S&P Granted Top Grades to Doomed Lehman CDO as Downgrades Rose

A unit of New York Life Insurance Co. issued a $1.5 billion collateralized debt obligation named after a Northern sky constellation in April 2007. The deal burst when it defaulted less than a year later.

The Corona Borealis CDO, underwritten by Lehman Brothers Holdings Inc., is one of dozens of deals named in the Justice Department’s Feb. 4 lawsuit accusing the world’s largest credit-rating company of deliberately misstating the risks of mortgage bonds as it sought to keep its share of the booming business of repackaging home loans for sale as securities.

Eastern Financial Florida Credit Union lost its investment after purchasing a portion of the Corona Borealis CDO, relying in part on Standard & Poor’s assessment of the securities, according to the Justice Department’s complaint filed in federal court in Los Angeles. The U.S. is seeking penalties against S&P and its New York-based parent, McGraw-Hill Cos. that may amount to more than $5 billion, based on losses suffered by federally insured financial institutions.

S&P was aware of its influence over such firms, and knowingly “devised, participated in, and executed a scheme to defraud investors,” according to the complaint.

Ed Sweeney, an S&P spokesman in New York, declined to comment.

Eastern Financial, founded in 1937 as the original credit union for Eastern Airlines, was forced to merge with Space Coast Credit Union after being seized by regulators in April 2009.

AAA Rankings

S&P gave more than half of the Corona Borealis deal its highest AAA grade, according to a prospectus from July 2, 2007. Its largest competitor, Moody’s Investors Service, offered an equivalent Aaa on the same portions. About 50 percent of the deal was linked to subprime mortgage bonds carrying grades of BBB or below, according to the Justice Department lawsuit. BBB is the second-lowest rung of investment grade on the rater’s scale.

When S&P blessed the deal with top rankings in April 2007, it wasn’t yet known exactly which securities would be included in the transaction. CDO issuers could lay out which types of bonds would be included in deals at the time of the sale while still in the process of acquiring the debt.

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.

Lehman Collapse

New York Life’s deadline for purchasing the collateral was July 9, 2007, according to the prospectus. Eligible collateral included credit-default swaps used to wager on the likelihood of subprime home-loan failures. The completion of the deal was contingent upon garnering AAA grades from the rating companies.

On June 28, 2007, S&P “authorized immediate large-scale negative rating actions on non-prime RMBS,” according to the government complaint. The downgrades didn’t affect the ratings on the Corona Borealis deal, which defaulted in February 2008, the complaint says.

Lehman, the biggest underwriter of mortgage-backed securities as the U.S. real estate market peaked, filed for the largest bankruptcy in history in September 2008, prompting a global credit freeze that led to the worst financial crisis since the Great Depression.

Corona Borealis, Latin for northern crown, is a constellation in the northern sky, according to the Encyclopedia Britannica. In Greek mythology the stars are the crown the god Dionysus presented to the Cretan princess Ariadne, who was deserted by Theseus after helping him escape the Labyrinth with a thread of jewels.

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