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US S&P suit points to ratings industry's role in crisis

US Attorney General Eric Holder leads a news conference in Washington, DC, on February 5, 2013
US Attorney General Eric Holder leads a news conference at the Department of Justice, in Washington, DC, on February 5, 2013. Holder announced that the US is bringing a civil lawsuit against the ratings agency Standards & Poor's and its parent company

The US government's $5 billion lawsuit against Standard & Poor's for exaggerating mortgage bond ratings in 2007 has cast a pall over the ratings industry and exposed its role in the financial crisis.

S&P competitors Moody's and Fitch find themselves potentially facing penalties after the Justice Department alleged S&P knowingly kept ratings on high-risk mortgage securities high in order to win revenues from issuers.

The Justice Department has not said whether it has the other two ratings agencies in its sights, but Moody's spent much of the week fending off questions about whether it faces similar action following the S&P suit.

The New York Attorney General has meanwhile launched an investigation into all three companies over their ratings prior to the 2008 crisis, sources close to the matter told AFP.

S&P parent McGraw-Hill's shares plunged 27 percent after the suit was filed, and Moody's dropped 22 percent for the week, underscoring the market's worry that the crackdown on S&P may be just the tip of the iceberg.

"Investors have been selling those stocks aggressively this week and keep doing so out of fear that the situation with the Department of Justice could get a lot worse in the future," said Wedbush Securities analyst Michael James.

A Standard & Poor's rating agency sign is seen at the company headquarters in New York, on September 18, 2012
A Standard & Poor's rating agency sign is seen at the company headquarters in New York, on September 18, 2012.

"They think there is probably more bad news to come."

The government's case argues that S&P knowingly placed triple-A ratings on billions of dollars worth of mortgage-based financial securities even as the US housing market collapsed, misrepresenting their true credit risk.

Many of the top-rated issues cited in the suit were in default within one year or less.

S&P exaggerated the ratings in part to please clients and keep issuer revenues high, the suit alleges.

US Attorney General Eric Holder called S&P's conduct "egregious," saying "it goes to the very heart of the recent financial crisis."

New York Attorney General, Eric Schneiderman, pictured at the Justice Department in Washington, DC, on January 27, 2012
New York Attorney General, Eric Schneiderman, speaks during a news conference at the Justice Department in Washington, DC, on January 27, 2012.

S&P has dismissed the lawsuit as "meritless" and said it plans to vigorously contest the claims.

The litigation, which reportedly came after settlement talks failed, poses a huge financial challenge to S&P and McGraw-Hill.

Justice Department officials said they intend to press for at least $5 billion in civil penalties to match the losses suffered by investors on the securities.

S&P is also being sued by 13 states, adding to the potential damages.

The attorney general of California cited two large institutional investors, the California Public Employees Retirement System and the California State Teachers Retirement System, which lost approximately $1 billion on the high-rated mortgage bonds.

A California statement said the suit claims triple damages.

To put those figures in context, McGraw-Hill earned $911 million in all of 2011.

Many were wondering if or when the government will take action against Moody's. A multi-billion dollar suit could devastate that company as well: on Friday Moody's reported 2012 earnings of $690 million.

Jacob Frenkel, a former federal criminal prosecutor now in private practice with Shulman Rogers, said S&P could possibly settle the case in the range of "hundreds of millions of dollars."

But he said that the terms of a settlement -- what the company admits to, in addition to paying fines -- are crucial.

A key question concerns whether the government insists on S&P admitting liability, which could expose the firm to additional suits by investors in the securities it rated, Frenkel said.

Charles Elson, director of the John L. Weinberg Center for Corporate Governance, thinks the government could have a hard time proving its case against S&P.

"Unless you can show the opinion was reached in an intentionally reckless way, it's pretty hard to prove," Elson said.

Frenkel said the language in the complaint suggests the government could have pursued a criminal case against S&P.

That would raise the stakes: the 2002 US criminal conviction of former accounting giant Arthur Andersen in the aftermath of the Enron scandal eventually led to the firm's demise.

But Frenkel said the government is mainly focused on "integrity in the ratings process."

"The government would prefer to win a civil case than lose a criminal case," he said, "particularly where there is a concern about vaporizing the company."