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In a First, SEC Warns Rating Agency It May Bring Financial Crisis Lawsuit

Update, 9/27: For more on the Delphinus, check the pitchbook we just posted.

 

Though they’ve been faulted for their central role in the financial crisis, the major credit-ratings agencies have thus far weathered the fallout of the crisis with no sanctions from federal regulators and little more than a bruised reputation.

But that could change soon.

In a formal warning known as a Wells notice, the Securities and Exchange Commission informed credit-ratings firm Standard & Poor’s that it’s considering civil charges tied to the firm’s ratings of a 2007 mortgage-backed securities deal. It’s the first such warning to be given to a credit-ratings agency over matters directly related to the financial crisis.

The deal, known as Delphinus, was one of more than two-dozen collateralized debt obligations linked to the hedge fund Magnetar, whose role in creating and betting against risky CDOs was detailed in a ProPublica investigation last year. Completed in the summer of 2007, Delphinus was one of the last deals done by Magnetar and was underwritten by the Japanese bank Mizuho.

Details on S&P’s potential violations are still unclear. But last year’s Senate investigation of the financial crisis may contain some hints.

The report, which blamed inaccurate ratings as “a key cause” of the financial crisis, said agencies failed to do due diligence in grading securities and too often bent to the wishes of the banks that paid them. The report also flagged Delphinus as a “striking example” of the failures of ratings agencies, noting that the CDO was downgraded “a few months after its rating was issued.” Moody’s and Fitch, S&P’s main rivals in the United States, had also rated Delphinus and had to downgrade or withdraw those ratings after it went into default in 2008.

Senate investigators also released an internal S&P email chain in which analysts discussed whether to address the fact that about two-dozen “dummy assets” in the Delphinus portfolio were swapped out at the last minute for assets that “made the portfolio worse.” (Asked during congressional testimony about the use of dummy assets, two S&P execs told lawmakers they were unfamiliar with the practice in the CDO business.)

In a statement disclosing the SEC’s Wells notice, S&P’s parent company, McGraw-Hill, noted that the letter was “neither a formal allegation nor a finding of wrongdoing,” and that “S&P has been cooperating with the Commission in this matter and intends to continue to do so.” A S&P spokeswoman declined further comment.

The SEC also declined comment.

Three big banks—Goldman Sachs, JPMorgan Chase and Wells Fargo—have already settled fraud charges related to specific CDO deals, and more banks are under investigation. Mizuho, which marketed and sold Delphinus to investors, is also under investigation for a separate CDO deal involving Magnetar, as we noted last week. 

I seem to recall someone predicting that the S&P’s downgrade of US Treasuries was actually a warning shot.  This story would seem to increase that likelihood.

I’ll be interested to see how this one ends.  Remember that, for the downgrade, S&P’s excuse was that they shouldn’t be limited by the truth in their ratings, so expect that argument to make another appearance.

These are the same knuckleheads who rated both US sovereign debt and subprime mortgage-backed securities as AAA, the latter as recently as a couple of weeks ago - after the US downgrade.  They’re either catastrophically stupid or the worst corporate shills on record.

James Tennier

Sep. 26, 2011, 3:57 p.m.

I think this story got my libido involved.
No no, wait, false alarm, close though. Wouldn’t it be nice if we could all never be held responsible for lying? That’s what S&P is trying to do.
WTF people.

The ratings agencies used to be paid by whoever bought their reports, but now the seller of risk pays.  That is like having an advertising agency, instead of Consumer Reports, write product reviews. 

Consumer credit rating agencies are paid by banks and creditors, the buyers of risk, not by the consumers.  What if we switch that around and see who complains?

Egan-Jones is the only anointed ratings agency that is paid entirely by investors, the buyers of risk.  Retirement/pension funds need to change their rules to require trustworthy ratings.

That’s a good point, Paul.  A friend was once a civil engineer filing a report on an old building that was packed with asbestos.  She was fired because, “the owner of the building didn’t pay to hear bad news.”

One imagines the ratings agencies find themselves in a similar position, that lying gets them more business.

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