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Reaction to the S&P Lawsuit Is Just What You’d Expect

1:08 pm in Financial Crisis by masaccio

Big lawsuits are great opportunities to look at the state of mind of reporters, pundits and bloggers. I have posts on the case focused on the facts, the law and what they say about the Department of Justice. Of course, my biases are obvious: I think the DOJ refused to enforce the laws against fraud by Wall Street executives, that the refusal to investigate and enforce the law was a deliberate policy choice by President Obama, and that policy was intentionally put into practice by Attorney General Eric Holder and the head of the DOJ Criminal Division, Lanny Breuer. Others show their biases as well.

John Tamny, writing for Steve Forbes’ rag, tells us that S&P was a bunch of second raters, and if the big Wall Street players couldn’t see the coming market crash no one should expect the “financial equivalent of the last player picked for a pickup basketball game” to catch it. Funny, yes, accurate, no. Tamny uses John Paulson’s massive bet against the market as proof that the big boys were ignorant. That’s just false. I discussed the SEC suit against Goldman Sachs here. Paulson and Goldman Sachs were not wild-eyed speculators, they were consciously selling garbage to unsuspecting small banks. In fact, Goldman Sachs made $3.7 billion shorting CDOs just before the Great Crash. The S&P complaint says that the big Wall Street players knew the crash was coming, and they were desperate to get the garbage off their books. The complaint says that S&P knew that, and still they continued to use the same rating system instead of one they had that was more accurate. Forbes isn’t going to let the facts get in the way of a good story.

The Wall Street Journal Op-Ed page explains that the S&P suit is a result of failed regulation and revenge. The evil feds regulated the ratings agencies and “ forced investors to rely on them”. That, of course, is nonsense. There is a rule that some financial institutions, including credit unions, can’t invest in securities that receive low ratings. That rule assumes that the ratings agencies are doing their jobs. If they don’t, they can and do cause enormous losses, and they should be sued.

And look, they say, Moody’s wasn’t sued, and they were just as bad. The decision to end the Moody’s investigation, if that happened, was made at the time S&P downgraded the US. And, get this:

… that’s also coincidentally when White House Chief of Staff Jack Lew was aggressively promoting the President’s campaign to prevent entitlement reform. Mr. Lew had worked in the heart of Citigroup’s subprime investment factory, and the President has not only been willing to forgive and forget. He’s even nominated Mr. Lew to become Secretary of the Treasury. But the company that put a shot across the Beltway bow over deficit spending is now the only target of a credit-ratings prosecution.

Those pesky facts again: Obama and the rest of his minions were perfectly willing to slash Social Security, Medicare and Medicaid to achieve his Grand Bargain, and that’s still on the table. The Wall Street Journal: once a valuable source of business reporting, now the print version of Fox News.

One more example from Red State’s Ed Morrisey, who managed to read a story from Bloomberg on the lawsuit. Bloomberg points out that the complaint says that Citibank and Bank of America are both the underwriters and purchasers of some of the overrated securities listed in the complaint. On its face this does seem odd. But recall that the investment banking arms of the company aren’t the same as the commercial banking group. Another Bloomberg writer, Jody Shenn, has an explanation. The suit is brought under FIRREA, the statute passed in the wake of the S&L disaster of the late 1980s in recognition of the fact that insiders at banks used their control to benefit themselves at the expense of shareholders and at the expense of federal insurance programs and taxpayers. The CEO of Citi testified to Congress that he didn’t know that the ratings system was corrupt. I imagine that this is true, and some employees of the bank were dumping the bad deals on the bank to enrich themselves.

Well, we all have our biases, don’t we, but that doesn’t mean we can’t agree on some things. I too want to know why Moody’s and Fitch weren’t sued. And why no one was indicted for fraud.

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The Legal Case Against S&P

1:41 pm in Financial Crisis by masaccio

I discussed here the compelling facts alleged in the complaint against Standard and Poor’s filed by Los Angeles US Atttorney André Birrotte, Jr. Now let’s look the legal claims, and try to explain why there is no criminal prosecution.

Wire Fraud

The suit is grounded in wire fraud. There are three elements to the crime. Shah, Mail and Wire Fraud, 40 Am. Crim. L. Rev. 825 (2003) (available through your public library). The prosecutor must prove the existence of a scheme to defraud, intent to defraud, and use of the internet or the phone in furtherance of the scheme to defraud.

a) Scheme to defraud. The concept of fraud comes to us from the Common Law, and has not been defined by statute. Here is a definition from Black’s Law Dictionary Free On-line:

Fraud consists of some deceitful practice or willful device, resorted to with intent to deprive another of his right, or in some manner to do him an injury.

It is easy to see how S&P’s actions described in the complaint fit this definition. S&P knew that the issuers would only hire it if the issuer was satisfied with the proposed ratings The complaint says that the issuers had input into the software used to calculate the ratings. See, for example, ¶¶ 125 and following, and 171. The goal of the scheme to defraud was to enable S&P to earn those fees. As part of that scheme, S&P defrauded investors about the nature of their ratings. At the same time, S&P was aggressively touting its independence and objectivity. This element doesn’t require that the injury itself results in gain to the perpetrator. It is enough if it injures the victim.

b) Intent to defraud. Lanny Breuer, the soon-to-depart head of the Criminal Division of the Department of Justice, constantly whines about the difficulty of proving intent. It isn’t hard. Shah explains:

The second element the government must prove for a mail fraud conviction is the defendant’s specific intent to defraud. This element is met using circumstantial evidence and “a liberal policy has developed to allow the government to introduce evidence that even peripherally bears on the question of intent.” Similarly, the defendant can also use circumstantial evidence to show that she did not have the requisite intent.

Id. at 835-6. The US Attorney Criminal Resource Manual agrees:

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US Says S&P Operated a Scheme to Defraud

11:08 am in Financial Crisis by masaccio

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.

PART TWO: The Legal Case Against S&P Read the rest of this entry →