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The Sharp Teeth of the Justice Department’s Lawsuit Against Standard & Poor’s for Its Fraudulent Credit Ratings

This financial fraud lawsuit seems more aggressive and may be more effective in finding fault than have been the previous multi-billion dollar efforts against other players in the financial crisis.


Our last blog described the lawsuit filed on February 4 against Standard & Poor’s for fraudulently inflating its credit ratings of mortgage-backed securities for its own financial gain.

It’s easy to get cynical about these kinds of enforcement and regulatory efforts. They all seem to end “not with a bang but a whimper.” (T.S. Eliot)  Their settlement terms and their actual consequences do not have the bang of meaningful penalties and acceptance of responsibility, but rather the whimper of a financial hand-slap and denial of wrongdoing.

For a series of specific reasons there seems to be more teeth to this one. Before listing those reasons, let’s start with a good summary of the lawsuit from the statement of one of the lead Dept. of Justice attorneys. It’s a bit long, but worth reading through, both to set the scene and the tone:

… S&P is the largest credit rating agency in the world.   As such, it plays a unique role on Wall Street.   Many investors, financial analysts and the general public look to S&P to be a fair and impartial umpire when it comes to the ratings it issues.   And in the years preceding the financial crisis, S&P played a role in rating the vast majority of financial transactions involving… two types of financial products… :   Residential Mortgage Backed Securities, or “RMBS,” and Collateralized Debt Obligations, or “CDOs.”   Between 2004 and 2007, S&P issued ratings on trillions of dollars worth of RMBS and CDOs.

And those ratings were important, because without a stamp of approval by S&P or one of the other major credit rating agencies, these financial transactions simply could not have occurred.   That is because nearly every single RMBS or CDO sold required a credit rating – typically, a triple-A rating – in order to attract the attention and confidence of investors.

And repeatedly, S&P promised that its ratings would be “objective and independent”:   Even though the banks and other institutions hired S&P to rate these financial products, and even though S&P earned millions as a result of issuing those ratings, S&P promised that its ratings would be unaffected by their concerns about market share, revenue or profits.

But the evidence we have uncovered tells a different story.   We allege that from at least 2004 to 2007, S&P lied about its objectivity and independence – that they said one thing yet did another.   The evidence reveals that S&P promised investors and the public that their ratings were based on data and analytical models reflecting the company’s true credit judgment, when in fact internal S&P documents make clear that the company regularly would “tweak,” “bend,” delay updating or otherwise adjust its ratings models to suit the company’s business needs.  

We also allege that from at least March 2007 to October 2007, S&P issued ratings for certain CDOs — ratings S&P knew were inflated at the time they issued them.  

And how did S&P know the CDO ratings they issued were inflated?   Because those CDO ratings were derived in large part from the ratings on classes of subprime mortgage bonds which backed those CDOs — classes of mortgage bonds whose own ratings S&P knew it was going to downgrade, yet did nothing to adjust the overall CDO ratings to reflect that inevitability.  

It’s sort of like buying sausage from your favorite butcher, and he assures you the sausage was made fresh that morning and is safe.   What he doesn’t tell you is that it was made with meat he knows is rotten and plans to throw out later that night.

Statement of Acting Associate Attorney General Tony West at Feb. 5, 2013 Press Conference. (Mr. West’s statement continued to detail how S&P intentionally inflated its ratings. It’s worth reading in its entirety.)

This lawsuit seems different and stronger than the previous multi-billion dollar lawsuits because:

1. Most of the other lawsuits against the residential mortgage banks and servicers, and other financial institutions of the last several years were negotiated in secret and settled in advance with the institutions being sued. The complaint and the stipulated settlement were usually announced and filed simultaneously as a done deal. In contrast, this lawsuit against S&P is not a neat and tidy settlement package. It’s at least starting as a contentious, real lawsuit.

2. The lawsuit is the result of an extensive investigation, one that appears to have been adversarial, with the implication that the investigation went into places that S&P would have preferred it hadn’t. As explained by Stuart F. Delery, the head of the Justice Department’s Civil Division, “today’s action culminates a massive, multi-year investigation… . Our lawyers and staff served hundreds of civil subpoenas, spent thousands of hours reviewing and analyzing millions of pages of documents, and contacted and interviewed over 150 witnesses, including dozens of former S&P analysts and executives.”

3. The allegations in the Complaint are painstakingly specific about the ways that S&P made misrepresentations about the credit ratings of the securities, with precise dates, transactions, quotes from incriminating emails and other communications, the names of specific S&P executives, as well as the code names of about a dozen other S&P executives and former employees, who are clearly cooperating with the Justice Department. More than half the 124-page complaint consists of detailed allegation after allegation reciting the misrepresentations. (See pp. 38-115 of the Complaint.) 

4. The plaintiff in this lawsuit is not a bank regulator but the U.S. Department of Justice. The bank regulators, especially the U.S. Comptroller of the Currency, and even the Federal Reserve, have been arguably all too easy on the banks and mortgage servicers, for reasons well beyond the scope of today’s blog. But those reasons should not have nearly as much influence on the Justice Department. 

5. To be realistic, most of what happens in Washington, D.C. is based on political power and influence. The large mortgage banks and servicers have a tremendous amount of this power. The major rating agencies presumably have some, but not likely anywhere as much. To be somewhat cynical, as a smaller albeit still crucial player in the financial meltdown, S&P and its rating agency brethren will more likely be allowed to take the fall.

It will be very interesting to see how this lawsuit plays out, particularly whether the Justice Department’s teeth will stay sharp to the end.  


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