The U.S. government is accusing Standard & Poor's of defrauding investors and causing them billions of dollars in losses in one of the most ambitious cases yet from the Justice Department over conduct tied to the 2007-2009 financial crisis.
The government said S&P consistently defrauded investors by saying its ratings were independent and not clouded by conflicts of interest, even though the firm's analysts disregarded risks posed by mortgage securities in order to gain business from the investment banks that issued them.
The 119-page lawsuit, filed late Monday in federal court in Los Angeles, is the first from the government against a ratings agency. The agencies have generally shielded themselves from liability by citing First Amendment protection.
No individuals were charged in the lawsuit, and it was not immediately clear why the government focused on S&P instead of rivals Moody's Corp or Fimalac SA's Fitch Ratings, who were also major raters of such securities.
S&P issued a statement on Tuesday saying the lawsuit is meritless and that it will vigorously defend itself. On Tuesday shares of S&P's owner McGraw-Hill fell more than 7 percent, extending Monday's decline.
Floyd Abrams, a lawyer for S&P, predicted the government may have a difficult time proving that S&P intentionally mismarked its own ratings. He also noted that S&P's opinion on mortgage-related products were not that far from major U.S. policymakers who did not foresee the depth of the financial crisis.
"There was no fraud," Abrams said on CNBC Tuesday morning. "The ratings that were issued were believed by the people who issued them. And that's what the government has got to disprove."
Between September 2004 and October 2007, as stress in the housing market was starting to emerge, S&P delayed updates to its ratings criteria and analytical models, which weakened its criteria beyond what analysts believed was needed to make them more accurate, the Justice Department said.
In that time frame, according to the complaint, S&P issued credit ratings on $2.8 trillion worth of mortgage securities and some $1.2 trillion in related structured products.
It charged up to $750,000 per deal it rated, which meant that S&P viewed the investment banks that issued the securities as its main customers, according to the complaint.
In August 2004, the head of S&P's commercial mortgage-backed securities sent an email to her colleagues and said they planned to meet to discuss adjusting criteria "because of the ongoing threat of losing deals."
Earlier in May, an analyst wrote, "We just lost a huge Mizuho RMBS deal to Moody's due to a huge difference in the required credit support level...our support level was at least 10% higher than Moody's," the complaint said.
S&P had planned in 2004 to update its model for rating mortgage securities by including a broader data set of past loans, which would provide more accurate comparisons for the more risky loans that were being packaged.
In 2006, S&P loosened assumptions on its ratings of collateralized debt obligations, which one of the firm's analysts described as creating a loophole big enough to drive a Mack truck through.
Between March and October of 2007, S&P knew the credit risks of certain non-prime deals were increasing, but disregarded those risks in rating related securities, the U.S. said.
OLD LAW, NEW TWIST
The lawsuit was brought under FIRREA, the Financial Institutions Reform, Recovery, and Enforcement Act, a federal civil fraud statute passed in the wake of the 1980s savings-and-loan scandals. It covers fraud affecting federally insured financial institutions.
While it has only appeared in a few dozen cases, its low burden of proof, broad investigative powers and long statute of limitations encouraged the Justice Department to dust it off for potential cases, especially after criminal inquiries failed to yield major prosecutions.
In its complaint against S&P, the Justice Department accused S&P of defrauding Western Federal Corporate Credit Union, and other institutions who purchased certain securities based on the high ratings by S&P.
Some credit unions are required by law to rely on credit ratings issued by firms that included S&P in making its investment decisions, the complaint said.
(Reporting By Aruna Viswanatha; Editing by Karey Wutkowski and Andrew Hay)