Firm-Wide blog

U.S. Department of Justice to sue S&P over faulty ratings on Collateralized Debt Obligations

By Burg Simpson
February 5, 2013
3 min read

Standard & Poor’s (S&P) today announced that it expects to be sued by the U.S. Department of Justice (D.O.J.) for illegally issuing false ratings on mortgage bonds, including Collateralized Debt Obligations (C.D.O.’s). S&P, along with Moody’s and Fitch [the “big three” of the national ratings agencies], issued credit ratings on thousands of mortgage bond CDO’s in the late-2006 to 2008 timeframe that shortly proved that they were not worthy of the rating given. Many have argued that the false credit ratings were not the result of a mistake.

Since their structure is opaque, investors in the CDO market have always relied upon the credit ratings given by the ratings agencies to determine the value and risk of CDO securities. In late 2008, when hundreds of credit ratings proved to be wholly inaccurate, the prices of CDO securities were immediately impacted, and countless investors lost their investment. For many institutional investors, such as retirement and pension funds, the result of these false ratings were losses in the billions of dollars.

From 2006 to 2008, many investment banks who held large portfolios of sub-prime mortgages used CDOs as a vehicle to “off load” their “toxic” investments. Since investors did not see what mortgages were inside the CDO securities, investment banks could fill them with these undesirable mortgages. However, critical to the process of dumping these toxic investments was being able to obtain favorable credit ratings on the CDO securities. Without the favorable credit ratings, the CDO’s would not sell.

History has shown that the ratings agencies willingly participated in the process of giving artificially-high ratings to the CDO securities created by the investment banks. The rating agencies cooperated because it was the investment banks who pay them to create the credit ratings. In many instances, once all of the CDO securities were sold, the same ratings agencies who issued the original ratings began the “surveillance” process, and almost immediately determined that the securities did not support the favorable credit rating originally given. Often times, the credit rating was so negatively impacted that the structure of the securities allowed certain protected investors to liquidate the entire investment. In a large number of these securities the protected investors were the investment banks themselves. This “pay for play” model of compensation for ratings agencies [where the ratings agencies only get paid for their “opinions” and ratings if they provide ratings that the issuer is happy with] has been heavily criticized for years.

According to the lawsuits Burg Simpson has filed, it is clear that at least by 2007 the process the ratings agencies were engaged in was more than the mere provision of “opinions” about the securities. As alleged in several lawsuits, the ratings agencies were key participants in allowing the investments banks “offload” their toxic investments and defraud investors who relied on the “good word” of the ratings agencies.

Burg Simpson has been at forefront of this litigation for the last several years, with civil cases against S&P, Moody’s and Fitch arising from losses suffered by investors. This anticipated suit by the D.O.J. is part of the latest round of suits to be filed over these failed investments.

It is anticipated that the DOJ’s lawsuit against S&P will be publically filed on Tuesday. Once that lawsuit is on file, more details will follow.

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