The Department of Justice (DOJ) has released details of the suit it has filed against Standard and Poor's (S&P) Ratings Services and its parent company McGraw Hill.  The lawsuit alleges that investors, many of them federally insured financial institutions, lost billions of dollars on residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDO) for which S&P provided inflated ratings misrepresenting the securities' credit risks. 

DOJ maintains that S&P represented its rates as objective and independent when "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."   DOJ says that S&P weakened those criteria and models from what S&P's own analysts believed was necessary to make them more accurate and 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 suit 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.  Also joining the Department of Justice in making this announcement were the attorneys general from California, Connecticut, Delaware, the District of Columbia, Illinois, Iowa and Mississippi, all of whom have 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 today.

The complaint 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.   

S&P had preemptively issued a press release in anticipation of the court filing denying the allegations.   Its statement was abstracted in MND's earlier story on the suit.

"Put simply, this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis," said Attorney General 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.   It is just the latest example of the critical work that the President's Financial Fraud Enforcement Task Force is making possible."