Detailed 124-page Complaint lists specific ways that Standard & Poor’s intentionally inflated its ratings of mortgage-backed securities for its own financial gain, while lying about the objectivity of those ratings.
Last week the Department of Justice filed a lawsuit in federal court alleging that Standard and Poor’s (S&P) engaged in a scheme to defraud investors of mortgage-backed securities by knowingly misrepresenting the credit risks associated with these securities. As a result the investors—specifically federally insured financial institutions—lost billions of dollars when many of these investments became worthless in spite of having received very high credit ratings from S&P.
Credit-rating agencies play an indispensable role in the U.S. financial system, and in the creation and sale of mortgage-backed securities. They “provide opinions about the creditworthiness of securities and are paid by the issuers of these securities. … . The rating agencies were also the only institutions outside of the mortgage or banking business with enough data and information to make an informed judgment about the securities’ safety.” Mark Zandi, Financial Shock: Global Panic and Government Bailouts, 2009. They hold themselves out to be objective and independent, reliable sources of information for investors about the safety of potential investments. Without the credit-rating agencies’ stamp of approval on a package of mortgage-backed securities, investors would not buy those securities.
The Complaint’s Allegations
Two sentences of Attorney General Holder’s speech provide a good summary of the Complaint’s allegations: “Our investigation… showed that – as early as 2003 – analysts within S&P raised concerns about the accuracy of the company’s rating system, as well as the underlying methodology. S&P executives allegedly ignored these warnings, and – between 2004 and 2007 – concealed facts, made false representations to investors and financial institutions, and took other steps to manipulate ratings criteria and credit models to increase revenue and market share.
The mail allegations of the Complaint track the traditional allegations for fraud:
1. “S&P repeatedly represented that its ratings were objective, independent, uninfluenced by any conflicts of interest that might compromise S&P’s analytical judgment, and reflected S&P’s true current opinion regarding creditor risks.”
2. “S&P’s representations were false.”
3. “S&P’s false representations were material to financial institutions’ investment decisions.”
The Complaint focuses most of its attention on the “representations were false” element, with 67 pages containing 146 highly detailed paragraphs of allegations, with exact dates, transactions, quotes of incriminating emails and other communications, and both the names of specific S&P executives and the code names of other executives and former employees who are apparently cooperating with the Justice Department. As summarized in the press release:
Contrary to [S&P’s] representations [that its ratings were objective and independent], from 2004 to 2007… S&P was so concerned with the possibility of losing market share and profits that it limited, adjusted and delayed updates to the ratings criteria and analytical models it used to assess the credit risks posed by [the mortgage-backed securities]. … S&P weakened those criteria and models from what S&P’s own analysts believed was necessary to make them more accurate. … [F]rom at least March to October 2007, and because of this same desire to increase market share and profits, S&P issued inflated ratings on hundreds of billions of dollars’ worth of [mortgage bonds]. At the time,… S&P knew that the quality of [the mortgage-backed securities] was severely impaired, and that the ratings on those mortgage bonds would not hold. … S&P failed to account for this impairment in the [mortgage bond] ratings it was assigning on a daily basis. As a result, nearly every [mortgage bond] rated by S&P during this time period failed, causing investors to lose billions of dollars.
For a series of reasons this lawsuit seems different than the other multi-billion dollar ones related to the recent financial crisis that have paraded through the news in the last several years. In the next blog we’ll look at why this lawsuit looks stronger and worth paying attention to.