US accuses S&P of ‘intent to defraud’

LOS ANGELES—The United States Department of Justice has filed a civil fraud lawsuit against one of the world’s larger credit-ratings agencies that services Trinidad and Tobago and several other Caribbean Community (Caricom) member states. On Monday, the department said it filed the suit in a US federal district court in which it accused the Wall Street-based Standard & Poor’s (S&P) of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis began.

Over the years, S&P, as well as other Wall Street-based credit rating firms, such as Moody’s and Finch, has rated the economies of T&T and most Caricom countries, such as Jamaica, Barbados, the Bahamas, Belize and Suriname. 

In its last rating of this country late last year, Standard & Poor’s Ratings Services affirmed its ‘A/A-1’ long-and short-term sovereign credit ratings, saying that the country’s outlook remains stable because of its low net general government debt, net external asset position and favourable debt profile which limits its external vulnerability.

In Monday’s suit, the US accused S&P and its parent company, McGraw-Hill Companies, of “knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors” in certain mortgage-related securities from September 2004 to October 2007. The suit also charges that S&P falsely stated that its ratings “were objective, independent, uninfluenced by any conflicts of interest.” 

The US Justice Department said the suit against S&P focuses on about 40 collateralised debt obligations (CDO), an exotic type of security made up of bundles of mortgage bonds, which comprised individual home loans.

“As S&P knew, contrary to its representations to the public, S&P’s desire for increased revenue and market share in the RMBS (residential mortgage-backed securities) and CDO ratings markets, and its resulting desire to maintain and enhance its relationships with issuers that drove its ratings business, improperly influenced S&P to downplay and disregard the true extent of the credit risks,” the suit claims.

The Justice Department said the securities were created at the height of the housing boom, and that S& P was paid fees to the tune of US$13 million for rating them. US prosecutors said they have unearthed a multiplicity of e-mails written by S&P employees, expressing deep concern about the way in which such securities were rated. 

In response to the lawsuit, S&P said in a statement that the Justice Department “would be wrong in contending that S& P ratings were motivated by commercial considerations and not issued in good faith.” The rating agency said it had started “stress-testing” the mortgage-backed securities it rated as early as 2005, in figuring out how they would perform in a severe market downturn. 

Two years ago, a US Senate probe found that S&P and Moody’s, from 2004 to 2007, used “inaccurate rating models” that failed to predict how high-risk mortgages would perform. The investigation also found that the rating agencies allowed competitive pressures to affect their ratings, and failed to reassess past ratings after improving their models in 2006. Even against this background, S&P said on Monday that the US Department of Justice’s lawsuit was “entirely without factual or legal merit.” 

The lawsuit came after S& P and the Justice Department failed to reach an agreement on a civil penalty to the tune of US$1 billion for S&P’s alleged wrongdoing.

Key allegations against S&P

Here is the basis of the case the US government is making against Standard & Poor's Ratings Services in a 128-page lawsuit:
—The charge: The government accuses S&P of knowingly giving high grades to risky mortgage-backed securities from about 2004 to 2007. The mortgages underlying those securities later imploded, causing investors billions of dollars in losses.
—The background: S&P is an agency that assigns ratings to investments. When an investment has a high rating, the risk is considered low. Even the most conservative investors, like some pension funds, feel confident enough to buy it.

Banks and other financial firms approach S&P and other major rating agencies when they have an investment that needs to be rated. The system contains an oddity: The banks not only pay for the ratings they receive but can also shop around to see which rating agency might give them the highest marks. This creates a conflict of interest: To earn business from the banks, the rating agencies can feel pressure to give high grades to the banks' investment products.
—The details: The government says S&P knowingly gave high grades to banks' risky mortgage-backed securities that later soured because it wanted to earn more business from the banks.
—The business model: To support its claims, the government refers to comments from S&P executives that they wanted their ratings to be handled in a "business friendly" way. The lawsuit also points to emails in which an S&P analyst says executives fear angering the banks by assigning low ratings to their securities. In another email, an analyst complains about missing out on a deal because S&P's criteria on a rating were stricter than those of its rival Moody's.
—What they knew: The government also refers to emails in which S&P employees appear to know how severe the subprime mortgage crisis is, even though they still had high ratings on subprime-backed mortgage bonds. In one report, the performance of subprime investments was so bad that S&P employees thought the numbers must be typos. One analyst emailed a video of himself singing about the collapse of subprime mortgages, with colleagues laughing.
—The government's role: The Justice Department is the government arm that filed the lawsuit. The government has an obligation to make investing fair and safe. But it's also been accused of failing to aggressively pursue wrongdoing related to the financial crisis. It has been under pressure to show it can bring and win lawsuits.
—The significance: This is the first time the federal government has filed a lawsuit against one of the major credit rating agencies over actions related to the financial crisis. S&P is also known as the rating agency that downgraded long-term US debt in 2011.
—The defense: S&P denies wrongdoing and says it can't be blamed for failing to predict the unpredictable financial crisis. It points out that the government was also saying as late as 2007 that the subprime crisis would likely be contained. S&P also says the lawsuit has taken its emails out of context.

It says it “deeply regret(s)” that some investments didn't perform as well as expected. But S&P adds, “20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals.”

CMC