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Tuesday, Feb 5, 2013 4:45 PM UTC

Key allegations government is making against S&P

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Topics: From the Wires,

Here is the basis of the case the U.S. government is making against Standard & Poor’s Ratings Services in a 128-page lawsuit:

—The charge: The government accuses S&P of knowingly giving high grades to risky mortgage-backed securities from about 2004 to 2007. The mortgages underlying those securities later imploded, causing investors billions of dollars in losses.

—The background: S&P is an agency that assigns ratings to investments. When an investment has a high rating, the risk is considered low. Even the most conservative investors, like some pension funds, feel confident enough to buy it.

Banks and other financial firms approach S&P and other major rating agencies when they have an investment that needs to be rated. The system contains an oddity: The banks not only pay for the ratings they receive but can also shop around to see which rating agency might give them the highest marks. This creates a conflict of interest: To earn business from the banks, the rating agencies can feel pressure to give high grades to the banks’ investment products.

—The details: The government says S&P knowingly gave high grades to banks’ risky mortgage-backed securities that later soured because it wanted to earn more business from the banks.

—The business model: To support its claims, the government refers to comments from S&P executives that they wanted their ratings to be handled in a “business friendly” way. The lawsuit also points to emails in which an S&P analyst says executives fear angering the banks by assigning low ratings to their securities. In another email, an analyst complains about missing out on a deal because S&P’s criteria on a rating were stricter than those of its rival Moody’s.

—What they knew: The government also refers to emails in which S&P employees appear to know how severe the subprime mortgage crisis is, even though they still had high ratings on subprime-backed mortgage bonds. In one report, the performance of subprime investments was so bad that S&P employees thought the numbers must be typos. One analyst emailed a video of himself singing about the collapse of subprime mortgages, with colleagues laughing.

—The government’s role: The Justice Department is the government arm that filed the lawsuit. The government has an obligation to make investing fair and safe. But it’s also been accused of failing to aggressively pursue wrongdoing related to the financial crisis. It has been under pressure to show it can bring and win lawsuits.

—The significance: This is the first time the federal government has filed a lawsuit against one of the major credit rating agencies over actions related to the financial crisis. S&P is also known as the rating agency that downgraded long-term U.S. debt in 2011.

—The defense: S&P denies wrongdoing and says it can’t be blamed for failing to predict the unpredictable financial crisis. It points out that the government was also saying as late as 2007 that the subprime crisis would likely be contained. S&P also says the lawsuit has taken its emails out of context.

It says it “deeply regret(s)” that some investments didn’t perform as well as expected. But S&P adds, “20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals.”

More By Christina Rexrode.

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