Rating Victims Didn’t Know S&P’s Toxic AAA Born of Greed

When Charles O. Prince III was chief executive officer of Citigroup Inc. from 2003 to 2007, he didn’t know about a surge in mortgage risk that his own investment bankers loaded on to its bank’s books.

Because such debt carried top credit ratings from firms such as Standard & Poor’s, few financial executives paid attention to the potential dangers.

“If someone had elevated to my level that we were putting, on a $2 trillion balance sheet, $40 billion of AAA rated, zero risk paper, that would not in any way have excited my attention,” Prince told the Financial Crisis Inquiry Commission, according to a transcript of his testimony released in 2011.

Mortgage securities granted top grades started souring in 2007, leading to ballooning losses. Citigroup required a $45 billion federal rescue, the largest of the bank bailouts that put taxpayer money at risk. The Justice Department sued New York-based S&P and parent McGraw-Hill Cos. last week over the damage caused by the practices allegedly behind the inflated rankings that contributed to the biggest financial crisis since the Great Depression.

Some of the biggest losers were banks, including Citigroup and Bank of America Corp., which created and purchased collateralized debt obligations. Many of these investments—created by packaging mortgage-backed bonds, derivatives and other CDOs and dividing them into new securities with varying degrees of risk—imploded within a year after they were sold, even though they had pristine credit ratings.

Smaller financial institutions were also ruined by mortgage-backed debt. Western Federal Corporate Credit Union failed after its executives employed an improperly “aggressive investment strategy” that had no limits on highly rated mortgage bonds, according to a regulatory report on its collapse.

Even Warren Buffett was affected. The Justice Department case identified Buffalo, N.Y.-based M&T Bank Corp., whose shareholders include Buffett’s Berkshire Hathaway Inc., as one of the buyers of failed CDOs. Berkshire of Omaha is also the biggest shareholder of Moody’s Corp., owner of the second-largest ratings firm after S&P.

The world’s leading financial institutions suffered more than $2.1 trillion of writedowns and losses after soaring U.S. mortgage defaults caused the credit crunch.

In the complaint filed Feb. 4 in U.S. District Court in Los Angeles, the Justice Department is invoking a law created in response to the savings-and-loan crisis of the 1980s that was designed to offer easier victories when damage has been done to institutions with federally insured deposits.

Success is “far from clear,” Jeffrey Manns, an associate professor at George Washington University Law School, said Feb. 7 in a telephone interview. S&P may argue it believed in its ratings or the statute doesn’t apply to the case.

“We start with proposition that we deny there was any fraud,” Floyd Abrams, the Cahill Gordon & Reindel LLP lawyer for S&P who represented the New York Times in the 1971 Pentagon Papers case, said in a telephone interview on Feb. 7. Fraud claims have “a high burden of proof,” he said.

Ed Sweeney, a spokesman at S&P, declined further comment.

McGraw-Hill’s market capitalization, which reached a five-year high of $16.2 billion at the start of the month, has plunged since the company said it anticipated the lawsuit would be filed, reaching $11.9 billion at the end of last week.

The company’s stock price declined 27% in the five-day period ended Feb. 8 to $42.67, the biggest weekly drop in data compiled by Bloomberg going back to August 1980. The yield on its 2017 bonds leapt 69 basis points to 2.69%. The cost of insuring its debt against nonpayment through five-year credit-default swaps jumped 135 basis points to 225.5 basis points, according to data provider CMA. McGraw-Hill owns CMA, which compiles prices quoted by dealers in the private market.

Citigroup underwrote at least eight of the 12 CDOs from 2007 named in the government’s complaint for which it’s listed as a victim. That included Bonifacius, an issue among the last of its type named for a general called the “last of the Romans” by historian Edward Gibbon because he fought and died for a fading empire.

Prince, who was forced out over New York-based Citigroup’s mortgage losses, didn’t return an email last week.

Bank of America, the second-largest U.S. lender by assets, hired S&P to grade two of the three CDOs for which it’s named as a victim, including one overseen by Bear Stearns Cos.’s Ralph Cioffi, the manager of two hedge funds whose collapse in June 2007 signaled the end of the boom in mortgage-tied CDOs. Bear Stearns collapsed in 2008 and was bought by JPMorgan Chase & Co., the largest U.S. bank, with assistance from the Federal Reserve.

Underwriters of CDOs typically signed off on the contents of the deals and the nature of disclosures regarding their risk. Pressure from such firms pushed S&P to weaken its standards and to put off changes in ratings methods that could have made it tougher to receive top rankings, the Justice Department said.

Even though the Justice Department lawsuit relies on examples where the same banks sold and bought their own toxic securities, saying they were harmed by S&P “isn’t a totally ridiculous assertion,” said Bert Ely, an Alexandria, Va.-based bank consultant.

“One of the things you’ve got to realize about large financial institutions is that they’re big organizations, they’ve got lots of different departments,” he said in a telephone interview. “So the left thumb doesn’t know what the right finger is doing, much less the right big toe.”

While no bank or regulator should have had a “blind reliance on ratings,” the correct, lower grades might have prevented risks from building, Thomas Stanton, a former senior staff member at the financial crisis commission, or FCIC, said Feb. 7 in a telephone interview.

“If we were in an era where rating agencies were simply incompetent and the investors failed to do due diligence, that’s one thing,” said Stanton, a Washington attorney and fellow at Johns Hopkins University’s Center for the Study of American Government. “But what seems to be coming out is a potentially higher level of culpability at S&P.”