SEC’s Notice to S&P May Signal Enforcement Cases Against Raters

Four years after defaults on U.S. home loans began to soar, regulators may be crafting their first case against a credit-rating firm for deeming mortgage-backed securities safe investments for pension funds and endowments.

Standard & Poor’s, the world’s largest provider of credit ratings, could face claims by the Securities and Exchange Commission related to the top grade it gave in 2007 to a $1.6 billion collateralized debt obligation that was downgraded six months later, McGraw-Hill Cos., S&P’s parent company, said in a regulatory filing yesterday.

“This was long overdue. They should have done this in 2007,” said Sylvain Raynes, a principal at R&R Consulting in New York and a former analyst at Moody’s Investors Service. “It’s not just a fishing expedition. They’re very serious about shaking up the ratings world and putting everyone else on notice.”

Credit-rating firms including S&P, Moody’s Corp. and Fitch Ratings Ltd. have come under fire from lawmakers and investors for failing to identify risks in the run-up to the financial crisis. While regulators have stepped up oversight of the firms and their processes for rating securities, they have yet to mete out sanctions.

The weakness in the subprime market was apparent by 2007, said Gene Phillips, a director at New York-based consulting firm PF2 Securities Evaluations Inc. “Everybody knew the game was over well before then,” he said. “Banks were actively trying to get deals done to clean up their balance sheets.”

‘Striking Example’

In the S&P matter, the SEC may seek penalties including disgorgement of fees related to Delphinus CDO 2007-1, a deal highlighted in a U.S. Senate panel’s report as a “striking example” of how ratings firms failed. S&P, Moody’s and Fitch all rated the CDO.

S&P rated six tranches of Delphinus AAA in August 2007 and began downgrading the securities by the end of the year, according to the U.S. Senate Permanent Subcommittee on Investigations report released in April. By the end of 2008, they were rated as junk, according to the report.

The SEC has previously sanctioned others involved in the mortgage securitization stream, from loan originators to the banks who bundled them into securities for sale to investors. The SEC last year said Moody’s violated its own procedures in declining to correct errors in ratings on constant proportion debt obligations out of concern that doing so would negatively impact the firm. The SEC declined to sue Moody’s, citing uncertainty about jurisdiction over the conduct, which had occurred in Europe.

Levin Report

CDOs are pools of assets such as mortgage bonds packaged into new securities in which interest payments on the underlying bonds or loans are used to pay investors.

In e-mails released by the Senate investigations panel led by Michigan Democrat Carl Levin, some S&P analysts questioned whether the Delphinus bonds deserved top grades. The analysts said the securities backing the deal were different from what bankers had described, according to the report.

“Um ... looks like the remaining portion is actually all sub-prime,” S&P analyst Lois Cheng wrote.

“Do you want to address this with them, or let it go?” Lauren Sprinkle, another S&P analyst, replied. “Hey, let the higher ups handle this,” Shannon Mooney, another analyst, wrote, according to the e-mails.

The e-mails also signaled that S&P employees were aware that a technicality had allowed Delphinus to skirt new rules at S&P that would have negatively affected its rating. The rules, which took effect a day before the Delphinus deal closed, were aimed at making such ratings more conservative, reflecting the firm’s expectation of imminent downgrades of mortgage-linked securities.


Delphinus, like several other CDOs, was created using “dummies,” indicative securities used as placeholders, according to the e-mails. S&P had rated Delphinus based on the dummies rather than the actual securities, which weren’t acquired until the deal closed. A rating based on the actual securities would have been notched lower under S&P’s new protocol, according to the e-mails. The analysts later discussed whether the new rules should have applied to Delphinus, the e-mails show.

Cheng, reached at her office at S&P, declined to comment. Sprinkle referred questions to Sweeney, the S&P spokesman.

Fitch, a unit of Paris-based Fimalac SA, hasn’t received a Wells notice regarding the Delphinus CDO or any other, said Daniel Noonan, a spokesman for the company. Moody’s also hasn’t received a notice about the deal, said Michael Adler, a spokesman for the New York-based rater.

Magnetar Trade

About three-quarters of Delphinus, which was underwritten by Mizuho Financial Group Inc. and managed by Delaware Asset Advisors, was based on subprime mortgages, according to a Fitch Ratings Ltd. report. Magnetar Capital Partners LLC invested in the deal, according to a report by ProPublica, a nonprofit investigative organization. Steven Lipin, a spokesman for Magnetar, didn’t return a call seeking comment.

Mizuho, Japan’s third-biggest lender by market value, stepped up its activity in U.S. mortgage-backed securities in late 2006 and 2007, just as the housing market began its steep decline. As defaults on subprime home loans climbed, Mizuho struggled to find buyers for its CDOs and, as their values plummeted, had to absorb losses.

Alexander Rekeda, who worked on the deal for Mizuho and now works for Guggenheim Securities in New York, didn’t respond to a phone call and an e-mail seeking comment.

S&P ‘Cooperating’

Masako Shiono, a spokeswoman for Tokyo-based Mizuho, didn’t return an e-mail seeking comment sent outside regular business hours in Japan.

A Wells notice is neither a formal allegation nor a finding of wrongdoing, McGraw-Hill said in its statement. S&P has been cooperating with the SEC in the matter and intends to continue to do so, according to the statement. SEC spokesman John Nester declined to comment.

S&P has successfully defended itself from investor lawsuits since the financial crisis by arguing that ratings are opinions, protected by the right to free speech, and that any mistakes were inadvertent, said Jeffrey Manns, a professor of law at George Washington University.

“They’ve won every lawsuit anybody has thrown at them and they’ve managed to answer every question the SEC has asked in the past,” said Edward Atorino, an analyst who follows McGraw-Hill at Benchmark Co. in New York.

Terry McGraw, the chief executive officer of S&P’s parent company, said on a July 28 conference call with analysts that 30 lawsuits against the rater have been dismissed or dropped and that he’s seeing “those dark clouds go away.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE