mortgage investments

Chip Somodevilla/Getty ImagesAttorney General Eric H. Holder Jr. announced the civil fraud charges against S.P. in Washington on Tuesday.

The subprime loans packaged as complex securities for Standard Poor’s to rate were already failing at such a fast clip in the fall of 2006 that some analysts at the firm thought they must be seeing typographical errors.

At the time, the nation’s biggest rating agency was making record profits, attaching sterling ratings to mortgage-related securities that were increasingly going bad. Inside the firm’s headquarters in Lower Manhattan, tensions were escalating. Some executives pushed to revise the firm’s rating models in hopes of preserving market share and profits, while others expressed deep concerns about the poor performance of the securities, according to court records.

“This market is a wildly spinning top which is going to end badly,” one executive wrote in a confidential memo.

Related Links

The account, culled from reams of internal e-mails, is part of civil fraud charges that the Justice Department filed late Monday against S.P. in federal court in Los Angeles, accusing the firm of inflating ratings of mortgage investments and setting them up for a crash when the financial crisis struck.

The government is seeking $5 billion in penalties against the company to cover losses to investors like state pension funds and federally insured banks and credit unions. The amount would be more than five times what S.P. made in 2011. S.P. said it would vigorously defend itself against “these unwarranted claims.”

Sixteen states, including Iowa, Mississippi and Illinois, joined the federal suit, and the New York attorney general said he was taking separate actions. California’s attorney general, Kamala D. Harris, said the state pension funds lost nearly $1 billion on the soured investments. The Securities and Exchange Commission has also been investigating possible wrongdoing at S.P.

“The action we announce today marks an important step forward in the administration’s ongoing effort to investigate — and punish — the conduct that is believed to have continued to the worst economic crisis in recent history,” said Mr. Holder. The Justice Department called its investigation “Alchemy,” after medieval alchemists’ attempts to turn lead into gold.

Standard Poor’s defended its corporate practices on Tuesday, saying the civil lawsuit filed by the Justice Department was “meritless.”

“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. S.P. has always been committed to serving the interests of investors and all market participants by providing independent opinions on creditworthiness based on available information,” the rating agency said in a statement on Tuesday.

The company said that at all times its actions reflected its best judgments about the investments at the heart of the suit — about 40 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of residential mortgage-backed securities, which in turn were composed of individual home loans.

“Unfortunately,” the company’s statement said, “S.P., like everyone else, did not predict the speed and severity of the coming crisis and how credit quality would ultimately be affected.”

McGraw-Hill shares were down 5 percent to $47.51 in early afternoon trading on the New York Stock Exchange, and have lost 19 percent of their value over the last two days.

The case is the first significant federal action against the ratings industry, which during the boom years bestowed high ratings that made many mortgage-related investments appear safer than they actually were.

It was unclear whether the Justice Department was looking at the other two major ratings agencies, Moody’s Investors Service and Fitch. Mr. West said he would not discuss actions against other rating agencies. In addition to joining the suit against S.P., James Hood, the attorney general in Mississippi, said his state had also filed lawsuit against Moody’s.

The joint federal-state suit against S.P. claims that from September 2004 through October 2007, S.P. “knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors” in certain mortgage-related securities. S.P. also falsely represented that its ratings “were objective, independent, uninfluenced by any conflicts of interest,” the suit said.

Settlement talks between S.P. and the Justice Department broke down in the last two weeks after prosecutors sought a penalty in excess of $1 billion and insisted that the company admit wrongdoing, several people with knowledge of the talks said. That amount would wipe out the profits of McGraw-Hill for an entire year. S.P. had proposed a settlement of around $100 million, the people said. The government pressed for an admission of guilt to at least one count of fraud, said the people. S.P. told prosecutors it could not admit guilt without exposing itself to liability in a multitude of civil cases.

On Monday, a spokesman for Moody’s declined to comment. A spokesman for Fitch, Daniel J. Noonan, said the agency could not comment on an action against Standard Poor’s, but added, “We have no reason to believe Fitch is a target of any such action.”

The securities were created at the height of the housing boom, mainly for investment banks. S.P. was paid fees of about $13 million for rating them. The firm gave the government more than 20 million pages of e-mails as part of its investigation, the people with knowledge of the process said.

