In the government's eyes, S&P's ratings stopped making sense

Barely two weeks after the big subprime lender New Century Financial Corp went bankrupt, a top Standard & Poor's executive assured Congress that her employer could be counted on to sound the alarm for the next credit disaster.

S&P ratings are "grounded in the cornerstone principles of independence, transparency, credibility and quality," resulting in a "long-standing track record of analytical excellence and objective commentary," Susan Barnes, managing director in charge of U.S. residential mortgage-backed securities (RMBS), testified.

But as Barnes spoke that April 17, 2007, before a Senate subcommittee, those principles were burning down around her, the U.S. government now argues in a $5 billion civil lawsuit accusing S&P of defrauding investors through inflated ratings.

The 119-page complaint sets out a litany of internal forebodings and warnings that investigators believe show the largest U.S. credit rating agency falsely represented that its ratings prior to the recent financial crisis were objective, and untainted by conflicts of interest.

While the complaint largely refers to S&P officials in the form of "Senior Analyst A", Reuters was able to identify many of them by referencing other public documents.

S&P, a unit of McGraw-Hill Cos, said it will vigorously defend against the lawsuit filed late Monday in Los Angeles federal court, and that it was "simply not true" that it deliberately kept ratings artificially high.

The government did not sue S&P's main rivals, Moody's Corp's Moody's Investors Service and Fimalac SA's Fitch Ratings.


According to the complaint, seeds for the fraud were planted in 2004 when S&P, mindful of its market share and profitability, began to drag its heels in updating its models to assess credit risks of debt it rated. And not everyone was pleased.

"Are you implying that we might actually reject or stifle 'superior analytics' for market considerations?" Frank Raiter, then head of U.S. RMBS, emailed some colleagues around April 2004, according to the complaint. "Inquiring minds need to know."

The government said S&P appeared deliberately slow in updating a CDO Evaluator that addressed risks in collateralized debt obligations, and a Loan Evaluation and Estimate of Loss System, known as LEVELS, that assessed risks in RMBS.

"Version 6.0 could have been released months ago and resources assigned elsewhere if we didn't have to massage the sub-prime and Alt-A numbers to preserve market share," S&P analyst Frank Parisi wrote around March 23, 2005, referring to LEVELS and two kinds of non-prime mortgages.

By late 2006, the government said S&P noted "unprecedented" deterioration in subprime RMBS. Privately, it seemed worried.

"This market is a wildly spinning top which is going to end badly," David Tesher, managing director of the cash CDO group, wrote on December 11, 2006, the complaint said.

But the government said it was investors who got spun.


According to the complaint, from March through late June of 2007, S&P issued CDO ratings that did not account for the "substantially increased" credit risks of non-prime RMBS.

In perhaps the most quotable passage in the complaint, the government describes an unnamed analyst who in March 2007 emails forwarded a parody of Talking Heads' 1983 song "Burning Down the House" and a video of himself performing its first verse:

"Watch out // Housing market went softer // Cooling down // Strong market is now much weaker // Subprime is boi-ling o-ver // Bringing down the house."

Two weeks later, on April 5, 2007, CDO analyst Shannon Mooney fired off an infamous instant message that surfaced during October 2008 Congressional hearings: "We rate every deal ... it could be structured by cows and we would rate it."


The cows came home.

By July 5, 2007, parts of the credit market had begun to seize up. Two Bear Stearns Cos hedge funds had just collapsed. And S&P's ratings were behind the times, the government said, quoting a new structured finance analyst's email to a client.

"The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up," the analyst wrote. "But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody's."

Six days later, in an allusion to the climactic scheme in the 1983 movie "Trading Places," the analyst wrote: "You should see how it is here right now. It's like a friggin trading floor. 'Downgrade, Mortimer, downgrade!!!'"

The next day, July 12, S&P announced a big downgrade of subprime RMBS. More would follow. It would end in October 2007 when S&P had finally eliminated the grade inflation behind dozens of RMBS-backed CDOs, the government said.


"I had forgotten all about the email until the Justice Department showed me," Raiter said on Tuesday in a phone interview, referring to his 2004 email. "The emails went to senior managing directors, most of whom had been on a senior leadership team, but some of us had been reorganized off that committee because we were too outspoken. They never responded to my observations."

Raiter said he left S&P in 2005 and is now retired.

Neither the other people named above in this article nor an S&P spokesman could immediately be reached for comment.

"Put simply," U.S. Attorney General Eric Holder said at a Tuesday press conference discussing the government's allegations, "this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis."

For S&P, it culminated in the same thing that Talking Heads lead singer David Byrne famously wore in his band's 1984 concert movie "Stop Making Sense."

A big suit.

(Reporting by Jonathan Stempel in New York; Additional reporting by Luciana Lopez; Editing by Tim Dobbyn)