Why is the Justice Department Really Suing S&P?
Five years after the financial crisis started to pick up steam, U.S. officials are finally bringing legal action against one of the three major credit rating firms. However, the motivation for the lawsuit is questionable to say the least.
The Department of Justice filed a civil lawsuit against Standard & Poor’s, alleging the McGraw-Hill (NYSE:MHP) unit improperly used its rating system to assign grades to mortgage bonds that did not predict the full magnitude of the housing downturn and nearly caused a meltdown of the global financial system. It would be the first federal enforcement action against a credit rating firm over the crisis and several states are likely to join the lawsuit.
For several years, the major rating agencies have been considered a prime suspect in the credit bubble, considering the firms essentially awarded junk bonds triple-A status and collected large fees in the process. The high ratings also paved the way for Wall Street to indulge itself on mortgage-backed securitization. According to unnamed sources, the Justice Department is seeking a 10-figure plus settlement and the admission of wrongdoing from Standard & Poor’s. In a statement on Tuesday, Attorney General Eric Holder said the U.S. is seeking as much as $5 billion in penalties. “This alleged conduct is egregious – and goes to the very heart of the recent financial crisis,” he said.
Naturally, the firm said it will vigorously defend itself against these erroneous claims…
S&P explains in a statement, “A DOJ lawsuit would be entirely without factual or legal merit. 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 – and that every CDO that DOJ has cited to us also independently received the same rating from another rating agency. S&P deeply regrets that our CDO ratings failed to fully anticipate the rapidly deteriorating conditions in the U.S. mortgage market during that tumultuous time. However, we did take extensive rating actions in 2007 – ahead of other ratings agencies – on the residential mortgage-backed securities (“RMBS”) which were included in these CDOs.”
Interestingly, S&P makes a noteworthy point. How can the DOJ sue S&P when the government itself, from New York Fed President at the time Timothy Geithner and current Federal Reserve Chairman Ben Bernanke, completely glossed over the housing bubble? Additionally, if S&P faces a lawsuit over its ratings, the two other major rating agencies, Moody’s (NYSE:MCO) and Fitch, should also warrant attention, but nothing has surfaced so far.
While the exact motivations of the DOJ are unknown, it is hard to ignore the fact that S&P was the only major agency firm to downgrade the United States’ credit rating…
Due to the political turmoil in Washington D.C. and the fiscal condition of the nation, S&P downgraded America to AA+ from AAA in August 2011. It also said the outlook was negative and that it could lower the long-term rating to AA within the next two years if “we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.”
Adding fuel to the questionable-motivation fire, the U.S. Securities and Exchange Commission banned small credit-rating agency Egan-Jones last month from grading government debt and asset-backed securities for 18 months. The action was part of an agreement to settle charges that Egan-Jones filed inaccurate documents with the regulator in 2008.
Much like S&P, Egan-Jones does not have the friendliest relationship with U.S. officials. Just weeks before S&P downgraded America’s credit rating, Egan-Jones was the first nationally recognized statistical rating organization to cut the nation’s credit rating from AAA to AA+. Last year, the firm cut the rating two more times, with the most recent downgrade coming one day after the Federal Reserve launched QE3 in September.
The announcement wreaked havoc on shareholders. McGraw-Hill shares closed nearly 14 percent lower on Monday, representing its worst single-day performance since Black Monday in 1987. Although it was not named in the lawsuit, shares of Moody’s dropped 10.7 percent. The declines carried over into Tuesday, as McGraw-Hill sank nearly 11 percent, while Moody’s declined 8.8 percent.
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