McGraw-Hill Cos and its Standard & Poor’s unit have been sued by the US over claims S&P knowingly understated the credit risks of bonds and derivatives that were central to the worst financial crisis since the Great Depression.
The US Department of Justice (DOJ) filed a complaint on Monday in Los Angeles, accusing McGraw-Hill and S&P of three types of fraud.
McGraw-Hill shares tumbled the most in 25 years on Monday when it said it expected the lawsuit, the first federal case against a ratings company for grades related to the credit crisis.
S&P issued credit ratings on more than US$2.8 trillion of residential mortgage-backed securities and about US$1.2 trillion of collateralized-debt obligations from September 2004 through October 2007, according to the complaint. S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them, the US said.
“It’s a new use of this statute,” Claire Hill, a law professor at the University of Minnesota who has written about the ratings firms, said in a telephone interview from Minneapolis. “This is not a line to my knowledge that has been taken before.”
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the US seeks civil penalties of as much as US$1.1 million for each violation.
Settlement talks broke down after the government sought a fine of more than US$1 billion and an admission of wrongdoing from S&P, the New York Times reported. More than a dozen state attorneys-general may join the federal lawsuit and New York officials are preparing a separate action, the newspaper said.
Ratings firms have faced criticism from US lawmakers over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading to a credit seizure, starting in 2007, that sent the world’s largest economy into its longest recession since 1933 as defaults soared and home values plummeted.
“S&P’s desire for increased revenue and market share in the RMBS [residential mortgage-backed securities] and CDO [collateralized debt obligation] ratings markets led S&P to downplay and disregard the true extent of the credit risks,” the US said.
According to the US complaint, S&P falsely represented to investors that its credit ratings were objective, independent and uninfluenced by any conflicts of interests.
The company bent rating models to suit its business needs to the extent that one CDO analyst commented that loosening the measure of default risk for a certain security in 2006 “resulted in a loophole in S&P’s rating model big enough to drive a Mack truck through,” the US said.
Banks create collateralized debt obligations by bundling bonds or loans into securities of varying risk and return. They pay ratings companies for the grades, which investors may use to meet regulatory requirements.
“A DOJ lawsuit would be entirely without factual or legal merit,” S&P said in a statement on Monday before the case was filed.
“It would disregard the central facts that S&P reviewed the same subprime mortgage data as the rest of the market, including U.S. government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained,” the firm said.
S&P, in its statement, cited court rulings that have dismissed challenges to the opinions of ratings firms.