McGraw-Hill (MHP) and its Standard & Poor's unit were sued by the U.S. over claims S&P knowingly understated the credit risks of bonds and derivatives that were central to the worst financial crisis since the Great Depression.
The U.S. Justice Department filed a complaint Monday in in Los Angeles, accusing McGraw-Hill and S&P of three types of fraud, the first federal case against a ratings company for grades related to the credit crisis. McGraw-Hill tumbled the most in 25 years yesterday when it said it expected the lawsuit.
S&P issued credit ratings on 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.
"It's going to be a tricky time for rating agencies," Fred Ponzo, a capital markets analyst at Greyspark Partners, said in a telephone interview. "S&P is probably just the first to face the music."
Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the U.S. seeks civil penalties of as much as $1.1 million for each violation.
Settlement talks broke down after the government sought a fine of more than $1 billion and an admission of wrongdoing from S&P, the New York Times reported. That amount would wipe out the profits of McGraw-Hill for an entire year, the newspaper said.
Before the case was filed, McGraw-Hill fell 14% to $50.30 in New York trading on Monday. Moody's Corp., owner of the second-largest ratings provider, fell 11% Monday to $49.45. Yields on McGraw-Hill's $400 million of bonds due November 2037 rose 31 basis points yesterday to 5.75%, the highest level since May, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Ratings firms have faced criticism from U.S. lawmakers over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading 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.
"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.
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.
"A DOJ lawsuit would be entirely without factual or legal merit," S&P said in a statement yesterday before the case was filed. "It would disregard the central facts that S&P reviewed the same subprime mortgage data as 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."
S&P, in its statement, cited court rulings that have dismissed challenges to the opinions of ratings firms. The company also said it planned to fight any lawsuits.
