Federal Reserve policy makers including Chairman Ben S. Bernanke voiced alarm in August 2007 over a loss of investor confidence in ratings companies, warning that the declining credibility could worsen market turmoil.

“There is an information fog” that “is very much associated with the loss of confidence in the credit-rating agencies,” Bernanke said at a meeting on Aug. 7, 2007. The firms’ “credibility has been shot” and “it is much harder to see that this market will unwind itself in a rather kind and comforting environment,” said Kevin Warsh, then a Fed Governor.

The 2007 transcripts of the Federal Open Market Committee, released last month, open a window onto how Fed officials viewed ratings companies during the end of the period that is the focus of a U.S. Justice Department lawsuit against McGraw-Hill Cos. and its Standard & Poor’s unit.

The Justice Department filed a civil complaint Monday 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. The U.S. is seeking as much as $5 billion in penalties in punishment for inflated credit ratings that Attorney General Eric Holder said were central to the worst financial crisis since the Great Depression.

The “egregious” conduct “goes to the very heart of the recent financial crisis,” Holder said Tuesday at a news conference in Washington. The complaint “is an important step forward in our ongoing efforts to investigate and punish the conduct that is believed to have contributed to the worst economic crisis in recent history.”

Flawed Ratings

In June 2007, William C. Dudley, then the head of the markets desk of the Federal Reserve Bank of New York, warned of the risk to broader financial markets from flawed credit ratings. That April, New Century Financial Corp., once the second-largest U.S. subprime mortgage lender, had filed for bankruptcy.

“High credit ratings don’t fully capture measures of risk,” Dudley said during the FOMC’s June 27-28, 2007 meeting.

“The ratings are based on the risk of default, not the market risks associated with illiquidity,” said Dudley, who became president of the New York Fed in January 2009. The flawed ratings may veil “significant market risk” posed by “highly leveraged portfolios of highly rated but illiquid assets.”

Bernanke and his FOMC colleagues met on Aug. 7, 2007, after a steady deterioration in financial market stability. The prior month Bear Stearns Cos. liquidated two hedge funds that invested in mortgage securities. American Home Mortgage Investment Corp. filed for bankruptcy on Aug. 6 and BNP Paribas Investment Partners temporarily suspended net asset value calculations for some funds on Aug. 9 because of disruptions in asset-backed securities markets.

‘Fundamental Reevaluation’

At the Aug. 7 meeting Dudley said “disturbing delinquency trajectories” had prompted ratings agencies to downgrade a significant number of assets and that losses had “led to a fundamental reevaluation of what a credit rating means and how much comfort an investor should take from a high credit rating.”

Dudley’s remarks sparked an FOMC discussion on the risk to the economy from declining confidence in ratings companies.

“With the rating agencies discredited and markets vulnerable to adverse news on the economy, the period of unusual uncertainty could be prolonged,” said Donald Kohn, the Fed’s vice chairman from 2006 to 2010.

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 Justice Department 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.

S&P has denied wrongdoing.

‘Not True’

“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true,” said Catherine Mathis, a company spokeswoman, in an e-mailed statement. “We will vigorously defend S&P against these unwarranted claims.”

“The fact is that S&P’s ratings were based on the same subprime mortgage data available to 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,” she said.

Bernanke testified to Congress in March of 2007 that “problems in the subprime market” were “likely to be contained.”

Yet in August 2007 the Fed cut the discount rate that it charges banks on emergency loans, and in September of that year the central bank began a series of cuts to its target Fed funds rate that ended with the rate near zero by December 2008.

Timothy F. Geithner, then New York Fed president, said at the meeting on Aug. 7, 2007, “You are also seeing a collapse in confidence, as Bill described it, in how to value complex structured credit products, probably from the loss of faith in ratings and from the changes ahead in ratings methodology and in actual ratings.”

Geither was U.S Treasury Secretary from January 2009 until last month.