Since the financial crisis in 2008, the ratings agencies’ business practices have been widely criticized, and questions have been raised as to whether independent analysis was corrupted by Wall Street’s push for profits.

A Senate investigation made public in 2010 found that S. P. and Moody’s used inaccurate rating models from 2004 to 2007 that failed to predict how high-risk mortgages would perform, allowed competitive pressures to affect their ratings and failed to reassess past ratings after improving their models in 2006.

The companies failed to assign adequate staff to examine exotic investments, and failed to take mortgage fraud, lax underwriting and “unsustainable home price appreciation” into account in their models, the inquiry found.

“Rating agencies continue to create an even bigger monster — the C.D.O. market,” one S.P. employee wrote in an internal e-mail in December 2006. “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Another S.P. employee wrote in an instant message the next April, reproduced in the complaint: “We rate every deal. It could be structured by cows and we would rate it.”

In its statement Tuesday, S.P. said that “the e-mail that says deals ‘could be structured by cows’ and be rated by S.P. had nothing to do with R.M.B.S. or C.D.O. ratings or any S.P. model. The company added that “the analyst had her concerns addressed with the issuer before S.P. issued any rating.” S.P. said that there was robust internal debate about how a rapidly deteriorating housing market might affect the C.D.O.’s, “and we applied the collective judgment of our committee-based system in good faith.”

“The e-mail excerpts cherry-picked by D.O.J. have been taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business,” the credit rating agency said.

The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors were not involved in the process but depended on the rating agencies’ assessments.

In a separate statement on Monday, S.P. said it had begun stress-testing the mortgage-backed securities as early as 2005, trying to see how they would perform in a severe market downturn. S.P. said it had also sent out early warning signals, downgrading hundreds of mortgage-backed securities, starting in 2006. Nor was it the only one to have underestimated the coming crisis, it said — even the Federal Reserve’s Open Market Committee believed that any problems within the housing sector could be contained.

The Justice Department, the company said, “would be wrong in contending that S.P. ratings were motivated by commercial considerations and not issued in good faith.”

For many years, the ratings agencies have defended themselves successfully in civil litigation by saying their ratings were independent opinions, protected by the First Amendment, which guarantees the right to free speech. But developments in the wake of the financial crisis have raised questions about the agencies’ independence.

One federal judge, Shira A. Scheindlin, ruled in 2009 that the First Amendment did not apply in a lawsuit over ratings issued by S.P. and Moody’s, because the mortgage-backed securities had not been offered to the public at large. Judge Scheindlin also agreed with the plaintiffs, who argued the ratings were not opinions, but misrepresentations, possibly the result of fraud or negligence.

The federal-state action is the first time a credit ratings agency has been charged under a 1989 law intended to protect taxpayers from frauds involving federally insured financial institutions, which since the financial crisis has been used against a number of federally insured banks, including Wells Fargo, Bank of America and Citigroup.

The government is taking a novel approach by accusing S.P. of defrauding a federally insured institution and therefore injuring the taxpayer.

The lawsuit was filed in Central District of California, home to the defunct Western Federal Corporate Credit Union, among the largest corporate credit unions in the country. The credit union collapsed during the 2008 financial crisis after suffering huge losses on mortgage-backed securities rated by S.P.

The Justice Department said it interviewed about 150 people in the investigation, including former S.P. executives and analysts.

Article source: http://dealbook.nytimes.com/2013/02/05/case-details-internal-tension-at-s-p-amid-subprime-problems/?partner=rss&emc=rss

Ozier Muhammad/The New York TimesAnn E. Rutledge and Sylvain R. Raynes are the founders of RR Consulting. They plan to name their new business Trade Metrics.

Credit ratings agencies have few friends on Wall Street or in Washington.

Politicians have pilloried them for bestowing top marks on risky mortgage investments. Big investors have accused them of missing the problems with subprime loans. And regulators have been writing rules to diminish the importance of their ratings.

But Ann E. Rutledge and Sylvain R. Raynes, two veteran credit analysts who founded RR Consulting, think it is an ideal time to enter the industry. After more than a decade of running their own firm, they are applying to be officially recognized by the government as a credit ratings agency. They aim to inject a dose of reality into an industry that they say has been clouded by a desire to please clients.

