Standard & Poor’s to face civil charges

The Justice Department is expected to file civil charges later this week against Standard & Poor’s. The lawsuit accuses the ratings agency of bad calls on mortgage bonds contributing to the financial crisis.

Here are some of the details from the New York Times:

The Justice Department, along with state prosecutors, plans to file civil charges against Standard & Poor’s Ratings Service, accusing the firm of fraudulently rating mortgage bonds that led to the financial crisis, people briefed on the plan said Monday.

A suit against S.&P. — expected to filed this week — would be the first the government has brought against the credit ratings agencies related to the financial crisis, despite continued questions about the agencies’ conflicts of interest and role in creating a housing bubble.

Several state prosecutors are expected to join the federal suit. The New York State attorney general is conducting a separate investigation, an official in that office said. The official declined to say whether New York State’s action involved other ratings agencies besides Standard & Poor’s.

Up until last week, the Justice Department had been in settlement talks with S.&P., these people said. But the negotiations broke down after the Justice Department said it would seek a settlement in excess of “10 figures,” or at least $1 billion, these people said. Such an amount would wipe out the profits of S.&P.’s parent, the McGraw-Hill Company, for an entire year. McGraw-Hill earned $911 million last year.

The Wall Street Journal has a similar focus at the top of its story, but did place the S&P response to the lawsuit up higher. Here’s what they said:

Standard & Poor’s dismissed the potential Justice Department lawsuit as “entirely without factual or legal merit.”

“A DOJ lawsuit would be entirely without factual or legal merit,” the ratings firm said in a statement. “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—and that every (collateralized debt obligation) that DOJ has cited to us also independently received the same rating from another rating agency.

“S&P deeply regrets that our CDO ratings failed to fully anticipate the rapidly deteriorating conditions in the U.S. mortgage market during that tumultuous time. However, we did take extensive rating actions in 2007—ahead of other ratings agencies—on the residential mortgage-backed securities, which were included in these CDOs. As a result of these actions, more collateral or other protection was required to support AAA ratings on CDOs.”

Many details of the looming enforcement action couldn’t be immediately determined, such as why prosecutors are zeroing in on S&P rather than rivals Moody’s Corp. and Fitch Ratings, a unit of Fimalac SA and Hearst Corp.

Reuters had this bit of content about the situation:

S&P, Moody’s and Fitch have long faced criticism from investors, politicians and regulators for assigning high ratings to thousands of subprime and other mortgage securities that quickly turned sour.

The rating agencies are paid by issuers for ratings, a standard industry practice that has nonetheless raised concern about potential conflicts of interest.

In January 2011, the Financial Crisis Inquiry Commission called the agencies “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.”

McGraw-Hill had acknowledged last July that the Justice Department and SEC were probing potential violations by S&P tied to its ratings of structured products, and that it was in talks to try to avert a lawsuit.

The Journal story was quick to point out its own reporting on the subject. It’s a good explanation of some of the problems.

The Wall Street Journal has reported that former S&P analysts were questioned by U.S. prosecutors in 2010 and 2011 as part of the sweeping probe. Former analysts told the Journal that the investigation focused on whether S&P managers ignored the firm’s own standards when assessing mortgage-backed securities in order to cater to investment banks.

Investment banks paid S&P to issue ratings on mortgage bonds created by the banks and then sold to investors. The “issuer pays” model is standard practice in the credit-rating industry.

Justice Department officials told the former S&P analysts that they weren’t targets of the inquiry, the Journal reported. U.S. officials presented former employees with dozens of S&P emails and documents from as early as 2004, asking for details about the correspondence, the former analysts have said.

The looming enforcement action could force a showdown over the primary defense used by S&P and other rating firms in civil lawsuits filed by mortgage-bond investors who claim they were misled by the firms’ ratings.

It will be interesting to see if the suit will prompt other ratings agencies to settle or if it will recoup anything for the government or investors.