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U.S. accuses S&P of fraud in pre-crisis mortgage ratings

By Christina Rexrode and Daniel Wagner

AP Business Writers

LAST UPDATED: 04:49 a.m. HST, Feb 05, 2013

WASHINGTON » The U.S. government is accusing the debt rating agency Standard & Poor's of fraud for giving high ratings to risky mortgage bonds that helped bring about the financial crisis.

The government filed a civil complaint late Monday against S&P, the first enforcement action the government has taken against a major rating agency related to the financial crisis.

S&P, a unit of New York-based McGraw-Hill Cos., has denied wrongdoing. It says the government also failed to predict the subprime mortgage crisis.

But the government's lawsuit paints a picture of a company that misled investors knowingly, more concerned about making money than about accurate ratings. It says S&P delayed updating its ratings models, rushed through the ratings process and was fully aware that the subprime market was flailing even as it gave high marks to investments made of subprime mortgages. In 2007, one analyst forwarded a video of himself singing and dancing to a tune about the deterioration of the subprime market, with colleagues laughing.

Ratings agencies like S&P are a key part of the financial crisis narrative. When banks and other financial firms wanted to package mortgages into securities and sell them to investors, they would come to a ratings agency to get a rating for the security. Many securities made of risky subprime mortgages got high ratings, giving even the more conservative investors, like pension funds, the confidence to buy them. Those investors suffered huge losses when housing prices plunged and many borrowers defaulted on their mortgage payments.

This arrangement has a major conflict of interest, the government's lawsuit says. The firms that issued the securities could shop around for whichever ratings agency would give them the best rating. So the agencies could give high ratings just to get business.

The government's lawsuit says that "S&P's desire for increased revenue and market share ... led S&P to downplay and disregard the true extent of the credit risks" posed by the investments it was rating.

For example, S&P typically charged $150,000 for rating a subprime mortgage-backed security, and $750,000 for certain types of other securities. If S&P lost the business — for example, if the firm that planned to sell the security decided it could get a better rating from Fitch or Moody's — then an S&P analyst would have to submit a "lost deal" memo explaining why he or she lost the business.

That created sloppy ratings, the government said.

"Most rating committees took less than 15 minutes to complete," the government said in its lawsuit, describing the process where an S&P analyst would present a rating for review. "Numerous rating committees were conducted simultaneously in the same conference room."

According to the lawsuit, S&P was constantly trying to keep the financial firms — its clients — happy.

A 2007 PowerPoint presentation on its ratings model said that being "business friendly" was a central component, according to the government.

In a 2004 document, executives said they would poll investors as part of the process for choosing a rating.

"Are you implying that we might actually reject or stifle 'superior analytics' for market considerations?" one executive wrote back. "...What is 'market perspective'? Does this mean we are to review our proposed criteria changes with investors, issuers and investment bankers? ... (W)e NEVER poll them as to content or acceptability!"

The lawsuit says this executive's concerns were ignored.

A 2004 memo said that "concerns with the objectivity, integrity, or validity" of ratings criteria should be communicated in person rather than through email.

Also that year, an analyst complained that S&P had lost a deal because its criteria for a rating was stricter than Moody's. "We need to address this now in preparation for the future deals," the analyst wrote.

By 2006, S&P was well aware that the subprime mortgage market was collapsing, the government said, even though S&P didn't issue a mass downgrade of subprime-backed securities until 2007. One document describing the performance of the subprime loans backing some investments "was so bad that analysts initially thought the data contained typographical errors," the government lawsuit said.

In March 2007, one analyst who had conducted a risk ranking analysis of 2006 mortgage-backed securities wrote a version of "Burning Down the House": "Going - all the way down, with/Subprime mortgages."

A video showed him singing and dancing another verse in front of S&P colleagues, who laughed.

Another analyst wrote in a 2007 email, referring to ratings for mortgage-backed investments: "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(asterisk)ssing of too many clients and jumping the gun ahead of Fitch and Moody's."

