McGraw-Hill Defense Seen as Diversion Against U.S. Fraud Claims

Standard & Poor’s news release responding to the government’s lawsuit over its mortgage-bond grades complained that the ratings company is being sued for “not predicting full magnitude of housing downturn despite failure of virtually everyone to do so.”

That’s far from an accurate representation of the case brought this week by the Justice Department, based on allegations in the government complaint.

“S&P is basically throwing a red herring out there,” Janet Tavakoli, founder of Chicago-based consulting firm Tavakoli Structured Finance Inc., said yesterday in a telephone interview. “That’s not what they’re being held accountable for. Nobody was asking them to predict the future. They were asking them to look at the risks in front of them and apply prudent and reasonable analysis.”

Federal prosecutors allege S&P failed to adjust its analytical models or take other steps it knew were necessary to accurately reflect the risks of the securities. The claims are tied to whether the company, a unit of New York-based McGraw-Hill Cos., accurately represented the care it took in providing credit grades and avoiding conflicts, not how incorrect its ratings later proved. E-mails and other internal documents discussed how the issuers might react to tougher standards by taking their business elsewhere.

58 Allegations

The complaint, filed in federal court in Los Angeles on Feb. 4, includes at least 58 examples of S&P executives ignoring internal warnings from analysts and others, dismissing relevant data, taking steps to appease issuers or acknowledging how pressure from banks could lessen the quality of its grades or delay downgrades.

Allegations in the civil lawsuit against S&P and its parent come after reports from the Financial Crisis Inquiry Commission and a Senate panel said that inflated mortgage-bond grades from the firm, Moody’s Investors Service and Fitch Ratings helped fuel the lending practices that let the housing bubble get so big before it burst.

Prices in 20 large metropolitan areas more than doubled from the start of 2000 through mid-2006 before tumbling 35 percent to a bottom last year, S&P/Case-Shiller index data show. As defaults soared and banks failed, the U.S. entered a credit crisis and its longest recession since 1933, from which it has yet to recover 3.23 million of the 8.74 million jobs lost.

642,000 Loans

At one point during the boom, S&P worked on an update to its model used in assessing residential mortgage-backed securities, or RMBS. Instead of the version, known as LEVELS

6.0, being introduced at the start of 2005 as planned, it was never released, according to the complaint.

The update incorporated data from 642,000 loans made between 1971 and 2001, including riskier loan types such as subprime, taken out by borrowers with poor credit, and Alt-A, often granted with reduced documentation, riskier terms or on investment properties.

That differed from the rules S&P was using that contained only 166,000 safer mortgages, according to the complaint. After the new model was discovered to have led to larger portions of deals receiving lower grades, S&P backtracked amid internal debate.

“When we first reviewed Version 6.0 results **a year ago** We saw the sub-prime and Alt-A numbers going up and that was a major point of contention which led to all the model tweaking we’ve done since,” an employee identified in the complaint as Senior Analyst B wrote. “Version 6.0 could’ve been released months ago and resources assigned elsewhere if we didn’t have to massage the sub-prime and Alt-A numbers to preserve market share.”

S&P Defense

S&P’s recognition that more-conservative standards could cost it business dated at least as far back as 2004, after an analyst sent an e-mail to managers saying Moody’s had been hired for a deal instead because it is was being too tough.

“Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact on future deals,” the analyst wrote, according to the complaint. “There’s no way we can get back on this one but we need to address this now in preparation for the future deals.”

Floyd Abrams, the Cahill Gordon & Reindel LLP lawyer for S&P who represented the New York Times in the 1971 Pentagon Papers case, has emphasized the housing market’s collapse in discussing the case. Officials including Federal Reserve Chairman Ben S. Bernanke and then-Treasury Secretary Henry Paulson also failed to predict the severity of the crisis, the attorney said Feb. 5 in a Bloomberg Television interview.

No ‘Fraud’

S&P, investors, government officials and “every member of the Fed had views in 2007 about how bad the housing market collapse would be, which did not pan out,” Abrams said. “It was a lot worse than S&P predicted it would be, and a lot worse than everyone else predicted it would be.”

He said that “there wasn’t any fraud” because S&P employees “tried their best to come out with the right answers about what would happen. All the folks at the Fed back in 2007 and Chairman Bernanke and Secretary Paulson, everyone, just about all these entities, were pretty much in the same ballpark.”

Bernanke said at an August 2007 meeting of Fed board members that there “is an information fog” that “is very much associated with the loss of confidence in the credit-rating agencies,” according to transcripts released last month.

‘Worked Diligently’

S&P has also said that the Justice Department is “wrong” in saying its “ratings were motivated by commercial considerations and not issued in good faith.” It issued “extensive” downgrades in 2007 before rivals, had analysts who “worked diligently to keep up with an unprecedented, rapidly changing and increasingly volatile environment,” and competitors matched its ratings on all of the so-called collateralized debt obligations, which repackaged mortgage-backed securities and other similar bundles of debt, cited in the lawsuit.

