Poorly Rated: A Look at the Landmark Lawsuit Against S&P

by Amy Lillard

(3/12/2013) In the five years since the mortgage subprime crisis snowballed into a massive financial collapse, federal regulators, companies and news agencies have all made efforts to parse through the mess and determine what went wrong. As a clearer picture has emerged, and as the country has slowly but surely made moves toward recovery, key players and events have been identified.

But in February the U.S. Department of Justice (DOJ) made the biggest move yet in assigning blame for the financial fiasco that led to what is now called the Great Recession. What does the record lawsuit against Standard & Poor’s (S&P) credit rating agency signify? And how could it help us learn the lessons to prevent another debacle?

The Suit

On February 5, the DOJ announced a $5 billion civil lawsuit against S&P, accusing the agency of defrauding investors during the financial crisis. The suit says the agency inflated ratings of mortgage-backed securities and ignored very real risks involved, all to gain more business. The subprime mortgages bundled into these securities failed, costing investors billions and dooming the economy.

The lawsuit is based on a federal probe beginning in 2009, designated “Alchemy.” According to reports, the probe discovered emails and other communications that allegedly indicate S&P officials knew the risks involved and knew the housing market was collapsing, but continued to highly rate hundreds of affected securities in order to keep business and clients.

As a result, the Justice Department says, banks and credit unions suffered losses of more than $5 billion.

"Put simply, this alleged conduct is egregious, and it goes to the very heart of the recent financial crisis," said Attorney General Eric Holder at the announcement of the lawsuit.

The Agency

The role S&P played during the time of the financial collapse was significant.

Between 2004 to 2007 a common product on the financial markets, one that became widely used as an investment tool for millions of individuals and organizations, was mortgage-backed securities. These products packaged mortgages (and often subprime mortgages, the most risky home loans in existence) into bonds.

Ratings agencies including S&P were formed to provide objective analysis for investors on specific securities. Their assessment of the different mortgage-backed bond options available to investors included assessing risk involved in purchasing these bonds.

While ratings agencies including S&P were supposed to be objective, there was and is a fundamental flaw in how agencies make money. They are paid by the same organizations issuing the securities being rated. In addition, when the housing boom was in full swing, rating agencies received significantly more money for rating mortgage-backed securities compared to corporate bonds and other investment vehicles. Subsequently, due to the very nature of how agencies were funded, there was no clear way to determine if ratings were truly objective.

As the housing market boomed, but also the first signs of major stress emerged due to defaulting subprime loans, S&P kept their ratings criteria the same, said the DOJ. During 2004-2007 they issued credit ratings on $2.8 trillion worth of mortgage securities. Their high ratings enabled and encouraged investors to buy these securities, fueling the demand. When the housing bubble finally burst, the losses from the bonds were catastrophic, triggering and deepening the financial collapse.

The lawsuit’s details allege S&P deliberately rated these securities highly. They charged up to $750,000 for each rating, along with additional fees and surcharges for services requested by the issuers of the securities. With that amount of money at stake, S&P allegedly wanted to keep them happy. Thus the high marks for safety even when not warranted.

To support their claim, the DOJ identified 5 key executives and 17 other employees involved in incriminating emails and documents. The paperwork allegedly shows employees discussing their favorable ratings in exchange for profits.

The Significance

While there has been fallout from the financial collapse and punitive measures from the government, this lawsuit represents many firsts.

This is the first time the DOJ has gone after a credit ratings agency, in part due to agencies usage of the First Amendment as protection against liability. This suit, however, is brought under the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), a statute first used in the 1980s Savings and Loan scandals. The statute is designed specifically for fraud involving FDIC-insured institutions, and has a relatively low burden of proof. The federal government is using it to make the case potentially easier against the agency.

Overall, this suit is widely seen as the most aggressive move yet to assign blame and punishment for the financial collapse. The DOJ says banks and credit unions experienced losses of more than $5 billion on more than 40 securities with inflated ratings by S&P. FIRREA specifies defendants are liable to $1 of damages for every $1 of losses by a federally insured institution.

The Outlook

Most experts agree — this lawsuit will last a long time.

The federal suit is joined by state lawsuits from 16 states and the District of Columbia. Initial settlement discussions may have already collapsed, several news agencies have reported, after S&P refused to pay $1 billion and admit wrongdoing. That probably means years of slow negotiation and argument even before the cases go to trial.

Perhaps the biggest question? If this suit will be followed by others against rival credit agencies like Moody’s Corp or Fimalac SA Fitch, who were also significant providers of security ratings at the time.

In the meantime, S&P is conducting damage control in the court of public opinion, making statements about their $400 million investments since 2007 in measures to increase compliance, train staff and rehaul rating standards. In statement earlier this year, the company said the changes have made it harder to achieve the highest ratings from S&P.

“We have taken to heart the lessons learned from the financial crisis and made extensive changes that reinforce the integrity, independence and performance of our ratings,” S&P President Doug Peterson said in February.