Picture: REUTERS
Picture: REUTERS

MCGRAW-Hill and its Standard & Poor’s (S&P) unit are being sued by the US over claims that S&P knowingly understated the credit risks of instruments that were central to the worst financial crisis since the Great Depression.

The US justice department filed a complaint in Los Angeles on Monday, accusing McGraw-Hill and S&P of three types of fraud. McGraw-Hill tumbled the most in 25 years on Monday when it said it was expecting the lawsuit, the first federal case against a ratings company for grades related to the credit crisis.

S&P issued credit ratings on more than $2.8-trillion of residential mortgage-backed securities and $1.2-trillion of collateralised-debt obligations from September 2004 through October 2007, according to the complaint. It said S&P downplayed the risks on portions of the securities to gain more business from the investment banks that issued them.

"It’s a new use of this statute," Claire Hill, a law professor at the University of Minnesota who has written about the ratings firms, said. "This is not a line … that has been taken before."

Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989, the US seeks civil penalties of as much as $1.1m for each violation.

Settlement talks broke down after the government sought a fine of more than $5bn and an admission of wrongdoing from S&P, the New York Times reported. More than a dozen state attorneys-general may join the federal lawsuit and New York officials are preparing a separate action, the newspaper said.

Before the case was filed, McGraw-Hill fell 14% to $50.30 in New York trading on Monday. Moody’s Corporation, owner of the second-largest ratings provider, fell 11% to $49.45. Yields on McGraw-Hill’s $400m of bonds due in November 2037 rose 31 basis points to 5.75%, the highest since May, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Ratings firms have faced criticism from US legislators over how they granted top grades to securities that packaged home loans from the riskiest borrowers, leading to a credit seizure, starting in 2007, that sent the world’s largest economy into its longest recession since 1933.

"S&P’s desire for increased revenue and market share in the RMBS (residential mortgage-backed securities) and CDO (collateralised debt obligations) ratings markets led S&P to downplay and disregard the true extent of the credit risks," the US complaint said. It said S&P falsely represented to investors that its credit ratings were not influenced by any conflicts of interest.

The company bent rating models to suit its business needs to the extent that one CDO analyst commented that loosening the measure of default risk for a certain security in 2006 "resulted in a loophole in S&P’s rating model big enough to drive a Mack truck through", the complaint said.

Banks create CDOs by bundling bonds or loans into securities of varying risk and return. They pay ratings companies for the grades, which investors may use to meet regulatory requirements.

"A DOJ (department of justice) lawsuit would be entirely without factual or legal merit," S&P said before the case was filed.

"It would disregard the central facts that S&P reviewed the same subprime mortgage data as the rest of the market, including US government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained."

The companies also face European Union curbs on how they update markets about the quality of government debt under plans approved by the bloc’s legislators last month.