Ed Sweeney, a spokesman for S&P in New York, declined to elaborate on the ratings firm’s statements.

Even before most of the declines in home prices, many pieces of CDOs such as Octonion I defaulted within months of getting S&P’s top grades as they were issued in 2007, according to the complaint and data compiled by Bloomberg. CDOs package assets such as mortgage bonds into new securities with varying risks.

2007 Warning

“It wasn’t just the character of the loans that was a problem, it was also the characters of the structures brought to market,” said Tavakoli, the Chicago consultant who has worked at banks including Merrill Lynch & Co. and Goldman Sachs Group Inc.

S&P’s CDO group enabled the boom to continue in 2007 by ignoring months of warnings and data from its RMBS group that their ratings, which it relied on in grading CDOs, were proving flawed, according to the complaint.

The group’s senior executives including Patrice Jordan and David Tesher often didn’t pass on that information to analysts responsible for CDOs created from mortgage-backed securities, the Justice Department said.

One example included an internal June 2007 report that found that the average ratio between the amount of mortgage delinquencies and investor protection on subprime RMBS slices rated BBB or lower exceeded a level that signaled downgrades were likely in the “near term,” according to the complaint.

Telephone messages left at numbers in New York state for individuals named Patrice Jordan and David Tesher weren’t returned.

Big Loophole

The CDO group had earlier tweaked its models to win business, the Justice Department said. At a 2006 meeting, it decided to take the step of beginning to assume no correlation between the performance of RMBS and CDOs filled with asset-backed securities such as RMBS, according to the complaint.

Correlation, or how likely it is for the debts to go bad at the same time, was a key metric in determining the odds of default for mortgage-tied CDOs, which were often filled with both types of assets.

“Tesher and other business personnel were in favor of this decision, which was made without the benefit of any data and would lead to S&P’s rating models arriving at lower estimates of credit risks for CDOs collateralized by such assets,” the Justice Department said.

The next year, a CDO analyst told a former coworker that the result was “a loophole in S&P’s rating model big enough to drive a Mack truck through,” the Justice Department said.

No Secret

Also in 2005 and 2006, after an internal report discussed how Bear Stearns Cos. pointed out “the potential business opportunities we would miss” by introducing an update to its CDO model the bank had tested, S&P delayed the new version, known as E3. It then allowed some issuers to use a weakened version during a three-month transition period, without telling investors, and allowed other types of CDOs to use the old version for months more, according to the complaint.

“We have toned down and slowed down our roll out of E3 to the market, pending further measures to deal with such negative results,” the report sent internally by Jordan had said, referring its model known as CDO Evaluator 3.0. The easier version was referred to as E3 Low.

Bear Stearns collapsed in 2008 and was bought by JPMorgan Chase & Co. with assistance from the Fed. The costs of government steps to revive the economy added to the national debt, leading S&P to strip the U.S. of its top credit grade in August 2011.

Concealed Danger

The dangers being cloaked by a housing boom and flawed AAA grades on mortgage debt were far from secret at the time.

In both residential- and commercial-mortgage securities, investors such as Scott Simon, Pacific Investment Management Co.’s mortgage head, said they were demanding AAA classes built with even more investor protection than rating firms demanded.

Credit graders’ “models are all insanely screwed up” because so many potential defaults were being averted through re-financings or home sales, Scott said during a panel discussion at a conference in New York in 2005.

That year, on a conference call for investors in which its analysts discussed a series of special reports S&P had published on the state of housing and related companies after its explosive gains, David Wyss, then the firm’s chief economist, said prices could fall 20 percent nationwide and almost 30 percent on the East and West coasts.

A ’Fizzle’

Still, he said he thought the most likely outcome was “that the bubble ends with a fizzle, not with a bang,” American Banker magazine reported at the time.

S&P in 2007 turned into “enablers of the grand fraud” in which banks created a final flurry of CDOs filled with credit-default swaps, according to Manal Mehta, founder of San Francisco-based hedge fund Sunesis Capital LLC. The swaps were side bets on the performance of mortgages, rather than being backed by actual loans.

In March of that year, S&P granted or confirmed initial ratings on $51 billion of CDOs, according to the complaint.

“Those CDOs magnified the impact of fraud in the system,” Mehta said. “Subprime on its own was a containable problem: Synthetic products such as CDOs which repeatedly copied and pasted the same faulty underlying collateral into multiple deals exacerbated the problems and blew up the world.”

The case is U.S. v. McGraw-Hill, 13-00779, U.S. District Court, Central District of California (Los Angeles).

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