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Justice is reviewing S&P work on loans

Rating of mortgage securities scrutinized; investigation began before US downgrade

By Louise Story
New York Times / August 18, 2011

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The Justice Department is investigating whether the nation’s largest credit ratings agency, Standard & Poor’s, improperly rated dozens of mortgage securities in the years leading up to the financial crisis, according to two people interviewed by the government and another briefed on such interviews.

The investigation began before Standard & Poor’s cut the United States’ AAA credit rating this month, but it is likely to add fuel to the political firestorm that has surrounded that action. Lawmakers and some administration officials have since questioned the agency’s secretive process, its credibility, and the competence of its analysts, claiming an error in its debt calculations.

In the mortgage inquiry, the Justice Department has been asking about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but may have been overruled by S&P executives, according to the people with knowledge of the interviews. If the government finds enough evidence to support such a case, which is likely to be a civil case, it could undercut S&P’s longstanding claim that its analysts act independently from business concerns.

It is unclear if the Justice Department investigation involves the other two ratings agencies, Moody’s and Fitch, or only S&P.

During the boom years, S&P and other ratings agencies reaped record profits as they bestowed their highest ratings on bundles of troubled mortgage loans, which made the mortgages appear less risky and thus more valuable. They failed to anticipate the deterioration that would come in the housing market and devastate the financial system. Since the crisis, the agencies’ business practices and models have been criticized from many corners, including in congressional hearings and reports that have raised questions about whether independent analysis was corrupted by the drive for profits.

The Securities and Exchange Commission has been investigating possible wrongdoing at S&P, according to a person interviewed for that matter, and may be looking at the other two major agencies, Moody’s and Fitch Ratings.

Ed Sweeney, a spokesman for S&P, said in an e-mail: “S&P has received several requests from different government agencies over the last few years. We continue to cooperate with these requests. We do not prevent such agencies from speaking with current or former employees.’’

S&P is a unit of the McGraw-Hill Cos., which is under pressure from some investors and has been considering whether to spin off businesses or make other strategic changes this summer.

The people with knowledge of the investigation said it had picked up steam early this summer, well before the debt rating issue reached a crescendo in Washington. Now members of Congress are investigating why S&P removed the nation’s AAA rating, which is highly important to financial markets.

Representatives of the Justice Department and the SEC declined to comment on whether they are investigating the ratings agencies.

Even though the Justice Department has the power to bring criminal charges, witnesses who have been interviewed have been told by investigators that they are pursuing a civil case.

Despite the public scrutiny and outcry over ratings agencies’ failures in the financial crisis, many investors still rely heavily on ratings from the three main agencies for their purchases of sovereign and corporate debt, as well as other complex financial products.

Companies and some countries - but not the United States - pay the agencies to receive a rating, the financial market’s version of the Good Housekeeping seal. For decades, the government issued rules that banks, mutual funds, and others could rely on a AAA stamp for investing decisions - which bolstered the agencies’ powers.

A successful case or settlement against a giant like S&P could accelerate the shift away from the traditional ratings system. The financial reform overhaul known as Dodd-Frank sought to lessen the emphasis on ratings in the way banks and mutual funds invest their assets. But bank regulators have been slow to spell out how that would work. A government case that showed problems beyond ineptitude might spur greater reforms, financial historians said.

“I think it would have a major impact if there was a successful fraud case that would suggest there would be momentum for legislation that would force them to change their business model,’’ said Richard Sylla, a professor at New York University’s Stern School of Business who has studied the history of ratings firms.

People with knowledge of the Justice Department investigation of S&P said investigators had made references to several individuals, though it was unclear if anyone would be named in any potential case. Investigators have been asking about a remark that was supposedly made by David Tesher about mortgage security ratings, two people said. The investigators have asked who heard Tesher say: “Don’t kill the golden goose,’’ in reference to mortgage securities.

S&P declined to provide a comment for Tesher.

Several of the people who oversaw S&P’s mortgage-related ratings went on to different jobs at McGraw-Hill. Investigators have told witnesses that they are looking for former employees and that has proved difficult because so many crucial people still work at the company.

One former executive who has been mentioned in investigators’ interviews is Richard Gugliada, who helped oversee ratings of collateralized debt obligations. Calls to his home were not returned.