Video settings

Please Log in to update your video settings

Video will begin in 5 seconds.

Video settings

Please Log in to update your video settings

US files lawsuit against S&P

US Attorney General, Eric Holder, explains the government's case against Standard & Poor's, who allegedly solicited illegal behaviour during the recent financial crisis.

PT1M41S http://www.canberratimes.com.au/action/externalEmbeddedPlayer?id=d-2dxcm 620 349

The US government is seeking $US5 billion from Standard & Poor’s, accusing the ratings service of defrauding investors in a case linked to the financial crisis, just several months after dozens of Australian councils celebrated a multi-million-dollar landmark victory against the ratings agency.

“Watch out / Housing market went softer / Cooling down / Strong market is now much weaker / Subprime is boiling over / Bringing down the house.” 

The United States said S&P inflated ratings and understated risks associated with mortgage securities, driven by a desire to gain more business from the investment banks that issued those securities. S&P committed fraud by falsely claiming its ratings were objective, the lawsuit said.

"Put simply, this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis," said Attorney General Eric Holder at a news conference in Washington announcing the charges.

The 119-page lawsuit, filed late on Monday in federal court in Los Angeles, is the first from the US government against a ratings agency, a sector that has generally shielded itself from liability by citing First Amendment protection of free speech.

It follows a Federal Court of Australia ruling in November that found S&P would have to pay nearly $20 million in compensation and legal costs to 13 NSW councils, which collectively invested about $16 million in financial products nicknamed Rembrandt notes. The investments collapsed during the financial crisis and the councils lost 90¢ in every dollar.

Justice Jayne Jagot of the Federal Court also found that an S&P AAA rating for ‘‘grotesquely complicated’’ financial products created by ABN Amro was misleading.

Standard & Poor’s indicated it planned to appeal the ruling.

Sixteen US states and the District of Columbia are also suing S&P, a unit of the McGraw-Hill Companies. McGraw-Hill shares fell as much as 8.9 per cent on Tuesday, after dropping 13.8 per cent on Monday.

No individuals were charged in the Department of Justice's lawsuit, and it was not immediately clear why the government focused on S&P instead of rivals Moody's Corp or Fimalac SA's Fitch Ratings, which were also major raters of such securities.

The 2007-2009 financial crisis was due in large part to massive losses triggered by risky mortgage loans packaged and sold to investors, often with top ratings from credit raters.

S&P issued a statement saying the lawsuit is meritless and that it will vigorously defend itself. It said the government "cherry picked" emails to misconstrue analyst activity.

"Claims that we deliberately kept ratings high when we knew they should be lower are simply not true," the company said.

Senator Carl Levin, who led a year-long inquiry into the causes of the financial crisis and singled out credit raters for blame, said in a statement the public was "eagerly awaiting" legal actions tied to the financial crisis.

"The credit rating agencies have yet to acknowledge any blame or make the changes necessary to prevent conflicts of interest from fuelling more inflated ratings in the future," the Democrat from Michigan said.

Years-long battle

A source close to S&P said the firm expected a years-long battle with the government over the lawsuit. Settlement talks recently collapsed, the source said, after the government sought a penalty of over $US1 billion and admissions of wrongdoing, which would exposed the firm to outside liability.

"There was no fraud," S&P lawyer Floyd Abrams said on CNBC on Tuesday morning. "The ratings that were issued were believed by the people who issued them. And that's what the government has got to disprove."

Between September 2004 and October 2007, as stress in the housing market was starting to emerge, S&P delayed updates to its ratings criteria and analytical models, which weakened its criteria beyond what analysts believed was needed to make them more accurate, the Justice Department said.

During that period, according to the complaint, S&P issued credit ratings on $US2.8 trillion worth of mortgage securities and some $US1.2 trillion in related structured products.

It charged up to $US750,000 per deal it rated, which meant that S&P viewed the investment banks that issued the securities as its main customers, according to the complaint.

In August 2004, the head of S&P's commercial mortgage-backed securities sent an email to her colleagues and said they planned to meet to discuss adjusting criteria "because of the ongoing threat of losing deals".

Earlier in May, an analyst wrote, "We just lost a huge Mizuho RMBS deal to Moody's due to a huge difference in the required credit support level ... our support level was at least 10 per cent higher than Moody's," the complaint said.

S&P had planned in 2004 to update its model for rating mortgage securities by including a broader data set of past loans, which would provide more accurate comparisons for the more risky loans that were being packaged.

In 2006, S&P loosened assumptions on its ratings of collateralised debt obligations, which one of the firm's analysts described as creating a loophole big enough to drive a Mack truck through.

Asked who came up with the idea, the analyst referred to a couple of colleagues and said: "I am interested to see if any career consequences occur. Does company care about deal volume or sound credit standards?"

That same year, CDO analysts met to discuss what one called “the blow up” of the housing market, the government said. Afterward, one wrote to another that the “market will crash”.

In March 2007, an analyst set new lyrics to the tune of Burning Down the House by the rock group Talking Heads.

According to the complaint, it began:

“Watch out / Housing market went softer / Cooling down / Strong market is now much weaker / Subprime is boiling over / Bringing down the house.”

The government said the analyst later sent a video of himself singing and dancing the first verse “before an audience of laughing S&P co-workers.”

By July 5, 2007, as the credit crisis began taking hold, a new S&P structured finance analyst told an investment banking client: "The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody's."

Six days later, the analyst alluded to a climactic scheme in the movie Trading Places by adding: "You should see how it is here right now. It's like a friggin trading floor. 'Downgrade, Mortimer, downgrade!!!'"

The next day, July 12, S&P announced a mass downgrade of 2005 and 2006 subprime residential mortgage debt.

Old law, new twist

The lawsuit was brought under FIRREA, the Financial Institutions Reform, Recovery, and Enforcement Act, a federal civil fraud statute passed in the wake of the 1980s savings-and-loan scandals. It covers fraud affecting federally insured financial institutions.

While it has appeared in only a few dozen cases, its low burden of proof, broad investigative powers and long statute of limitations encouraged the Justice Department to dust it off for potential cases, especially after criminal inquiries failed to yield major prosecutions.

In its complaint against S&P, the Justice Department accused S&P of defrauding Western Federal Corporate Credit Union, and other institutions that purchased certain securities based on the high ratings by S&P.

Some credit unions are required by law to rely on credit ratings issued by firms that included S&P in making its investment decisions, the complaint said.

Reuters with Lucy Battersby, Bloomberg