McGraw-Hill and its Standard & Poor's unit were sued by the U.S. over claims S&P knowingly understated the credit risks of bonds and derivatives that were central to the worst financial crisis since the Great Depression.
The U.S. Justice Department filed a complaint Monday in Los Angeles, accusing McGraw-Hill and S&P of three types of fraud, the first federal case against a ratings company for grades related to the credit crisis. McGraw-Hill tumbled the most in 25 years yesterday when it said it expected the lawsuit.
S&P issued credit ratings on more than $2.8 trillion of residential mortgage-backed securities and about $1.2 trillion of collateralized-debt obligations from September 2004 through October 2007, according to the complaint. S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them, the U.S. said.
"It's going to be a tricky time for rating agencies," Fred Ponzo, a capital markets analyst at Greyspark Partners, said in a telephone interview. "S&P is probably just the first to face the music."
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the U.S. seeks civil penalties of as much as $1.1 million for each violation.
Settlement talks broke down after the government sought a fine of more than $1 billion and an admission of wrongdoing from S&P, The New York Times reported. That amount would wipe out the profits of McGraw-Hill for an entire year, the newspaper said.
Before the case was filed, McGraw-Hill fell 14% to $50.30 in New York trading on Monday. Moody's Corp., owner of the second-largest ratings provider, fell 11% Monday to $49.45. Yields on McGraw-Hill's $400 million of bonds due November 2037 rose 31 basis points yesterday to 5.75%, the highest level since May, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Ratings firms have faced criticism from U.S. lawmakers over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading to a credit seizure, starting in 2007, that sent the world's largest economy into its longest recession since 1933 as defaults soared and home values plummeted.
"S&P's desire for increased revenue and market share in the RMBS and CDO ratings markets led S&P to downplay and disregard the true extent of the credit risks," the U.S. said.
According to the U.S. complaint, S&P falsely represented to investors that its credit ratings were objective, independent and uninfluenced by any conflicts of interests.
The company bent rating models to suit its business needs to the extent that one CDO analyst commented that loosening the measure of default risk for a certain security in 2006 "resulted in a loophole in S&P's rating model big enough to drive a Mack truck through," the U.S. said.
Banks create collateralized debt obligations by bundling bonds or loans into securities of varying risk and return. They pay ratings companies for the grades, which investors may use to meet regulatory requirements.
"A DOJ lawsuit would be entirely without factual or legal merit," S&P said in a statement yesterday before the case was filed. "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."
S&P, in its statement, cited court rulings that have dismissed challenges to the opinions of ratings firms. The company also said it planned to fight any lawsuits.
Catherine Mathis, a spokeswoman for S&P, had no immediate comment on the complaint after it was filed.
Analysts at New York-based S&P, Moody's Investors Service and Fitch Ratings, majority-owned by Fimalac of Paris, were pressured to give their stamp of approval to complex investments in a "race to the bottom" to win lucrative business from Wall Street banks, the U.S. Senate Permanent Subcommittee on Investigations said in an April 2011 report.
The Justice Department cites emails from S&P employees discussing the need to modify ratings criteria to win business after the company's grades were more conservative than competitors.
"Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact on future deals," one analyst said in a May 2004 email cited in the lawsuit. "There's no way we can get back on this one but we need to address this now in preparation for future deals."
The credit-grading business was targeted by lawmakers in the 2010 Dodd-Frank Act after the collapse of top-ranked mortgage-backed securities contributed to $2.1 trillion in losses at the world's largest banks. Reports from the Senate panel, along with the Financial Crisis Inquiry Commission, cited failures of the companies as a reason for the financial crisis.
While the 18-month recession ended in June 2009, with the global economy contracting 2.4% that year, the U.S. has yet to recover 3.23 million of the 8.74 million jobs that were lost. The unemployment rate last month was 7.9%, compared with 5% in January 2008.
More than a dozen state attorneys general may join the federal lawsuit and New York officials are preparing a separate action, The New York Times said.
Attorneys general from at least two U.S. states have filed claims against S&P challenging its method of rating mortgage-backed securities.
Illinois Attorney General Lisa Madigan accused the ratings firm of putting profitability before accuracy.
"S&P ignored the increasing risks posed by mortgage-backed securities, instead giving the investment pools ratings that were favorable to its investment bank client base," Madigan said in a January 2012 statement announcing the filing.
In a Nov. 7 decision, Cook County, Illinois, Circuit Court Judge Mary Anne Mason rejected defense arguments that ratings firms' opinions were protected by constitutional guarantees of free speech. A status conference is scheduled for March 26.
In 2009, then-Ohio Attorney General Richard Cordray sued S&P, Moody's and Fitch at the U.S. court in Columbus, accusing the firms of issuing faulty ratings that caused five public employee pension funds, on whose behalf he sued, to buy money-losing investments.
U.S. District Judge James L. Graham threw out the case in September 2011, ruling the ratings were "predictive opinions" and that absent specific allegations of intent to defraud, the firms could not be held liable.
A Cincinnati-based federal appeals court unanimously upheld that decision in December.
Cordray was appointed by President Obama in January 2012 as director of the federal Consumer Financial Protection Bureau.
In November, an Australian judge ruled S&P misled investors by giving its highest credit grade to securities whose value plunged during the global financial crisis.
The companies also face European Union curbs on how they update markets about the quality of government debt under plans approved by the bloc's lawmakers last month. Some governments in the EU, including France and Germany, have called for tougher rules on ratings companies, saying their decisions risk harming the bloc's fight against its fiscal crisis.