LITTLE ROCK — The federal government has started one of its most ambitious efforts to assign blame for the financial crisis, going after Wall Street’s biggest credit-rating firm by claiming it had a role in pumping up the housing bubble.
The Justice Department filed a lawsuit late Monday in Los Angeles federal courtagainst Standard & Poor’s Corp. The suit accuses the company’s analysts of issuing glowing reviews on troubled mortgage securities whose subsequent failure helped cause the worst financial crisis since the Great Depression.
The credit-rating firm gave high marks to mortgagebacked securities because it wanted to earn more business from the banks that issued the investments, theJustice Department alleges in a civil complaint.
The case is the government’s first major action against one of the credit-rating agencies that stamped their approval on Wall Street’s soon-to-implode mortgage bundles. It marks a milestone for the Justice Department, which has faced criticism for failing to act aggressively against the companies that are accused of contributingto the crisis.
Standard & Poor’s, a unit of New York-based McGraw-Hill Cos., called the lawsuit “meritless.”
“Hindsight is no basis to take legal action against the good-faith opinions of professionals,” the company said in a statement. “Claims that we deliberately kept ratings high when we knew they should be lower are simply not true.”
According to the lawsuit, Standard & Poor’s knew that home prices were falling and that borrowers were having trouble repaying loans. Yet these realities weren’t reflected in the safe ratings Standard & Poor’s gave to complex real-estate investments known as mortgage-backed securities and collateralized debt obligations.
At least one Standard & Poor’s executive who had raised concerns about the company’s proposed methods for rating investments was ignored.
Standard & Poor’s executives expressed concern that lowering the ratings on some investments would anger the clients selling these investments and drive new business to rivals, the government claims.
“Put simply, this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis,” Attorney General Eric Holder said at a news conference Tuesday.
Holder called the case “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.”
Joining the Justice Department in the announcement were attorneys general from California, Connecticut, Delaware, the District of Columbia, Illinois, Iowa and Mississippi, who have filed or will file separate, similar civil-fraud lawsuits against Standard & Poor’s.
On Tuesday, Arkansas Attorney General Dustin Mc-Daniel filed a lawsuit in Pulaski County Circuit Court against McGraw-Hill and Standard & Poor’s claiming “unconscionable, deceptive, and illegal business practice of systematically and intentionally misrepresenting that its analysis of structured finance securities was objective, independent and not influenced by either S&P’s or its clients’ financial interests. These representations were untrue and S&P knew they were untrue.”
More states are expected to sue, the Justice Department said.
Rating agencies are widely blamed for contributing to the financial crisis that caused the deepest recession since the Great Depression. They gave high ratings to pools of mortgages and other debt assembled by big banks and hedge funds. Their ratings gave even risk-averse investors the confidence to buy them.
Some investors, including pension funds, can buy only investments with high ratings. In effect, Standard & Poor’s is charged with greasing the assembly line that allowed banks to package and sell risky mortgages that generated huge profits.
When the housing market collapsed in 2007, the agencies acknowledged that mortgages issued during the bubble were far less safe than the ratings had indicated. They lowered the ratings on nearly $2 trillion worth, spreading panic that spiraled into a crisis.
In its statement Tuesday, Standard & Poor’s said its ratings “reflected our current best judgments” and noted that other rating agencies gave the same high ratings. It said the government also failed to predict the subprime mortgage crisis.
But the government claims the company delayed updating its ratings models, rushedthrough the ratings process and kept giving high ratings even after it knew the subprime market was flailing.
The complaint includes emails and other evidence that Standard & Poor’s analysts saw the market’s problems early:
In 2007, an analyst who was reviewing mortgage bundles forwarded a video of himself singing and dancing to a song written to the tune of “Burning Down the House”: “Going - all the way down, with/Subprime mortgages.” The video showed colleagues laughing at his performance.
A PowerPoint presentation that year said being “business friendly” was a core component of S&P’s ratings model.
In a 2004 document, executives said they would poll investors as part of the process for choosing a rating. One executive asked, “Does this mean we are to review our proposed criteria changes with investors, issuers and investment bankers? ... (W)e NEVER poll them as to content or acceptability!” The executive’s concerns were ignored, the government said.
Also that year, an analyst complained that Standard & Poor’s had lost a deal because its standards for a rating were stricter than Moody’s. “We need to address this now in preparation for the future deals,” the analyst wrote.
Standard & Poor’s countered that the e-mails were “cherry picked,” that they were “taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business.”
The lawsuit comes just 18 months after Standard & Poor’s cut its rating on longterm U.S. government debt by a notch. The downgrade occurred after a contentious debate between the White House and Congress over the raising of the government’s borrowing limit that was resolved at the last hour.
Holder was asked about a possible link between the lawsuit and the downgrade.
“There’s no connection,” said Holder, who added the department’s investigation began in 2009.
Federal Reserve policy makers including Chairman Ben Bernanke voiced alarm in August 2007 over a loss of investor confidence in ratings companies, warning that the declining credibility could worsen market turmoil.
The government’s case sides with critics of rating agencies who argue that the agencies suffer from a conflict of interest. Because they’re paid by the banks that create investments they’re rating, the agencies had to compete for banks’ business. If one firm appeared too strict, banks could shop around for a better rating.
Standard & Poor’s typically charged $150,000 for rating a subprime mortgagebacked security and $750,000 for certain other securities. If the firm lost the business to Fitch or Moody’s, its main competitors, the analyst who issued the rating would have to submit a “lost deal” memo explaining why he or she lost the business.
The government charged Standard & Poor’s under a law intended to make sure banks invest safely. If Standard & Poor’s is found to have committed civil violations, it could face not only fines but also limits on how it does business. There are no criminal charges, which would require a higher burden of proof.
McGraw-Hill shares dropped $5.38, or 5.4 percent, to close at $44.92 after plunging nearly 14 percent on Monday after the lawsuit was first reported.
Information for this article was contributed by Alejandro Lazo and Andrew Tangel of the Los Angeles Times, Daniel Wagner and Christina Rexrode of The Associated Press and Joshua Zumbrun and Jeff Kearns of Bloomberg News.
Front Section, Pages 1 on 02/06/2013