“Somebody has to do it,” Ms. Rutledge said. “In this business, if there isn’t somebody in the middle who is willing to tell the truth, then there is no basis in trust.”

It has been a slow and arduous process.

In 2006, Congress developed guidelines for potential credit ratings agencies to become licensed. Lawmakers hoped the new rules would encourage smaller players to jump into the industry and shake up the business, which traditionally had been dominated by Standard Poor’s and Moody’s.

Still, the hurdles remain high, say upstarts like RR, which plans to operate under the name Trade Metrics after it gets licensed. Applicants are required to furnish 10 letters from banks, pension funds or other institutions that have used their credit ratings.

But customers can be reluctant to vouch for a fledgling credit ratings agency. Experts say that some companies may see little benefit, and even a potential liability, in revealing what can be a confidential business relationship. RR, which has had dozens of clients, has been able to get only eight letters in a little more than a year.

One RR client, Charles W. Gerber, the president of the boutique investment bank Triumph Global Securities, turned down the firm’s request, citing the advice of counsel. In an e-mail, Mr. Gerber declined to elaborate on his relationship with the ratings company.

“Customers may be happy to employ RR, and pay some fees, but a public vouching may be more than the customer wants to do,” said Lawrence J. White, a professor at the Stern School of Business at New York University, who has testified before Congress on credit ratings agencies. Some customers, he said, may ask, ‘What’s in it for me?’ ”

In the years since the rule passed, the makeup of the industry remains relatively unchanged. Just nine credit ratings agencies have the government’s approval, compared with five before 2006.

Ms. Rutledge, 58, and Mr. Raynes, 54, are undeterred. With RR, they are aiming to take on the giants. As they see it, credit ratings agencies are paid to provide the critical perspective.

“An architect can design a building that is going to collapse. A civil engineer cannot afford to do that,” said Mr. Raynes, an engineer by training. “That’s why they don’t like each other.”

It is a philosophy honed over two decades in the business. The married couple first met in the 1990s at a training class while working at Moody’s. Ms. Rutledge, who was based in Hong Kong at the time, says she was initially put off by Mr. Raynes’s messy handwriting, but she soon found him to be “the smartest” analyst at the firm. They said that in those days, Moody’s was like a university, with an open exchange of ideas.

By the late 1990s, they had become disenchanted with the business. In Mr. Raynes’s view, it was transforming into a “rollover shop,” aiming to please its clients rather than to offer sometimes-critical opinions.

Michael N. Adler, a Moody’s spokesman, said that “the quality and independence of our credit ratings has always been of paramount importance to us, and we have strong protections in place to separate the commercial and analytical aspects of our business.”

The pair, which started RR in 2000, have offered a variety of services over the years. They have written two textbooks on the makeup of structured securities. They have taught college courses and have trained officials at the Federal Deposit Insurance Corporation.

They also have been vocal critics of the flaws in the financial system. In early 2004, speaking at an event sponsored by New York University, Ms. Rutledge argued that the boom in complex securities like collateralized debt obligations paralleled the events leading to the market crash of 1929. With home values soaring at the time, the reception to her warning was icy, she recalls.

Last year, Mr. Raynes’s appearance on CNBC went viral after he suggested facetiously that Jim Cramer, host of the program “Mad Money,” was a “public relations officer” for Goldman Sachs. Mr. Cramer, who had been discussing a big lawsuit by the Securities and Exchange Commission against Goldman, dismissed the charge, taking offense.

RR, which operates out of a small office near New York’s Grand Central Terminal, offers clients the same blunt talk. The firm’s seven employees use custom-built software to predict defaults in portfolios of loans, or to rate investments like asset-backed securities. If a deal doesn’t pass muster, they let their clients know.

“We consider them our third-party independent advisers slash consultants,” said Magchiel Groot, a senior investment officer at the Netherlands Development Finance Company, a public-private bank based in The Hague. “We present a case to them, and then we let them shoot at it.”

Article source: http://feeds.nytimes.com/click.phdo?i=8ff28ff431eb620dec5f8c2679738053

DealBook: Case Details Tension at S.&P. as Crisis Loomed

Related Links

DealBook: R&R Consulting Sets Sights on Being a Credit Ratings Agency

Recent News

Partners