Last month the federal Department of Justice filed a lawsuit in U.S. District Court for the Central District (the Los Angeles area) that is one of the most significant ones ever brought related to the recent financial crisis.
It is the first major lawsuit against any of the major credit rating agencies-of which Standard & Poor's (S&P) and Moody's are by far the two largest. These companies have long been considered by many to have played a crucial role in propping up the house of cards whose collapse brought the financial system and the entire economy to its knees.
A Little Background Information
A credit rating agency is different than a credit bureau or consumer reporting agency which provides credit scores for personal credit-worthiness-such as Equifax. Instead it is a company that assigns credit ratings on behalf of financial and other institutions which issue certain types of debt obligations, such as securities and bonds. The credit rating agencies assign ratings to those securities and bonds so that investors which are considering whether to invest in those securities and bonds can efficiently make judgments about how safe or risky those investments are.
So, credit rating agencies play an indispensable role in the U.S. financial system, and in the creation and sale of mortgage-backed securities. They hold themselves out to be objective, independent, and reliable sources of information for investors about the safety of potential investments. Most of the time, these securities have to have a rating from a respected credit rating agency for investors to be willing to invest in them. In fact, often the investors are not allowed to put their money into such securities and bonds otherwise.
The Lawsuit's Allegations Against S&P
The Complaint initiating this lawsuit is long and detailed--119 pages with 286 paragraphs of allegations. It alleges that S&P systematically defrauded investors in mortgage-backed securities, resulting in losses for those investors amounting to billions of dollars. Specifically S&P is alleged to have engaged in an ongoing scheme from 2004 through 2007 to provide inflated credit ratings for the mortgage-backed securities. S&P's alleged motive was its own profit: by making these securities look like safer investments than it knew they were, S&P would keep getting hired and paid by the banks that were creating and selling these mortgage-backed securities. The alleged direct result of S&P's fraudulent scheme was that the buyers of these securities-specifically federally insured financial institutions-lost billions of dollars when most of these investments became worthless after having received intentionally inflated credit ratings from S&P.
These allegations are summarized in a press release issued by the U.S. Department of Justice announcing the lawsuit, which included the following:
Contrary to representations [by S&P that its ratings were objective and independent], from 2004 to 2007 . . . S&P was so concerned with the possibility of losing market share and profits that it limited, adjusted and delayed updates to the ratings criteria and analytical models it used to assess the credit risks posed by [the mortgage-backed securities]. . . . S&P weakened those criteria and models from what S&P's own analysts believed was necessary to make them more accurate. . . . [B]ecause of this same desire to increase market share and profits, S&P issued inflated ratings on hundreds of billions of dollars' worth of [mortgage bonds]. . . . As a result, nearly every [mortgage bond] rated by S&P during this time period failed, causing investors to lose billions of dollars.
The California Connection
The U.S. Department of Justice filed the lawsuit in Southern California because this had been the home of the Western Federal Corporate Credit Union, a federally insured credit union. It had been the largest corporate credit union in the U.S., but collapsed in 2009 after it lost almost $7 billion from its investments in mortgage-backed securities, many of which had been rated by S&P. Wescorp is included in the lawsuit, among many others, as one glaring example of the fraud alleged in the complaint.
The day after this federal lawsuit was filed, a completely separate one was also filed by the California Department of Justice in San Francisco Superior Court, largely based on the same facts but relying not on violations of federal law but on separate California state laws. The alleged victims of S&P's misrepresentations in this lawsuit are the California Public Employees Retirement System and the California State Teachers Retirement System, two of the country's largest institutional investors. These pension funds are a prime examples of institutional investors which are only allowed to buy securities which are rated "AAA," which supposed means they involve minimal risk. These two pension funds lost about $1 billion from their S&P rated investments.
It will be quite interesting to see what happens to both the federal and state lawsuits. They are both taking a different tack than the lawsuits and regulatory actions in response to the recent financial we have seen during the last few years against the large banks and other
financial institutions, all of which seemed to result in damage awards that were relatively mild compared to the financial devastation involved. These new lawsuits seem to be more aggressive in a number of ways, so they'll be worth following.