The U.S. Justice Department slapped Standard & Poor's Rating Services with a lawsuit claiming the agency sidestepped its own standards when rating mortgage bonds that collapsed during the financial crisis, resulting in billions of dollars in losses for investors.
U.S. Attorney General Eric Holder's civil charges, filed late Monday against S&P, are the first federal enforcement charges against a credit rating firm over the financial crisis.
Reports say the government is going after S&P to the tune of more than $1 billion.
Following a report in The Wall Street Journal Monday afternoon that the government planned to file the suit, S&P acknowledged it was expecting the action and claimed the firm was being wrongly punished by the U.S. government for "failing to predict" the housing meltdown or financial crisis.
New York-based S&P, one of the three major rating firms, has denied any wrongdoing. The firm said in a statement before the government filed the suit that it would be "entirely without factual or legal merit."
CDOs and Subprime Mortgages
The government allegations stem from S&P's rating of collateralized debt obligations (CDOs) issued in 2007 that included a bevy of subprime (risky) mortgages.
CDOs were created in 1987 by bankers at the now-defunct Drexel Burnham Lambert Inc., home of the infamous one-time junk bond king Michael Milken.
Over two decades, sales of CDOs swelled to $503 billion. In spite of their popularity, CDOs are dicey and complicated securities.
Bankers and money managers bundle securities into a CDO, then divide it into pieces with credit ratings as high as AAA.
The riskiest parts have no rating because they are first to absorb losses. However, investors in this "equity" portion expect to reap returns of more than 10%, if all goes well.
But as well all know, things didn't go well with these securities. Their implosion is responsible for the financial crisis.
People close to the situation told The Wall Street Journal S&P and the government have been discussing a possible deal for nearly four months but S&P backed away from negotiations, worried a settlement could threaten its existence.
Officials at the rating agency also grew alarmed that the government was strong-arming the company to confess to transgressions. Doing so would leave S&P susceptible to pending lawsuits and open the floodgates for new suits from investors.
The government has been investigating S&P for about three years, trying to determine if rating agency managers pushed to relax company standards for mortgage-linked deals, or simply overlooked the standards altogether.
Targeted are some 30 deals which plunged in value shortly after being sold to investors, a source told The Wall Street Journal.
The suit claims that from September 2004-October 2007, S&P "knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors in" CDOs and securities backed by residential mortgages.
S&P maintained it "would be wrong" to assert its ratings were "motivated by commercial considerations and not issued in good faith."
The government alleges the firm's desire for increased revenue and market share "led it to downplay and disregard the true extent of the credit risks."
A Senate committee in 2011 accused S&P, Moody's and Fitch rating agencies as well as Hearst Corp. of providing overly robust ratings to CDOs and then causing an "economic earthquake" by downgrading hundreds of the bonds when the true scope of housing collapse came to light.
The rating firms contended the financial crisis was caused by several factors, and they were not to blame.
Neil Barofsky, the former inspector general for the Troubled Asset Relief Program, told the Journal the suit against S&P appears to be a way for the government to get "some measure of accountability" for the financial mess, which to date has been "something that's been lacking across the board."
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Wall Street Journal:
U.S. Sues S&P Over Ratings
US sues S&P over pre-crisis mortgage ratings
U.S. sues S&P over pre-crisis ratings