Ridgeway Court CDO Shows S&P Didn’t Follow Own Rating Downgrades

On the same day in June 2007 that Standard & Poor’s decided large-scale downgrades of mortgage-backed securities might be necessary as the subprime market fell apart, S&P analysts awarded $2.8 billion of a collateralized debt obligation called Ridgeway Court Funding II Ltd. a AAA grade, the best they could possibly bestow.

The CDO, which was underwritten by New York-based Citigroup Inc. and composed of subprime mortgage-backed securities and other similar bundles of debt, defaulted 201 days later, leaving investors with almost nothing.

That’s just one of dozens of transactions valued at tens of billions of dollars in 2007 in which S&P deliberately misled investors about the risks of mortgage bonds in order to win business from Wall Street banks, the Justice Department said in a lawsuit filed against the company and parent McGraw-Hill Cos. The U.S. is seeking penalties that may exceed $5 billion, based on losses suffered by federally insured banks.

“We dropped the ball on this one,” an S&P analyst wrote in a July 11, 2007, e-mail to an investment-banker client about the structured finance group. “But you think it’s bad now, wait ’till next week.”


Ridgeway Court was made up of about 33 percent subprime residential-backed mortgage securities from 2006, 10 percent from 2005, and 7 percent from 2007, according to the complaint. An additional 31 percent was other CDOs made up of asset-backed bonds originally assigned the lowest investment-grade ratings by S&P or its competitors Moody’s Investors Services and Fitch Ratings.

CDOs pool assets such as mortgage bonds and package them into new securities with varying risks in which revenue from the underlying bonds or loans are used to pay investors.

S&P decided on June 28, 2007, the same day it awarded the Ridgeway Court ratings, that it would “authorize immediate large-scale negative rating actions on non-prime RMBS,” according to the government complaint filed Feb. 4 in Los Angeles.

Some of Ridgeway Court’s CDO holdings included even more CDOs, according to documents prepared for investment managers reviewed by Bloomberg News. It owned directly part of Carina CDO Ltd., whose assets were liquidated, and indirectly another CDO called 888 Tactical Fund Ltd. that had a stake in Carina. Two other CDOs it invested in, Pinnacle Peak CDO Ltd. and Octonion CDO Ltd. held interests in 888 Tactical Fund, according to the documents.

Ridgeway Court’s 196-page prospectus cites increasing stress in the mortgage market, including rising delinquencies and default rates, falling property values, and fraudulent mortgage loan applications. Sales of bonds backed by subprime mortgages were tumbling as investors and bankers pulled back, concerned about rising delinquency rates.

’Internal Pressure’

“There was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up,” the S&P analyst said in a July 5, 2007, e-mail cited in the lawsuit. “But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.”

S&P’s CDO group ignored warnings and data from its mortgage securities unit that their MBS ratings, used in grading CDOs, were proving flawed, according to the complaint. The lawsuit includes at least 58 examples of S&P executives taking steps to appease issuers or acknowledging how pressure from banks could lessen the quality of its grades or delay downgrades.

Ridgeway Court, managed by Zurich-based Credit Suisse Group AG, defaulted on Jan. 15, 2008, according to the lawsuit, meaning almost total losses for investors including Eastern Financial Florida Credit Union.

Ambac Suit

A unit of bond insurer Ambac Financial Group Inc. sued Citigroup and Credit Suisse for fraud, negligent misrepresentation, breach of fiduciary duty and fraudulent conveyance after its insurance unit sold investors protection against default on the Ridgeway CDO’s most senior notes, the top 65 percent, through credit-default swaps.

Ambac alleged that Citigroup withheld material information, necessary for accurate ratings, about the deteriorating collateral portfolio, which included “recycled detritus” from other CDOs and RMBS offerings it hadn’t been able to sell, according to the claim filed Aug. 3, 2009.

The collateral included “substantially deteriorated subprime mortgage backed securities that Citigroup sold to Ridgeway II in order to get off its own books,” according to Quinn Emanuel Urquhart & Sullivan LLP, which represented Ambac.

Ratings Cut

Fitch cut Ridgeway Court’s most-senior class seven levels in November 2007, from the top AAA grade assigned when the notes were issued in June. Moody’s began considering a downgrade on the class that month.

Two days after Ridgeway Court defaulted, S&P raised its loss estimates for Ambac, MBIA Inc. and other bond insurers by 20 percent after updating models for subprime-mortgage bonds and CDOs. The next day the ratings firm expanded its review of the top-rated class, saying it might downgrade an additional $876 million of AAA rated debt issued by Ridgeway, up from about $351 million, of the top-rated classes, which represented $1.95 billion of the deal.

“The rating agencies have been living in a conflicted position of denying all of this for a long time,” David Einhorn, co-founder of Greenlight Capital LLC, the New York-based hedge-fund manager that bet on a decline in MBIA shares, said in a January 2008 interview.

S&P downgraded the AAA rated slices on Feb. 20, 2008.

Credit raters are poised to face more lawsuits after the U.S.’s, according to Einhorn, who’s been wagering against the shares of ratings firms for more than five years.

’Road Map’

“When you look at the government complaint, it’s like a road map,” Einhorn said yesterday in an interview at Bloomberg LP headquarters in New York. “It shouldn’t take too much effort for the people who bought the CDOs who aren’t banks to essentially copy the government and sue for further damages. I would expect there to be a large amount of private actions from people not named in this complaint who bought these CDOs in 2007, who suffered the same fate as the bank victims.”

S&P rated more than $2.8 trillion of residential mortgage-backed securities and about $1.2 trillion of CDOs from September 2004 through October 2007, according to the Justice Department complaint.

The company contests the suit’s allegations. Despite its best efforts to “keep up with an unprecedented, rapidly changing and increasingly volatile environment,” the severity of “what ultimately occurred was greater than we -- and virtually everyone else -- predicted,” the company said in a Feb. 4 statement.

S&P said in its statement that all of its CDOs cited by the Justice Department received the same ratings from a competitor. Moody’s granted $2.7 billion of Ridgeway Court Funding II the same grades as S&P.

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