The Department of Justice (DOJ) filed a civil lawsuit against the credit rating agency Standard & Poor’s Ratings Services alleging that S&P engaged in a scheme to defraud investors in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) in the run up to the financial crisis. The lawsuit, filed on Feb. 5, alleges that investors, many of them federally insured financial institutions, lost billions of dollars on CDOs for which S&P issued inflated ratings that misrepresented the securities’ true credit risks. The complaint also alleges that S&P falsely represented that its ratings were objective, independent and uninfluenced by S&P’s relationships with investment banks when, in actuality, S&P’s desire for increased revenue and market share led it to favor the interests of these banks over investors.
“This alleged conduct is egregious — and it goes to the very heart of the recent financial crisis,” said U.S. Attorney General Eric Holder. “Today’s action is an important step forward in our ongoing efforts to investigate and punish the conduct that is believed to have contributed to the worst economic crisis in recent history.”
The complaint, which names McGraw-Hill Companies Inc. and its subsidiary, Standard & Poor’s Financial Services LLC as defendants, seeks civil penalties under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) based on three forms of alleged fraud by S&P: 1) mail fraud affecting federally insured financial institutions; 2) wire fraud affecting federally insured financial institutions; and 3) financial institution fraud.
FIRREA authorizes the attorney general to seek civil penalties up to the amount of the losses suffered as a result of the alleged violations. To date, the government has identified more than $5 billion in losses suffered by federally insured financial institutions in connection with the failure of CDOs rated by S&P from March to October 2007.
According to the complaint, S&P publicly represented that its ratings of RMBS and CDOs were objective, independent and uninfluenced by the potential conflict of interest posed by S&P being selected to rate securities by the investment banks that sold those securities. Contrary to these representations, from 2004 to 2007, the government alleges 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 RMBS and CDOs. According to the complaint, S&P weakened those criteria and models from what S&P’s own analysts believed were necessary to make them more accurate. The complaint also alleges that, from 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 CDOs. At the time, according to the allegations in the complaint, S&P knew that the quality of non-prime RMBS was severely impaired, and that the ratings on those mortgage bonds would not hold. The government alleges that S&P failed to account for this impairment in the CDO ratings it was assigning on a daily basis. As a result, nearly every CDO rated by S&P during this time period failed, causing investors to lose billions of dollars.
The underlying federal investigation, code-named “Alchemy,” that led to the filing of this complaint was initiated in November 2009 in connection with the president’s Financial Fraud Enforcement Task Force.
The DOJ’s action was filed in the Central District of California, home to the now defunct Western Federal Corporate Credit Union (WesCorp), which was the largest corporate credit union in the country. Following the 2008 financial crisis, WesCorp collapsed after suffering massive losses on RMBS and CDOs rated by S&P.
Attorneys general from California, Connecticut, Delaware, Washington, D.C., Illinois, Iowa and Mississippi also filed or will file civil fraud lawsuits against S&P alleging similar misconduct in the rating of structured financial products. Additional state attorneys general are expected to make similar filings.
Issues related to credit ratings and the quality of asset-backed securities led lawmakers to enact numerous reforms under the Dodd-Frank Act.
Section 932 of the Dodd-Frank Act requires ratings agencies to have an effective internal control structure governing the way in which the agencies determine credit ratings. Dodd-Frank also requires each ratings agency to submit an annual report to the Securities and Exchange Commission (SEC) about its internal controls. The SEC in May 2011 proposed rules to implement these Dodd-Frank requirements.
Dodd-Frank
Section 939 requires federal agencies to remove references to credit ratings from their regulations and adopt alternative standards of creditworthiness. To ensure the quality of asset-backed securities,
Section 941 of the Dodd-Frank Act generally requires securitizers to retain at least 5 percent of the credit risk in any asset-backed security.