The government filed its lawsuit in U.S. District Court in Los Angeles. The government charged S&P under a law aimed at making sure banks invest safely, and said that S&P's alleged fraud made it possible to sell the investments to banks. .

If S&P is eventually found to have committed civil violations, it could face fines and limits on how it does business. The government said in its filing that it's seeking financial penalties.

The action does not involve any criminal allegations. Critics have long complained about the government's failure to bring criminal charges against any major Wall Street players involved in the financial crisis.

Criminal charges would require a higher burden of proof and carry the threat of jail time.

McGraw-Hill shares rose 25 cents to $50.55 in today's premarket session, after plunging nearly 14 percent the day before on the expectation that a lawsuit would be filed.

Shares of Moody's Corp., the parent of Moody's Investors Service, another rating agency, rose 31 cents to $49.45 before today's opening bell, after closing down nearly 11 percent on Monday.

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serious wrote:
Fines don't send the message, but jail time sure would.
on February 5,2013 | 04:56AM
tiki886 wrote:
The hundreds or thousands of mortgage loans contained in each Mortgage Backed Security (MBS) were underwritten to the rules and guidelines of Fannie Mae, Freddie Mac, FHA/VA all government agencies. So how can you blame S&P for over-rating a product whose quality was determined by the government in the first place and GUARANTEED by the government in many instances?
on February 5,2013 | 05:19AM
tiki886 wrote:
Banks and lenders are risk averse. There is no way any bank or lender could bear the enormous risk of a subprime mortgage loan. The government, FNMA, FHLMC and FHA/VA were the ones who created the sub prime loan to begin with. They wrote the rules and guidelines and GUARANTEED the loans!

The whole subprime mess began with the GOVERNMENT!

on February 5,2013 | 05:34AM
serious wrote:
Does the names Chris Dodd and Barney Frank ring a bell???? they should be jailed!!!
on February 5,2013 | 10:16AM
tiki886 wrote:
Yes, they should! I thought you were referring to the private sector.
on February 5,2013 | 05:22PM
HawaiiCheeseBall wrote:
Not true, there was widespread fraud from the mortgage originators. Bank of America is paying the price for that now. Yes there are standards for FHA loans but the bad guys simply lied. S&P knew their standards for rating these instruments were bad, but they were in competition with the likes of Moody s and Fitch to earn fees for rating these instruments from various investment banks and willfully turned a blind eye and continued to give investment grade ratings to shaky securities.
on February 5,2013 | 08:09AM
Anonymous wrote:
How would S&P and other rating agencies know who lied on their loan application or not? The reason the mortgage loan is in a Mortgage Backed Security (MBS) is because it is a "performing asset". That means the borrower is still making payments.
on February 5,2013 | 09:04AM
Allenk wrote:
Unfortunately, the damage is already done. Another case of the "foxes guarding the hen house."
on February 5,2013 | 07:07AM
serious wrote:
The system is flawed!! I pay YOU to rate ME????
on February 5,2013 | 10:23AM
ShibaiDakine wrote:
tTlk about the kettle calling the pot black........
on February 5,2013 | 07:09AM
ShibaiDakine wrote:
Talk-- oopsie
on February 5,2013 | 07:11AM
HD36 wrote:
The government's retribution for S&P downgrading The debt rating of the US Government. The Government only gives out a few licenses to rate its debt. If you don't play the game and rate the US debt as AAA, they will send an army of auditors your way and find something wrong. In any event the fault with the housing bubble lies with the government. Fannie and Freddie were buying any and all mortgages regardless of the credit standards. They had a duty to use the standard credit analysis of mortgage loans in the industry and to reject loans that were unworthy. This government does not take responsibility for anything.
on February 5,2013 | 07:54AM
Anonymous wrote:
You are exactly right! S&P downgraded US debt and made it more difficult for that crook Tim Geithner to borrow money from China cheaper and more easily so Obama and Geithner sic Eric Holder on S&P.
on February 5,2013 | 09:10AM
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