WORD ON THE STREET: Standard & Poor's Rating Services (S&P) is the largest credit rating agency in the world. As such, it plays a unique role on Wall Street. Many investors and financial analysts, as well as the general public look to S&P to be a fair and impartial umpire when it comes to the ratings it issues.
And in the years preceding the financial crisis, S&P played a role in rating the vast majority of financial transactions involving the two types of financial products: residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). Between 2004 and 2007, S&P issued ratings on trillions of dollars worth of RMBS and CDOs.
And those ratings were important, because without a stamp of approval by S&P or one of the other major credit rating agencies, these financial transactions simply could not have occurred. That is because nearly every single RMBS or CDO sold required a credit rating – typically, an AAA rating – in order to attract the attention and confidence of investors.
And repeatedly, S&P promised that its ratings would be ‘objective and independent.’ Even though the banks and other institutions hired S&P to rate these financial products, and even though S&P earned millions as a result of issuing those ratings, S&P promised that its ratings would be unaffected by their concerns about market share, revenue or profits.
But the evidence we have uncovered tells a different story. We allege that from at least 2004 to 2007, S&P lied about its objectivity and independence – that they said one thing, yet did another. The evidence reveals that S&P promised investors and the public that their ratings were based on data and analytical models reflecting the company's true credit judgment, when in fact internal S&P documents make clear that the company regularly would ‘tweak,’ ‘bend,’ delay updating or otherwise adjust its ratings models to suit the company's business needs. Â
We also allege that from at least March 2007 to October 2007, S&P issued ratings for certain CDOs – ratings S&P knew were inflated at the time they issued them. Â
And how did S&P know the CDO ratings they issued were inflated? Because those CDO ratings were derived in large part from the ratings on classes of subprime mortgage bonds which backed those CDOs – classes of mortgage bonds whose own ratings S&P knew it was going to downgrade, yet did nothing to adjust the overall CDO ratings to reflect that inevitability. Â
It's sort of like buying sausage from your favorite butcher, and he assures you the sausage was made fresh that morning and is safe. What he doesn't tell you is that it was made with meat he knows is rotten and plans to throw out later that night.
And how did it all happen? Well, our complaint alleges that as of late 2006, executives at S&P began hearing alarm bells about subprime RMBS, as S&P's internal information revealed that borrower delinquencies in subprime mortgages were rising dramatically, leading the financial instruments that were based on these subprime mortgages to perform far worse than their S&P ratings suggested they should perform.
By early 2007, S&P's own analysts had come to believe that many mortgage-backed securities were in trouble. They began recommending that the company start the process of lowering credit ratings for hundreds of subprime mortgage bonds that S&P had previously rated.
But S&P's business executives rejected these downgrade recommendations, choosing instead to continue rating subprime mortgage bonds for their bank clients, whose appetite for highly-rated, mortgage-backed securities was growing.
By March 2007, we allege that S&P knew that mortgage-backed securities were in such deep trouble that unprecedented downgrades were inevitable; it wasn't a matter of if, but when. Of course, such downgrades meant that the value of subprime mortgage bonds on the books of some of S&P's most significant bank clients would be dramatically reduced. Â
So to avoid the significant financial hit such downgrades would have caused, these banks packaged those subprime mortgage bonds into CDOs and sold them to investors as a way to get those bonds off of their books. And we have evidence that S&P not only knew this is what the banks were doing, but in fact S&P helped them do it.
As our complaint explains, through the spring and summer of 2007, S&P moved at a record pace, rating hundreds of billions of dollars worth of CDOs packed with subprime mortgage bonds. Yet, throughout this period, S&P made no adjustments in issuing these ratings – in fact, S&P gave AAA ratings to nearly all of the CDOs it rated during this time – and they did this despite their own internal reports showing that the ratings on the mortgage bonds on which the financial quality of these CDOs depended would not hold.
Even after S&P executives chose the date on which to inform the public of their plan to institute mass downgrades, S&P continued to issue ratings on CDOs as if nothing had changed. On July 11, 2007, just one day before S&P publicly announced the downgrades, an internal S&P email to executives warned: ‘CDO deals that close now will be downgraded if we don't stop them.’ Yet, on that very day, S&P rated two new CDOs backed by subprime bonds – in fact, S&P gave them AAA ratings, making no ratings adjustments for the downgrades S&P knew were coming.
And in July 2007, S&P issued the mass downgrades it had for months known were inevitable. Soon after, credit markets in the U.S. and around the world collapsed. Nearly every CDO that S&P rated between March and October 2007 defaulted, and the ratings were downgraded to junk. The failure of those CDOs led to billions of dollars in losses to federally insured financial institutions and other investors.
In the Justice Department, our code name for this investigation was ‘Alchemy.’ Â Centuries ago, medieval alchemists tried various methods to turn lead into gold. Here, we allege that S&P's desire to ensure market share, revenue and profits led it on a misguided venture to take securities it knew were lead and tell the world through its ratings that they were gold. And in so doing, we believe S&P played a significant role in helping to bring our economy to the brink of collapse.
Tony West is the acting associate attorney general within the U.S. Department of Justice. This article is adapted from remarks made at a Feb. 5 press briefing. The original text is available online.
