The federal government has filed a lawsuit against a prominent credit ratings agency, alleging the agency issued inflated ratings that misrepresented the true credit risks of mortgage-backed securities in the boom years leading up to the financial crisis and subsequently cost investors billions.

The U.S. Department of Justice alleges Standard and Poor’s Ratings Services and its parent company, McGraw-Hill Companies Inc., engaged in a scheme to defraud investors — many of them federally insured financial institutions — who purchased products known as residential mortgage-backed securities (RMBS) and collateral debt obligations (CDOs) under repeated assurances by S&P that its ratings of these products were objective, independent and uninfluenced by S&P’s relationships with the investment banks that issued the products, the DOJ said.

"Contrary to these representations, from 2004 to 2007, the government alleges, S&P was so concerned with the possibility of losing market share and profits that it limited, adjusted and delayed updates to the ratings criteria and analytical models it used to assess the credit risks posed by RMBS and CDO," the DOJ said.

The complaint further alleges that between March and October 2007, S&P issued inflated ratings on hundreds of billions of dollars’ worth of CDOs, and nearly every CDO rated by S&P during that time period eventually failed.

Federal law authorizes the U.S. attorney general to seek civil penalties up to the amount of the losses suffered due to the alleged violations, which, to date, the government tallies at more than $5 billion between March and October 2007 alone.

"Many investors, financial analysts and the general public expected S&P to be a fair and impartial umpire in issuing credit ratings, but the evidence we have uncovered tells a different story," said Acting Associate Attorney General Tony West in a statement.   

"Our investigation revealed that, despite their representations to the contrary, S&P’s concerns about market share, revenues and profits drove them to issue inflated ratings, thereby misleading the public and defrauding investors. In so doing, we believe that S&P played an important role in helping to bring our economy to the brink of collapse."

Attorneys general from California, Connecticut, Delaware, Washington, D.C., Illinois, Iowa and Mississippi have filed or will file civil fraud lawsuits against S&P alleging similar misconduct, the DOJ said.

In a statement, S&P said the DOJ’s lawsuit was "unjustified and without legal merit."

"Claims that we deliberately kept ratings high when we knew they should be lower are simply not true. We will vigorously defend S&P against these unwarranted claims," the company said. 

"At all times, our ratings reflected our current best judgments about RMBS and the CDOs in question. Unfortunately, S&P, like everyone else, did not predict the speed and severity of the coming crisis and how credit quality would ultimately be affected. Although we deeply regret that these 2007 CDO ratings did not perform as expected, 20/20 hindsight is no basis to take legal action against the good-faith opinions of professionals.

"The fact is that S&P’s ratings were based on the same subprime mortgage data available to the rest of the market — including U.S. government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained. Every CDO cited by the DOJ also independently received the same rating from another rating agency."

S&P added that it had spent about $400 million in the past five years to reinforce the integrity, independence and performance of its ratings, including strengthening independence from issuer influence, improving its methodologies, monitoring global credit risks, and enhancing regulatory compliance and analytical quality.

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