The ratings firms that helped trigger the 2008 financial crisis are coming under escalating scrutiny as U.S. authorities late Monday sued Standard & Poor's Ratings Services.
The lawsuit, in connection with the ratings that S&P assigned to complex mortgage-backed bonds, marks the first time that U.S. federal prosecutors have pursued a credit ratings agency for wrongdoing related to the housing meltdown.
The civil charges from the U.S. Justice Department were filed late Monday in federal court in Los Angeles. Several state prosecutors are also expected to join the suit.
S&P, which is a unit of McGraw Hill Cos., said in a statement that a lawsuit "would be entirely without legal or factual merit."
News of the charges comes amid continuing popular pressure on U.S. authorities to punish those responsible for the 2008 financial crisis. To date, the response from regulators and prosecutors has consisted of civil actions against banks that have ended in monetary settlements with no acknowledgment of misconduct. No senior executives at major institutions have faced civil or criminal charges.
For years, the major ratings firms have experienced withering criticism for their role in the lead-up to the crisis. They stamped triple-A ratings on dubious mortgage-related investments, many of which later turned out to be worthless. The ratings agencies were "essential cogs in the wheel of financial destruction," said the Financial Crisis Inquiry Commission in its official report to the U.S. Congress in 2011.
The ratings agencies were not just incorrect in their assessment of the investments, the commission said, but riddled with conflicts of interest. It described an environment where the ratings agencies put profits ahead of their own internal standards and where employees were pressured by issuers to give more favourable ratings. At Moody's Investors Service Inc., the corporate culture morphed from one of "just say no" to "must say yes," in the words of one ex-employee.
The lawsuit expected from the U.S. Justice Department will focus on about 30 highly complex mortgage-backed securities created in 2007, according to a report from The New York Times. To build their case, prosecutors are relying in part on internal e-mails between S&P employees, the paper said, and were pushing for a billion-dollar settlement from the firm before talks broke down.
In its statement, S&P said that every security in question "also independently received the same rating from another ratings agency." U.S. authorities "would be wrong in contending that S&P ratings were motivated by commercial considerations and not issued in good faith."
It remains unclear why U.S. authorities are focusing on S&P and not Moody's or Fitch Ratings Inc., the other two major players.
A number of private investors as well as the states of California and Illinois have already sued ratings agencies, alleging that misleading ratings led to significant investment losses.
In November, an Australian judge ruled in response to an investor suit that S&P had engaged in "misleading and deceptive" conduct by placing a triple-A rating on a mortgage-backed security she deemed "grotesquely complicated." S&P has said it will appeal the ruling.
In the United States, ratings agencies have argued successfully in court that their assessments are opinions that are protected under the right to freedom of speech guaranteed by the U.S. Constitution.
"A traditional defence has been for the credit ratings agencies to say they are like The Globe and Mail – that they are publishers of information," said Lawrence White, an economist at New York University. He noted that a famous law review article once called ratings "the world's shortest editorials."
Other experts questioned the timing of the suit, which appears to target behaviour from six years ago. They worry that such efforts will substitute monetary penalties for real structural change in how ratings agencies function. The business model that led to trouble for the ratings agencies – where issuers pay for ratings and can "shop" between agencies for the best possible rating – remains intact.
The expected suit against S&P "looks like extortion to me," said Ann Rutledge, an expert on structured finance and principal at R&R Consulting in New York. Although she is a critic of the ratings agencies, Ms. Rutledge doesn't think a lawsuit seeking money is the answer. No one is "really focused on reforming the system," she said.