Standard & Poor's Subprime Performance

      The unnamed senior analyst was new to the credit rating agency Standard & Poor’s in July 2007 when he told an investment banker client by e-mail that the job was “going great.” Except, the analyst added sardonically, that the world of mortgage-backed securities that accounted for much of the company’s business was “crashing,” investors and the media “hate us,” and “we’re all running around to save face.”
      Continuing the e-mail string two days later, the analyst acknowledged that there had been “internal pressure” for S&P to lower its all-important investment ratings on many deals. But the pressure apparently came to naught. Why? Because “the leadership was concerned of p*ssing off too many clients” and “jumping the gun ahead of” S&P’s lesser rivals in the credit-rating business, Fitch and Moody’s.
      The newbie analyst’s unguarded admission of S&P’s conflict of interest between satisfying clients and providing objective financial advice was one of many revealing e-mails cited in the government’s massive suit filed last week [Feb. 4] charging S&P with fraud. The 119-page complaint depicts S&P as giving its coveted investment-grade triple-A rating to packages of subprime mortgages even as S&P analysts and executives were well aware of the record level of delinquencies in the mortgage marketplace.
      The suit, United States v. McGrawHill, filed in federal court in Los Angeles, represents the government’s most ambitious effort to date to go after one of the financial companies that played a part in the great financial crisis of 2007-2008. (McGraw Hill is S&P’s parent company.) The government is asking for up to $5 billion in civil penalties under a 1989 law, the Financial Institutions Reform, Recovery and Enforcement Act, which Congress passed after the savings & loan crisis of the 1980s. The law allows the government to recoup fraud-related losses suffered by federally insured banks and credit unions.
      In announcing the lawsuit, Attorney General Eric Holder said S&P’s “egregious” conduct went “to the very heart of the recent financial crisis.” S&P analysts were aware as early as 2003 of doubts about the accuracy of its ratings for financial packages made of up residential mortgages, Holder said. But S&P executives allegedly ignored the warnings, concealed facts, made false representations to investors and financial institutions, and took “other steps” to manipulate the ratings, all for the purpose of increasing S&P’s revenue and market share.
      Prepared for the filing — S&P was reported to have turned down a proposed settlement — the company sent the high-powered Wall Street attorney Floyd Abrams out to answer the charges. In a succession of TV interviews, Abrams tut-tutted the seemingly damning e-mails cited in the government’s complaint.
      The government had picked a few “angry” or “embarrassing” e-mails out of 20 million pages of documents, Abrams said. Overall, he insisted, the evidence would show that S&P was doing its best in difficult times to make good judgments about what was going to happen in the future. And if S&P got it wrong, Abrams said, so did everybody else: the other credit rating companies and the top government leaders, including the Bush administration’s secretary of the treasury, Henry Paulson.
      The government’s complaint, however, charges that the company was not merely wrong, but knowingly and intentionally wrong. In the government’s telling, the company stood to gain more from pleasing the clients who paid six-figure fees to have their investment packages favorably rated than it stood to lose from misleading investors about the risks of billion-dollar bundles of subprime residential mortgages.
      One analyst complained in a 2004 e-mail about losing a deal to Moody’s because S&P was requiring higher credit support for a favorable rating. Over time, the government alleges, S&P stopped being so demanding. By 2006, one analyst was asking rhetorically: “Does company care about deal volume or sound credit standards?” Despite the unprecedented level of mortgage delinquencies, S&P failed to downgrade any of the mortgage-backed securities even when they consisted primarily of subprime mortgages.
      Experts handicapping the suit disagree on its prospects. Writing in the New York Times’ blog Dealbook, law professors Peter Henning and Steven Davidoff argue the government faces an “uphill battle” despite “the colorful e-mails.” A few complaints by low-level employees will not be enough to prove intentional fraud, Henning and Davidoff suggest. In addition, the government will have trouble showing that investors relied on the ratings since prospectuses typically include boilerplate advice not to rely on them.
      Disagreeing, former financial executive Richard Eskow argues in an op-ed in Huffington Post that the government makes out a “strong” case that S&P intentionally misled investors about its internal controls, methodology, and objectivity. Eskow, now a senior fellow with the liberal group Campaign for America’s Future, also notes the irony that S&P, accustomed to bragging about the quality of its services, will be defending in part by saying, “We weren’t crooked, just incompetent.”
      Whatever the outcome of the suit, Eskow argues that the credit rating agency system remains “broken” despite efforts by Congress to fix it. An amendment sponsored by Sen. Al Franken, the Minnesota Democrat, sought to eliminate the conflict of interest inherent in the system of issuer-paid ratings by having an independent board pick the agency to rate structured deals. The Securities and Exchange Commission, however, has failed to act on the issue. Despite its subprime performance in the past, the credit rating industry apparently has enough clout in Washington to bottle up any reforms that threaten its lucrative business.