S&P: Can It Survive a Suit for Fraud?

Econintersect:  There are widespread reports that Standard & Poors (S&P) will be charged with fraud in a civil suit by the U.S. Department of Justice (DoJ) and an unspecified number of U.S. states.  The suit will allege that the rating agency fudged its credit quality opinions prior to the financial crisis because overly generous assessments would bring them more business.  The suit will charge that S&P ignored its own internal standards in order to issue “rosy” ratings.   S&P issued a statement saying the suit would be “entirely without factual and legal merit.”

S&P maintains that it was being unfairly punished for “failing to predict” the collapsing housing bubble and the financial crisis.

The Financial Times said that Connecticut and Illinois already have actions started against S&P and that California is expected to join the Federal suit.  The New York Times said that more than a dozen states are expected to join the Federal suit.

A possible defense that Huffington Post says have been used by credit rating agencies is that the ratings were merely opinions and therefore protected from suit by the First Amendment to the U.S. Constitution.  That may not do well in court.  From the HP:

“This defense has largely been pushed to one side,” said James Cox, a securities law professor at Duke University. “The argument is now viewed skeptically. Courts won’t cut them much slack.”

Investors that include pension funds and foreign banks, as well as smaller investors, lost hundreds of billions of dollars on failed MBS (mortgage backed securities), according to the Huffington Post.  That estimate may be too low since at least $1 trillion in defaulted mortgages have already occurred with up to $3 trillion more additional potentially to come.  (See GEI Opinion.)  With 50% recovery after repossession the losses to mortgage holders could eventually be $1 to $2 trillion dollars.  And 50% recovery after all the expenses are deducted may be too generous an estimate.

Note: Many news stories refer to the secutities in question as CDOs (collateralized debt obligations).  Mortgage backed securities (MBS) are a special case of CDOs and all reports indicate that mortgage backed CDOs are what are being addressed.

According to the Financial Times the investigation by the DoJ and negotistions with S&P have been onging for some time:

During settlement talks with S&P last November, the DoJ pushed for a fine of more than $1bn and wanted the agency to admit wrongdoing, the person familiar with the matter said. Talks broke down last month.

Andrew Sorkin in The New York Times suggests that a billion dollar cost might put McGraw-Hill under.  The key area that stopped the negotiations last year was the admission of wrongdoing.  S&P felt that would open the door to open ended suits from many sources and the cost could not be born by the company.  If the $1 billion were just the start how far could the liabilities go?  A few billion?  $5 billion?  $10 billion?

On their 29 September 2012 financial statement, the McGraw-Hill balance sheet shows a net worth of $2.6 billion.  (McGraw-Hill (NYSE:MHP) is the parent of S&P.)  It is not at all likely that amount would be recovered in liquidation because it undoubtedly contains totally illiquid “assets” such as good will.  The same balance sheet gives net tangible assets as minus $1.8 billion.  Net income for the last four quarters is listed on the company’s income statement as $0.9 billion.  The cash flow statement shows a net change in cash flow over the past four quarters of minus $0.2 billion.

If S&P was subjected to judgements of just a few billion dollars, a small percentage of losses accrued on MBS they gave overly generous ratings to, where could the money come from?   Have you heard the one about blood from a stone?

Shares of S&P’s parent corporation, McGraw-Hill (NYSE:MHP), declined 14% during trading and after hours Monday (04 February 2013).  The price at 7:58 pm according to Yahoo Finance was %50.11.  MHP had closed last Friday at $58.34.  Reuters said it was the worst one-day decline for the stock since the 1987 crash.

John Lounsbury

Sources:

• U.S. Sues S&P Over Ratings (Jean Eaglesham, Jeannette Neuman and Evan Perez, The Wall Street Journal, 04 February 2013)

• S&P faces DoJ lawsuit over ‘rosy’ ratings (Kara Scannell, Financial Times, 04 February 2013)

• U.S. Accuses S.&P. of Fraud in Suit on Loan Bundles (Andrew Ross Sorkin and Mary Williams Walsh, The New York Times, 04 February 2013)

• S&P Lawsuit First Amendment Defense May Fare Poorly, Experts Say (Ben Hallman, Huffington Post, 04 February 2013)

• FDIC Sues Bank Directors: What’s Wrong with this Picture? (John Lounsbury, GEI Opinion, 03 Fenruary 2013)
  

• The McGraw-Hill Companies Market and Financial Data (Yahoo Finance)

• S&P 500 posts worst day since November; McGraw-Hill shares sink (Caroline Valetkevitch, Reuters, 04 February 2013)