Trying to get ahead of a potentially explosive story, credit rating agency Standard & Poor’s announced Monday that the Justice Department had informed the company that it’s the subject of a civil lawsuit for the AAA ratings it gave to complex bonds in 2007 that later turned out to be junk.
In a highly unusual statement, S&P, a subsidiary of publishing giant The McGraw-Hill Companies Inc., said that the Justice Department would sue the company for failing to predict the full magnitude of the U.S. housing downturn, something Wall Street banks and federal regulators all missed as well.
Given that S&P issued a historic downgrade of U.S. creditworthiness in August 2011 and has threatened to take that rating down a further notch, the pending suit is raising questions of whether it actually amounts to retaliation.
At issue are financial instruments called collateralized debt obligations, shorthanded as CDOs, which were sold to investors in 2007 and are comprised of mortgages and other consumer and business debt pooled together into a complex bond. Investors bought into differing levels of risk and thus got varying levels of financial return.
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S&P said Monday that it’s being unfairly singled out.
“It would disregard the central facts that S&P reviewed the same subprime mortgage data as the rest of the market – including U.S. government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained – and that every CDO that DOJ has cited to us also independently received the same rating from another rating agency,” the company said.
Justice Department spokeswoman Adora Andy declined comment. An S&P official said the company was told it would be charged under the Financial Institutions Reform, Recovery and Enforcement Act. That statute dates back to the savings and loan crisis in the late 1980s and early 1990s.
“This has never been used in conjunction with a rating agency and is unprecedented,” Catherine Mathis, S&P’s senior vice president of marketing and communications, told McClatchy. “They have used it against some of the banks in the past. Clearly this was not the purpose for which it was intended.”
Ratings agencies historically have enjoyed First Amendment protection under the law, with courts determining that their ratings amount to protected free speech since they reflect opinions about the creditworthiness of an issuer of a bond.
Reporting by McClatchy, later confirmed in Senate hearings and by the special Financial Crisis Inquiry Commission, found that ratings agencies effectively let their lucrative business for rating complex bonds – a subset called structured finance – erode the quality of ratings.
Further complicating matters, AAA ratings on government bonds issued by, say, France are based on a long history of past performance, something that didn’t exist for complex mortgage bonds that were being offered by giant Wall Street investment banks. The ratings agencies had to invent a methodology to approximate past performance based partly on geography, which turned out to be a poor measure of the chance of a bond’s default.
Critics of the ratings agencies say a lawsuit is long overdue.
“I think that the American public has been hungering for holding the rating agencies accountable for AAA ratings that by any commonsense understanding of the word could not have applied to pools of subprime mortgages,” said Michael Greenberger, a University of Maryland law professor and former financial regulator. “My only fear is that the Department of Justice has had a record of letting financial institutions off lightly for their wrongdoings.”
Among the many questions raised by the pending Justice Department civil suit is why S&P alone is being charged. A person familiar with the department’s investigation of ratings agencies said the probe has gone on for three years and originally also involved Moody’s Investors Service. A Moody’s spokesman did not respond to a request for comment, but Daniel Noonan, a spokesman for Fitch Ratings, the third major rating agency and the only one that is not a publicly traded company, said that “we have no reason to believe Fitch is a target of any such action.”
Investigator interest in Moody’s apparently dropped off around the summer of 2011, about the same time S&P issued the historic downgrade of the U.S. government’s creditworthiness because of mounting debt and deficits.
“After the U.S. downgrade, Moody’s is no longer part of this,” said the person familiar with the case, who demanded anonymity in order to speak freely about the matter.
Others share that perception.
“Why not Moody’s and Fitch?" asked Sylvain Raynes, a onetime Moody’s employee who has crusaded for reforms on Wall Street. "Are they innocent of similar things? Why S&P? Because they downgraded the United States. The fact that this targeted one rating agency when all three are equally guilty is suspicious, (needs) to be explained and leads me to believe that this is a politically motivated lawsuit. Yes, there is wrongdoing, but not everybody who speeds on the highway gets stopped by the cops.”
S&P, he cautioned, is “certainly guilty of gross negligence, which is, I’m sure, provable.”
Arguments are “pretty strong” that bundles of risky mortgage bonds that S&P rated were fraudulent, said structured securities expert Ann Rutledge.
“And they’re equally fraudulent in the case of Moody’s and S&P, because they worked in pretty much the same way,” said Rutledge, who is married to Raynes.
In another unusual element of the pending civil suit, McClatchy has learned that the Justice Department apparently will bring its case in Southern California, one of the hardest hit regions during the housing crisis and an area where jurors presumably would be more sympathetic. New York City is usually the venue for civil lawsuits against Wall Street players tied to the U.S. financial crisis.
It’s not clear which complex bonds are subject to the Justice Department civil suit.