Some Charge ‘Revenge’ From Downgrade as DOJ Sues S&P Over Bond Ratings

Tuesday, 05 Feb 2013 10:59 PM

By Todd Beamon

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The Justice Department sought $5 billion from Standard & Poor’s on Tuesday from what it called a blatant scheme to defraud investors just before the financial crisis — but some observers dubbed the lawsuit “revenge” for the 2011 downgrade of the nation’s AAA bond rating by the agency.

“Is it true that after the downgrade, the intensity of this investigation significantly increased?” Floyd Abrams, the lead lawyer for S&P, asked in a CNBC interview. “Yeah.”

S&P downgraded the U.S. government’s AAA bond rating in August 2011 because of the standoff in Congress over the fiscal crisis.

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The downgrade apparently did not scare investors off, as the government continues to borrow at historically low interest rates, Reuters reports.

But while S&P’s two main competitors, Moody’s and Fitch, graded also securities tied to subprime mortgages from September 2004 and October 2007, only S&P has been sued by the government.

“To make a claim against S&P of this sort when what they did was so consistent with not just what Moody’s and Fitch did but with serious, respected opinion makers in Washington and New York thought is simply indefensible,” Abrams told The Wall Street Journal.

Attorney General Eric Holder, in announcing the civil lawsuit on Tuesday in Washington, said that there was "no connection" between the ratings downgrade and the DOJ's investigation of S&P, which started in November 2009.

In the lawsuit, the Justice Department contends that S&P misled investors by stating that its ratings on mortgage products were objective and not influenced by conflicts of interest.

Instead, the DOJ contends, S&P inflated ratings and understated risks as the housing bubble started to burst — driven by a desire to gain more business from the investment banks that issued mortgage securities.

“Put simply, this alleged conduct is egregious — and it goes to the very heart of the recent financial crisis,” Holder said.

Further, the Justice Department said banks and credit unions experienced losses of more than $5 billion on more than 40 collateralized debt obligations — securities backed by bonds, loans or other financial instruments — with inflated ratings by S&P.

Sixteen states and the District of Columbia are also suing S&P.

In one of the Justice Department's most ambitious cases tied to the financial crisis, the lawsuit is the first by the government against a ratings agency — and employs a little-used law with a lower burden of proof, Reuters reports.

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If successful, the Justice Department could use the strategy in other cases.

William Black, a former regulator at the Federal Home Loan Bank Board, told the Journal that U.S. officials seemed “willing to push this case harder than with any financial-crisis case against a major bank.”

According to the Journal, the Justice Department’s case is pinned heavily on emails and other correspondence that show growing concerns by S&P about the health of the housing market even as the firm's management pushed to seek more business.

The government’s action came after four months of settlement talks collapsed, in which the government sought a penalty of more than $1 billion and pushed S&P to admit wrongdoing.

S&P refused, saying the admission would have exposed it to more outside liability, Reuters reports.

Legal experts told the Journal that both sides face an uphill battle in the case — and it easily could take years before an outcome is reached.

S&P is likely to contend that its views of the U.S. housing market were similar to those by government agencies, financial institutions, and other experts. In other words, almost everyone turned out to be wrong about the severity of the housing crisis.

But the Justice Department — while it still must prove that S&P intentionally committed fraud — it only needs to prove that based on a preponderance of the evidence, rather than the higher threshold for criminal cases of beyond a reasonable doubt, Reuters reports.

Other legal experts told Reuters, however, that the Justice Department is using a relatively untested interpretation of a federal civil fraud statute passed after the 1980s savings-and-loan crisis, which makes predicting the success of the lawsuit difficult.

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While the law has appeared in only a few dozen cases, its low burden of proof, broad investigative powers and long statute of limitations encouraged the Justice Department to use it, especially after criminal inquiries failed to yield major prosecutions.

The law covers fraud affecting federally insured financial institutions but has generally been used when the government was the target of fraud. The Justice Department says the law applies in the S&P case because the alleged fraud caused a federally insured California credit union to suffer losses.

“It's rare but not unprecedented for the Justice Department to bring a civil fraud suit where the government itself is not the victim of the fraud,” Andrew Schilling of the New York law firm Buckley Sandler told Reuters.

Schilling led the civil division in the U.S. Attorney's office in Manhattan and helped build prior cases under the law.

However, writing on HotAir.com Ed Morrissey, called the Justice Department’s lawsuit “breathtaking in its hypocrisy.

“After all, S&P didn’t issue mortgage-backed securities and insist that the housing bubble could go on forever. The MBS blizzard came from the two [government sponsored enterprises], Fannie Mae and Freddie Mac.

“Congress authorized them to securitize the paper they bought from lenders in order to encourage riskier loans to buyers who otherwise wouldn’t have qualified for home loans,” Morrissey added. “And that was motivated not by normal regulatory concerns or ‘good faith,’ but by political considerations and a desire by both Democrats and Republicans to conduct social engineering rather than regulate rational markets.

He continued: “It was Congressional intervention, not S&P that fueled the irrational demand on both sides of the lending markets. People bought houses they couldn’t afford, took out home-equity loans on equity that never really existed, and lenders shoved money into the hands of people who couldn’t even establish that they had an income.

“S&P and other rating agencies may have erred in rating these bonds as highly as they did, but the Congressional intervention behind the GSE-issued MBSs left everyone with the very distinct impression that the government would stand behind these bonds. And guess what? They were correct. In the end, Congress bailed out Fannie and Freddie.

Urgent:
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“This lawsuit is just an attempt to shift blame away from the real culprits: Congresses from 1998-2008,” Morrissey concluded. “Why? Because if Washington D.C. can blame the ratings agencies instead of the bond issuers and their enablers inside the beltway, then they can circle back around again and start distorting the lending markets for their social engineering.

“Plus,” he added, “it’s not a bad revenge for that credit downgrade in August 2011, either.”

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