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Government S&P Lawsuit: Who’s Next? Money Morning

This is a syndicated repost published with the permission of Money Morning. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

A massive U.S. government S&P lawsuit has no doubt hurt the fortunes of Standard & Poor’s parent company The McGraw-Hill Companies Inc. (NYSE: MHP), whose shares have dropped 25% since it was filed.

But the collateral damage could spell bad news for a number of parties and has implications even for the overall health of the U.S. economy.

The Justice Dept., joined by attorneys general from 16 states, unveiled a case accusing S&P of fudging its ratings of subprime mortgages to make the toxic securities appear better than they were.

The federal government is seeking $5 billion in penalties — more than five times what S&P made in 2011 — to cover losses to investors in federally insured banks and credit unions. Separate suits filed by individual states could more than double that figure.

It’s the first time the government has taken action against a credit rating agency over illegal behavior tied to the recent financial crisis.

Government S&P Lawsuit: Bringing Down the House

At the heart of the allegations against S&P is that the ratings agency changed its ratings models to get more business from the investment banks that issued them.

What’s more, S&P knowingly understated the credit risks of bonds and derivatives to gain more market share from competitors Moody’s Corp. (NYSE: MCO) and Fitch Group, the complaint said.

According to the government’s suit, S&P “knowingly and with the intent to defraud, devised, participated in, and executed a scheme to defraud investors.”

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.

Some of the most damning evidence is contained in emails obtained by the government that detail internal conversations that took place among employees.

In April 2007, two S&P analysts discussed the company’s model for collateralized debt obligations, with one messaging that a deal was “ridiculous” and that S&P “should not be rating it,” according to Bloomberg News.

We rate every deal,” the other replied. “It could be structured by cows and we would rate it.”

Why Just S&P?

Even though the ratings were central to the biggest financial meltdown since the Great Depression, few have suffered any real consequences…until now.

Here’s who may be in the line of fire.

Moody’s & Fitch – It’s unclear why the government limited the suit to S&P when Moody’s and Fitch both provided the same AAA ratings for mortgage securities during the housing boom.

Some observers speculate that the lawsuit may have singled out S&P because it stripped the U.S. of its AAA rating in August of 2011, during Congress’ standoff over the debt ceiling.

Floyd Abrams, the lead lawyer for S&P, noted that the government turned up the heat on S&P after the downgrade.

“Is it true that after the downgrade, the intensity of this investigation significantly increased? Yeah,” he told CNBC.

Whatever the motive, a victory by the government is likely to spur other lawsuits.
“This lawsuit is significant because it could augur future government action or, even worse for the agencies, more litigation by investors,” Jeffrey Manns, a law professor at George Washington University in Washington, D.C. told Reuters.

Moody’s, the second-biggest provider of credit ratings, would be a natural target.

Fitch, the smallest of the “big three,” covers a more limited share of the market than S&P and Moody’s, but could still be vulnerable to future legal actions.

Warren Buffett – Through his Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Buffett remains Moody’s biggest shareholder, even after slashing his stake in 2009.
Berkshire owns 28.4 million Moody’s shares, or about 13% of the firm.

Shares of Moody’s have dropped nearly 26%–a paper loss of about $401 million–since news of the lawsuit hit the street.

Although it’s unlikely Buffett has any legal liability, he told the Financial Crisis Inquiry Commission in 2010 that Moody’s wasn’t alone in missing the collapse of the housing market and that he invested in the business because of its “natural duopoly” with S&P.

Risks to the U.S. Economy

Experts say that the way the ratings agencies are allowed to operate makes the entire U.S. economy increasingly vulnerable to the risks that took it down in 2008.

The lawsuit “may help the government appear to be dealing with the problem and holding S&P to account, but that isn’t dealing with the core problems,” Jeffrey Manns, associate professor of law at George Washington University, told the Washington Post.

The core issue is that the agencies are paid by the very companies who are packaging the products they are grading.

Having Wall Street banks as their most important customers may push the agencies to award better grades to products even if they have reason to doubt their safety.

While the lawsuit focuses on that relationship, it doesn’t provide any solution to the overall problem — leaving the housing market open to the same kind of abuse that nearly tanked the global economy in 2008.

>>Don’t miss Why Did the U.S. Government Sue Standard & Poor’s?

>>You might also like Fitch’s Warning on U.S. Credit Downgrade.

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