S&P Lawsuit Portrays CDO Sellers as Duped Victims
The U.S. Justice Department made some peculiar allegations in its lawsuit this week against S&P and its parent, McGraw-Hill Cos. According to the government, Citigroup was defrauded by S&P credit ratings on subprime mortgage bonds that Citigroup itself created and sold. Bank of America, too, allegedly was defrauded by S&P in the same way.
If this doesn’t make sense, that’s the point. The notion is far-fetched. No wonder S&P wouldn’t agree to a settlement and told the government to see it in court.
Here’s the gist. Near the end of its 119-page complaint, the Justice Department listed about two-dozen collateralized- debt obligations issued in 2007 as examples where S&P allegedly defrauded banks and credit unions. It was important that the Justice Department be able to identify such lenders as investors, because it’s suing S&P under a 1989 statute that covers frauds against federally insured financial institutions.
Under the government’s theory, Citigroup and Bank of America paid S&P for ratings that convinced the banks their own CDO offal was rock-solid. And because S&P deceived them into thinking the best of their own rubbish, these banks and other lenders suffered more than $5 billion of investment losses, according to the suit.
For nine of the CDOs, the government’s complaint listed Citigroup as the harmed investor -- without mentioning that Citigroup’s investment-banking division had managed the bonds’ offerings. The complaint identified Bank of America as the defrauded CDO investor in two instances, also without mentioning that its securities unit underwrote those bonds.
It’s a novel concept. If only S&P had given honest opinions to Citigroup and Bank of America -- which were paying S&P millions of dollars for ratings -- then the banks would have realized they were buying ticking time bombs from themselves. And who knows? Maybe they could have found some other hapless chumps to immolate instead, if S&P had told them in time.
One of the CDOs was a $502 million deal called Plettenberg Bay. The government’s suit said S&P rated $436 million of the debt AAA, its highest mark, and that “Citibank suffered an almost total loss of its investment” after buying $8 million of the CDO’s lower-rated tranches. The suit didn’t mention that Citigroup was the CDO’s underwriter, or that other Plettenberg Bay investors are suing the bank over their losses.
Under the government’s version of the facts, S&P’s fraud caused the banks’ losses, and Citigroup and Bank of America were victims. I would hate to be a government attorney who has to stand in front of a jury and try to make that argument.
I asked Justice Department officials to explain how the underwriter of a CDO could be defrauded by an S&P rating on the CDO it underwrote. (The bank that sold the CDO should know more about it than S&P does.) Here’s the response:
“Some of the federally insured financial institutions whose losses are identified in the government’s complaint had operations involving the securitization of mortgages or other types of collateral,” said Charles Miller, a Justice Department spokesman. “This involvement does not prevent the United States from seeking to recover civil penalties relating to these federally insured financial institutions.”
So one unit of Citigroup can lose money on fraudulently rated bonds that were concocted by another part of Citigroup, and the government can sue the rating company for penalties -- as if S&P’s opinions actually mattered to Citigroup’s divisions when they were buying and selling the dreck to each other.
In real life, it probably will be hard to convince anyone that S&P deceived Citigroup or Bank of America about the safety of their own monstrous creations. S&P’s ratings duped lots of investors, for sure -- but these investors? Come on. It’s almost like the feds are suing on the banks’ behalf.
A Citigroup spokeswoman, Shannon Bell, declined to comment when asked if the bank believed it had been defrauded by S&P. I put the same question to a Bank of America spokesman, Jerry Dubrowski. He, too, declined to comment.
There are other CDO investors cited in this week’s complaint, including M&T Bank Corp., that didn’t underwrite the S&P-rated bonds on which they lost money. Maybe the government’s claims over their losses will stick, even if the allegations related to Citigroup and Bank of America don’t.
Perhaps the Justice Department deserves credit for at least trying to hold one of the major credit-rating companies accountable for helping cause the financial crisis. That could be a step forward after years of inaction. During a news conference this week, Attorney General Eric Holder said his agency’s investigation of S&P began in November 2009 -- more than two years after it became obvious that Moody’s Corp. and S&P’s mortgage-bond ratings were worthless.
It would have been far better if the Justice Department’s case didn’t have its own glaring credibility problem.
(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)
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