The US Attorney for Los Angeles, André Birotte, Jr., sued Standard and Poors for wire fraud against financial institutions earlier this week. Thanks to FT Alphaville, we have a copy of the complaint. This is a fraud case, and the rules require that the circumstances showing fraud be alleged “with particularity”. The complaint is full of particularity, about 110 pages worth. You can get a good idea of the sense of the complaint from the table of contents. Let’s take a look at the alleged facts; I’ll have a separate post on legal stuff.
S&P is a Nationally Recognized Statistical Rating Organization, regulated by the SEC. Some federally regulated financial institutions, such as Credit Unions, are only allowed to hold securities rated as AA- or better by at least one NRSRO. Other regulated financial institutions used ratings as an integral part of their investment decisions. S&P knew this.
Issuers pay S&P for the ratings, and for follow-up monitoring of the performance of their real estate backed mortgage securities (RMBS) and collateralized debt obligations (CDO). S&P knew that if it understated the risks of securities, it would be easier for issuers to sell them, so issuers would use S&P instead of one of its competitors. S&P knew that it would make more money if its ratings were higher than justified by the data. And it knew that if it understated the risks, investors could more easily lose money. The complaint alleges that S&P deliberately understated the risks in order to preserve and increase its sales. At the same time, it constantly and loudly insisted that its ratings were objective and accurate. The complaint says that this constitutes a scheme to defraud investors by S&P.
The complaint puts flesh on these bones. The rating system used by S&P in 1999 to estimate defaults on real estate backed mortgage securities was called LEVELS 5.6. It used a sample of “166,000 almost exclusively first-lien, fixed rate, prime mortgage loans”. ¶ 135. The issuer gave S&P information about the proposed pool of securities. S&P ran the data through LEVELS 5.6 to create the ratings. Over the next few years, S&P used LEVELS 5.6 even as the securities it was rating included more and more risky non-prime loans, including Alt-A and subprime loans.
By 2002, S&P had acquired a sample of 642,000 loans which included many riskier loans. It did not incorporate this into LEVELS 5.6, so actual evaluation was based on the old sample for the next two years.
When it began to test the new sample in 2004 in an update called LEVELS 6.0, it found that the ratings were substantially lower than those given by the old sample. The new data sample recognized that new RMBSs held riskier loans, so issuers would have to increase the number of loans in a pool to insure that the lower rated tranches of the RMBSs would receive investment ratings. That made the RMBS less profitable for the issuers. ¶ 143 A salesperson reported that S&P lost a deal because the new data required 10% more loans than Moody’s, one of S&Ps competitors. S&P did not convert to LEVELS 6.0. Instead, it issued updated versions of LEVELS 5.6 that did not increase the credit support requirements even for the riskier loan pools.
I note that the complaint does not allege what steps, if any, were taken in LEVELS 5.6 to adjust for the different kinds of mortgage loans in the RMBS and the CDOs. However, the complaint says (¶¶ 148-9):
Prior to March 2005, Executive H had suggested to Structured Finance executives that proposed LEVELS 6.0 should be released as soon as possible, because it … was simply a better model. … LEVELS 6.0 would require higher loss coverage levels for subprime loans and … S&P was underpricing risk on RMBS deals by having loss coverage levels that were too low.
The response Executive H received from Structured Finance executives was that if proposed LEVELS 6.0 was not going to result in S&P increasing its market share or gaining more revenue, there was no reason to spend money putting it in place.
The complaint contains similar claims about the rating of Collateralized Debt Obligations. ¶¶ 158 and following. Here is one example. CDOs are pools of debt securities, including tranches of RMBSs, credit default swaps and combinations of the two. CDOs include lower rated tranches of RMBSs that the issuers hadn’t sold. The complaint says that by Spring 2007 S&P knew these tranches would be downgraded, because as part of its services, it monitored their ongoing results. S&P knew that issuers were anxious to get these lower RMBS tranches off their books and into CDOs to help protect their balance sheets. S&P continued to use the original ratings of those lower tranches when they were included in CDOs until public information on the tranches was changed. That meant that the CDOs got higher ratings than would be justified in the face of known upcoming downgrades. ¶¶ 199, 229, 233(b), (i), and (n).
S&P claims that the complaint is without merit. No, really. And they are getting some PR help where you’d expect it, in the pages of Steve Forbes’ rag. I disagree. I think S&P has a problem, and I wonder if Moody’s and Fitch will face similar claims.