Investors Intentionally Misled by S&P Lawsuit Claims

Story first appeared on USA Today -

The legal government's complaint cited a string of e-mails alleging that S&P defrauded investors of billions by issuing falsely glowing appraisals that produced record profits for the firm.

Standard & Poor's planned to issue a more accurate model for rating mortgage-backed securities in 2004, amid early signs of growth in the more risky loans that eventually would lead to the national financial crisis.

But then an S&P analyst warned executives the ratings giant was losing business because it was more conservative than industry rivals. The bonds' issuers paid for the ratings and many institutional investors who bought them would only buy securities rated AAA, which meant they were the least risky.

"We just lost a huge Mizuho (mortgage-backed) deal to Moody's due to a huge difference in the required credit support level," the analyst wrote in a May 25, 2004, e-mail cited in a new civil fraud lawsuit filed by the Department of Justice. "This is so significant that it could have an impact on future deals."

S&P updated its existing rating model in a way that wouldn't have a major impact on bond issuers, according to the complaint filed late Monday against the world's largest rating firm.

The more accurate S&P model "was never released," government lawyers charged in the lawsuit, the first major federal action filed against the ratings industry.

The lawsuit widens Washington efforts to hold financial firms accountable for the financial crisis. The legal complaint cited a string of similar e-mails and other examples in alleging that S&P defrauded investors of billions of dollars by issuing falsely glowing appraisals that produced record profits for the firm.

S&P has long proclaimed that its ratings were independent. But government lawyers charged the appraisals were instead tainted by conflicts of interest and weak or deliberately inadequate research — all part of the firm's drive to reap higher profits by pleasing bond issuers at the expense of investors.

Investigators found evidence of more than $5 billion in losses suffered by federally insured financial institutions from mortgage-backed bonds S&P rated between March and October 2007, just before the crisis exploded.

"During this period, nearly every single mortgage-backed collateralized debt obligation that was rated by S&P not only underperformed, but failed," Attorney General Eric Holder said at a Washington news briefing. "Put simply, this conduct is egregious, and it goes to the very heart of the recent financial crisis."

S&P denied any wrongdoing and said the lawsuit was unwarranted.

Defense attorney Floyd Abrams spent months talking with government lawyers in an unsuccessful bid to avoid a lawsuit. He argued that the Federal Reserve, Treasury Department and Securities and Exchange Commission — as well as rival credit-rating firms — similarly misjudged the financial risk mortgage-backed securities posed before the crisis.

"When all those entities, whose probity is not at issue and is not being questioned by the Department of Justice, had the same views, the idea that Standard & Poor's didn't believe what it was saying seems preposterous," Abrams said.

However, e-mails and other internal communications cited in the 118-page complaint filed late Monday in Los Angeles federal court paint an embarrassing if incomplete picture of S&P, a unit of McGraw-Hill Companies.

• When the firm circulated details of plans to require "market insight" from investment bankers and investors about changes in ratings criteria in 2004, one senior analyst complained. "Are you implying that we might actually reject or stifle 'superior analytics' for market considerations? Inquiring minds need to know," the analyst wrote.

The plan was implemented without any response to the analyst.

• In a February 2005 e-mail, an S&P executive stressed the need to poll some issuers of investments linked to potentially risky mortgages to gauge their tolerance for proposed revisions to analysis procedures that could make it tougher to win top ratings.

"This looks too much to me as though we are publicly backing into a set of levels driven by our clients," one company analyst warned.

• In March 2007, an S&P analyst sent an e-mail to co-workers that included a parody of the Talking Heads song Burning Down the House: "Watch out. Housing market went softer. Cooling down. Strong market is now much weaker. Subprime is boi-ling o-ver. Bringing down the house."

Minutes later, the analyst e-mailed a follow-up: "For obvious, professional reasons please do not forward this song. If you are interested, I can sing it in your cube ;-)."

Government lawyers "cherry-picked" a non-representative smattering of embarrassing e-mails and messages, Abrams said. "We will be presenting the norm, a fair picture of the day-to-day effort of hundreds and hundreds of people at Standard & Poor's just trying to get it (securities ratings) right," he said.

The federal lawsuit echoes allegations and suspicions of legal officials in many states. A January 2012 case filed against S&P by the Illinois Attorney General's office cited an April 2007 instant message in which one company employee stated an investment "could be structured by cows and we would rate it." The new case includes the same message.

Legal representatives from Illinois, California, Connecticut, Delaware, Mississippi, Iowa and the District of Columbia joined Holder's news briefing and signaled they may join the case. New York is investigating S&P independently.

The comparatively swifter charges filed against S&P by Illinois Attorney General Lisa Madigan and similar allegations raised in congressional hearings into the causes of the financial crisis prompted questions about the timing of the Department of Justice action. Stuart Delery, chief of the Justice Department's Civil Division, said the inquiry required the review of "millions of pages of documents'' and interviews with more than 150 witnesses, including former S&P executives.

Associate Attorney General Tony West declined to address questions about possible culpability of other credit-rating firms, saying the lawsuit was specific to Standard & Poor's.

But the case appeared to have an immediate financial impact on the ratings industry. After getting hammered in Monday trading, shares of S&P's parent, McGraw-Hill, closed down an additional 10.7% Tuesday. Moody's shares closed down nearly 9%.

The Department of Justice filed the lawsuit using a federal statute that could require S&P to pay millions of dollars in penalties if the government prevails in court. By bringing the case as a civil action, the government must meet a lower standard of proof than in a criminal lawsuit.

That decision was supported by the alleged evidence, said West, who did not elaborate.