case, the Justice Department’s burden of proof will be less, perhaps lowering the bar for a successful prosecution.
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