Feb. 5 (Bloomberg) -- The U.S. is seeking as much as $5 billion in penalties from McGraw-Hill Cos. and its Standard & Poor’s unit as punishment for inflated credit ratings that Attorney General Eric Holder said were central to the worst financial crisis since the Great Depression.
Holder, flanked today in Washington by state attorneys general who also filed suit against the New York-based company, said S&P made false representations, concealed facts and manipulated ratings criteria and credit models for profit.
“This alleged conduct is egregious -- and goes to the very heart of the recent financial crisis,” Holder said.
McGraw-Hill fell 11 percent in New York today, after declining 14 percent yesterday, its biggest tumble in 25 years, when the company said it expected the lawsuit.
S&P rated 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.
The collapse in value of securities that packaged home loans from the riskiest borrowers led 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.
The Justice Department complaint, filed yesterday in Los Angeles, accuses McGraw-Hill and S&P of three types of fraud in the first federal case against a ratings company for grades related to the credit crisis. Attorneys general for 13 states and the District of Columbia filed suits against the company. Three states -- Illinois, Connecticut and Mississippi -- had previously filed suits.
U.S. penalties could amount to more than $5 billion under the law, based on the losses suffered by federally insured financial institutions, according to acting U.S. Associate Attorney General Tony West. The department considered that number “fairly conservative,” he said.
McGraw-Hill, which had net income of $867 million in the past four quarters, denied wrongdoing.
‘Simply Not True’
“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true,” said Catherine Mathis, a company spokeswoman, in an e-mailed statement. “We will vigorously defend S&P against these unwarranted claims.”
“The fact is that S&P’s ratings were based on the same subprime mortgage data available to 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,” she said.
The Justice Department probe, code-named “Alchemy,” began in November 2009. The suit marked the culmination of a “massive, multiyear investigation” by a team of almost two dozen lawyers, said Stuart Delery, principal deputy assistant attorney general.
Over the course of the investigation, the company turned over more than 20 million pages of documents, which included e-mail between the firm’s employees, said a person familiar with the probe, who asked for anonymity to discuss details. The e-mails, along with questions about the models used by the company to rate bonds, have become the basis for the lawsuit.
“It’s going to be a tricky time for rating agencies,” Fred Ponzo, a capital markets analyst at Greyspark Partners in London, said in a telephone interview. “S&P is probably just the first to face the music.”
Fitch Ratings has “no reason to believe” it faces a similar lawsuit, Dan Noonan, a spokesman in New York for the third-largest credit-rating firm, said in an e-mailed statement.
S&P stripped the U.S. of its AAA credit rating on Aug. 5, 2011, and said the world’s biggest economy was no longer the safest of borrowers. The downgrade failed to dissuade investors as dollar-denominated assets have appreciated.
Holder said the downgrade of U.S. debt had “no connection” to the decision to bring the suit against the company. He didn’t rule out a settlement between the government and the company, though he said the case wouldn’t have been brought if he weren’t sure the government would win.
McGraw-Hill fell today to $44.92. Before the case was filed yesterday, McGraw-Hill fell 14 percent to $50.30 in New York trading. Moody’s Corp., owner of the second-largest ratings provider, dropped 8.8 percent to $45.09 after falling 11 percent yesterday. Yields on McGraw-Hill’s $400 million of bonds due November 2037 rose 31 basis points yesterday to 5.75 percent, the highest level since May, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
“They finally got their attention,” said Robert Piliero, a lawyer at Butzel Long in New York who has worked on structured finance litigation. “The fraud that’s alleged is a disconnect from the representations made by S&P about its objectivity and independence and the fact it was neither.”
West, the third-ranked official at the Justice Department, declined to say whether there were similar investigations into the other ratings companies.
“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.
McGraw-Hill’s net income climbed 15 percent to $1.01 billion in 2007, only to decline more than 20 percent the following year.
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.
Analysts at S&P, Moody’s Investors Service and Fitch, half-owned by Fimalac SA of Paris and half owned by Hearst Corp., were pressured to give their stamp of approval to complex investments 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 cited e-mail 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 e-mail 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 percent 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 percent, compared with 5 percent in January 2008.
New York Attorney General Eric Schneiderman, who is helping to lead a state-federal group probing misconduct in the bundling of mortgage loans into securities, is separately investigating S&P over its ratings on mortgage bonds, according to a person familiar with the matter who asked not to be identified because the investigation hasn’t been made public.
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, who sued S&P more than a year ago, commended Holder and her state colleagues in a statement today.
“Standard & Poor’s was a trigger for the destruction of our economy,” Madigan said. “While the big banks and lenders built mortgage-backed bombs, it was S&P’s faulty ratings that detonated them.”
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 Barack Obama in January 2012 as director of the federal Consumer Financial Protection Bureau in Washington.
The case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).