Posted on 05 Feb 2013 by Neilson
On March 19, 2007, as the U.S. housing market weakened, an analyst at Standard & Poor's Ratings Service sent out some song lyrics to colleagues, set to the tune of the Talking Heads 1980s song "Burning Down the House."
"Housing market went softer/Cooling down/Strong market is now much weaker/Subprime is boi-ling o-ver/Bringing down the house."
The song lyrics are among the U.S. government's allegations against S&P in a 128-page lawsuit filed late Monday in a U.S. District Court in Los Angeles. The suit alleges that the largest U.S. rating firm "falsely" represented that crisis-era credit ratings on complex securities "were objective, independent" and "uninfluenced by any conflicts of interest."
S&P, a unit of McGraw-Hill Cos., didn't immediately comment on the suit Tuesday morning. Before the lawsuit was filed, the company said in a statement that it "downgraded a record number" of residential mortgage-backed securities before 2007 and "repeatedly warned of deteriorating conditions in the housing market and potential additional downgrades to come, in many cases before our peers."
McGraw-Hill shares fell again Tuesday after sliding 14% on Monday, its worst one-day decline in 25 years, after The Wall Street Journal reported that the U.S. government and state attorneys general intended to file civil charges against S&P.
The Justice Department said it will announce at an 11:15 a.m. press conference in Washington D.C. "a major financial fraud enforcement action," without disclosing the target. The press conference will be led by U.S. Attorney General Eric Holder and include six state attorneys general.
Among the attorneys general is Lisa Madigan of Illinois, who filed a civil suit against S&P last year alleging the firm violated Illinois consumer-protection laws with misleading assertions about how it rated bonds in the years before the housing market imploded. S&P is fighting the Illinois lawsuit.
In the U.S. government's lawsuit Monday, prosecutors said an unnamed "Analyst D" working at S&P in 2007 sent the song lyrics to several colleagues, with "apologies to David Byrne," the Talking Heads front man. Analyst D was part of the "global" group that rated bonds backed by residential mortgages and had been doing an in-depth analysis of the risk on complex securities first issued in 2006, according to court documents.
Two days after the analyst sent the email, he followed up with colleagues, sending a video of himself singing and dancing the first verse of the song while S&P co-workers laughed, the documents say.
The lawsuit cites dozens of chats between analysts, internal reports and emails, all aimed at showing S&P didn't actually stand behind the triple-A and other top-notch ratings it issued on hundreds of complex securities backed by home mortgages to U.S. consumers.
The Justice Department alleges that S&P knew the housing market was collapsing but was intentionally slow to downgrade hundreds of securities because of concerns that such a move would cut off the pipeline of deals and anger issuer clients. S&P and other major rating firms are paid by debt-issuers such as banks to rate their bonds. Lawmakers and regulators have long said the "issuer pays" model is a potential conflict of interest.
S&P and other firms have long fought lawsuits targeting the quality of their ratings by citing the First Amendment and contending that the ratings are an opinion. In its suit, the Justice Department lawsuit tries to get around that argument by dusting off a law from the savings-and-loan crisis that imposes a relatively lower burden of proof.
The federal government is suing S&P for three types of fraud under that law: mail fraud, wire fraud and financial-institution fraud. The suit doesn't indicate how much the U.S. is seeking in damages.
In a statement Monday, S&P said the U.S. government's use of the Financial Institutions Reform, Recovery, and Enforcement Act is a "questionable legal strategy." The firm said it would "vigorously defend our Company against such meritless litigation."
The government's lawsuit said S&P is represented in the case by Floyd Abrams, a partner at law firm Cahill Gordon & Reindel LLP who is one of the nation's best-known First Amendment lawyers. He represented the New York Times in the Pentagon Papers case and is defending S&P in other crisis-related litigation.
Monday's lawsuit suit zeroes in on the way S&P rated more than 40 collateralized debt obligations, or CDOs, issued in 2007. CDOs are securities created from pools of risky subprime mortgages and other loans.
One of those CDOs was called Sorin CDO VI, Ltd., a $550 million security backed by subprime mortgages. Most of the deal was assigned high ratings by S&P on March 27, 2007. The lead analyst on the Sorin deal was among the recipients of the "Bringing Down the House" song lyrics. He had asked if he could forward the song to others, court documents allege.
On May 28, 2008, Sorin defaulted. One the investors named in the suit, Western Federal Corporate Credit Union, suffered losses $90 million as a result, according to the lawsuit.
The $1.1 billion Gemstone CDO VII Ltd., also highly rated by S&P on March 15, 2007, was downgraded in July 2007 and then defaulted on April 15, 2008.
"In issuing these CDO ratings, S&P deceived financial institutions that invested in these CDOs into believe that S&P's ratings reflected its true current opinion regarding the credit risks of these CDOs, when in fact they did not," the lawsuit alleges. Financial institutions such as Western Federal Corporate Credit Union suffered more than $5 billion in losses, the suit alleges.