The Justice Department late Monday filed civil fraud charges against the nation’s largest credit-ratings agency, 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.
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.
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 Cos. 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 DOJ 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.
A spokesman for Moody’s declined to comment. A spokesman for Fitch, Daniel 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.”
Focused on complex CDOs
The case against S&P is said to focus on about 30 collateralized debt obligations, or CDOs, 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 emails written by S&P employees, which the government considers damaging. The firm gave the government more than 20 million pages of emails as part of its investigation, the people with knowledge of the process said.
Practices widely criticized
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.
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.