The U.S. Department of Justice (DOJ) filed suit yesterday against Standard & Poor's and its parent McGraw-Hill Companies over alleged illegal behavior by its ratings division.  While the filing has apparently taken place there are no details yet available from DOJ.  Most news reports are based on a press release from S&P Ratings on Monday afternoon which said it was anticipating the suit.  Both S&P and McGraw Hill stocks dropped precipitously on the news.

The suit apparently seeks civil money penalties from both S&P and McGraw Hill for bond ratings issued by S&P during the period leading up to the financial collapse of the mortgage industry.  According to the New York Times, the suit was filed after talks between the companies and government broke down over a $1 billion settlement demand from DOJ.  Reuters says that both the Attorneys General of New Jersey and Illinois are expected to join in the suit and the Attorney General of New York is pursuing legal action of his own.

This is the first federal enforcement action against a ratings firm and it is unclear why DOJ is targeting S&P and not Moody's or Fitch Ratings which have also been accused of similar misdeeds.  Ratings from the agencies have been presented in numerous civil suits brought against banks by the federal government, especially in reference to loans acquired or guaranteed by Freddie Mac and Fannie Mae.

Ahead of the filing S&P's Rating Services released a statement saying that the expected suit focused on its ratings in 2007 of certain U.S. collateralized debt obligations (CDOs).  The company said the lawsuit would be entirely without factual or legal merit and would disregard the central fact that S&P reviewed the same subprime data as the rest of the market and federal agencies and that every CDO cited by DOJ received the same independent ratings from other  rating agencies. 

The company said it did take extensive rating actions in 2007, ahead of other agencies, on residential mortgage-backed securities (RMBS) included in these CDOs and "As a result of these actions, more collateral or other protection was required to support AAA ratings on CDOs. With 20/20 hindsight, these strong actions proved insufficient but they demonstrate that the DOJ would be wrong in contending that S&P ratings were motivated by commercial considerations and not issued in good faith."

S&P provided numerous other examples of downgrades and other actions it took as problems became apparent and said its analysts "worked diligently to keep up with an unprecedented, rapidly changing and increasingly volatile environment, while acting to ensure changes to their ratings reflected robust analysis and deliberation." 

McGraw-Hill's stock was down 8 percent Tuesday morning on top of a 13.8 percent loss on Monday after the S&P press release.   Shares of Moody's Corp slid 10.7 percent on Monday and another 2 percent so far today.