Rating Trouble – US Department of Justice Lawsuit against S & P

First a bit of flash-back

  • An estimated USD 3.2 trillion in loans were made to homeowners with bad credit and undocumented incomes (e.g., subprime or Alt-A mortgages) between 2002 and 2007.
  • These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors.
  • Higher ratings were believed justified by various credit enhancements including over-collateralization (i.e., pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses.
  • Without the AAA ratings , demand for these securities would have been considerably less.
  • When the crisis hit, Rating Agencies lowered the credit ratings on USD 1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, a firm indicator that their initial ratings were not accurate. For example, as of July 2008, Standard & Poor’s (S&P) had downgraded 902 tranches of U.S. residential mortgage backed securities (RMBS) and CDOs of asset-backed securities (ABS) that had been originally rated “triple-A” out of a total of 4,083 tranches originally rated “triple-A;” 466 of those downgrades of “triple-A” securities were to speculative grade ratings. S&P had downgraded a total of 16,381 tranches of U.S. RMBS and CDOs of ABS from all ratings categories out of 31,935 tranches originally rated, over half of all RMBS and CDOs of ABS originally rated by S&P.
  • This put additional pressure on financial institutions to lower the value of the MBS and similar securities in their portfolio. Since certain types of institutional investors are allowed to only carry investment-grade (e.g., “BBB” and better) assets, there was forced asset sales, which could caused further devaluation.
  • Then we had the worst crisis after the Great Depression with banks writing down more than USD 500 billion in the value of their securities portfolio  (which had most of these instruments) and thereby wiping down their capital which required the sate the step in and support the banks with tax payers’ money.

Why Rating Agencies Do what they Did

The ratings of these securities was a lucrative business for the rating agencies, accounting for just under half of their total ratings revenue in 2007. Through 2007, ratings companies enjoyed record revenue, profits and share prices.

The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business.

Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards.

Media reports of interviews with rating agency senior managers indicated that the competitive pressure to rate the CDO’s favorably was strong within the firms. Internal rating agency emails from before the time the credit markets deteriorated, discovered and released publicly by U.S. congressional investigators, suggest that some rating agency employees suspected at the time that lax standards for rating structured credit products would produce negative results. For example, one email between colleagues at Standard & Poor’s states “Rating agencies continue to create and [sic] even bigger monster–the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters”

It is very clear that conflict of interest is involved, as rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks.


US Department of Justice Lawsuit against S & P

On February 5th the Department of Justice filed a complaint against Standard & Poor’s (S&P) in a Los Angeles federal court. The complaint charges that the ratings agency “limited, adjusted and delayed updates to the rating criteria and analytical models” needed to evaluate risk, and, based on information from an unnamed executive, did so deliberately to protect its business. S&P has been accused by the US justice department of defrauding investors in mortgage-related securities out of at least $5bn by issuing inflated ratings to win hundreds of millions of dollars in fees.

The DoJ also alleges S&P falsely represented to investors, including Western Federal Corporate Credit Union, Citibank and Bank of America, that its ratings were objective when instead they were influenced by a desire to win fees and market share.

However, this is not the first lawsuit against rating agencies. Since the crisis, 41 legal actions targeting S&P have been dropped or dismissed. The company and other ratings agencies have prevailed by asserting their rights under the first amendment of the constitution, which states that “Congress shall make no law…abridging the freedom of speech”.

So the Department Of Justice is taking a new approach, accusing the firm of knowing misrepresentation, which is not covered by the first amendment. Similar cases have failed, but the Department Of Justice ‘s complaint is based on a law passed in 1989 in response to the savings-and-loans crisis. Called the Financial Institutions Reform, Recovery, and Enforcement Act, it has never been used in this sort of case.

S&P says it will mount a defense. It will certainly present evidence that its performance during the crisis was consistent with that of others trying to determine the validity of the troubled credits, and that it operated in good faith. As the complaint makes clear, the ratings in question were issued after intense arguments within S&P about how to evaluate complex new securities—and about how to expand the business without undermining the quality of opinions.

The firm is likely to argue that the decision-making process was inherently subjective rather than intentionally fraudulent. Implicit in this defense is the notion that the decision to invest is ultimately the responsibility of the buyer—particularly if the buyer is large, established and operating under the scrutiny of federal regulators, as was the case of many investment banks.

The outcome of this lawsuit will be keenly watched. But in the recent times, the importance of rating in investment decisions has seen a clear decline and this has not been helped by some of the actions of rating agencies themselves. One example is rating downgrade of USA by S&P which was actually followed by increased demand and tightening of spreads of US Treasury Instruments! 

 (Based on various media reports and articles)


The Dog that failed to bark (Advisers who failed to advise) – HP write-down of USD 8.8 Billion after an acquisition

(Based on media reports)

 IN AUGUST 2011, when HP said it would buy Autonomy, a British software company that specialises in analysing “unstructured” data, for $10.3 billion, many people thought the Californian maker of computers and printers had paid over the odds. On November 20th HP agreed that it had—and claimed that it had been duped. It said that it was taking a charge of $8.8 billion related to Autonomy in its fourth-quarter results, of which more than $5 billion was “linked to serious accounting improprieties, misrepresentation and disclosure failures”. Some of Autonomy’s former managers, it said (naming no individuals), had inflated the company’s figures before the acquisition.

When Hewlett Packard acquired Autonomy, some 15 different financial, legal and accounting firms were involved in the transaction — and none raised a flag about what HP said  was a major accounting fraud.

HP Chief Executive Meg Whitman, who was a director at the company at the time of the deal, said the board had relied on accounting firm Deloitte for vetting Autonomy’s financials and that KPMG was subsequently hired to audit Deloitte.

HP had many other advisers as well: boutique investment bank Perella Weinberg Partners to serve as its lead adviser, along with Barclays. The company’s legal advisers included Gibson, Dunn & Crutcher; Freshfields Bruckhaus Deringer; Drinker Biddle & Reath; and Skadden, Arps, Slate, Meagher & Flom, which advised the board.

On Autonomy’s side of the table were Frank Quattrone’s Qatalyst Partners, which specializes in tech deals, as well as UBS, Goldman Sachs, Citigroup, JPMorgan Chase and Bank of America. Slaughter & May and Morgan Lewis served as Autonomy’s legal advisers on the deal.

While regulators in the United States and the United Kingdom, as well as the Federal Bureau of Investigation, are likely to spend many months if not years investigating what happened, legal experts said on Tuesday that it wasn’t clear if any of the advisers would ultimately be held liable.

“The most logical deep pocket would be the acquired firm’s auditors, who should have allegedly caught these defalcations,” said James Cox, a professor at Duke University law school who specializes in corporate and securities law. Since both auditors missed the problems and it appeared to have taken HP a while to catch it after it took over Autonomy, the auditors may have a strong defense.

“You can have a perfectly sound audit and still have fraud exist,” he said. A Deloitte UK spokesman said the company could not comment and would cooperate with any investigations.

The law firms and the bankers will likely argue that they were not hired to review the bookkeeping and had relied on the opinion of the auditors, securities law experts said.

Multiple sources with knowledge of the HP-Autonomy transaction added that the big-name banks on Autonomy’s side were brought in days before the final agreement was struck. These sources said the banks were brought on as favors for their long relationships with the companies, in a little-scrutinized Wall Street practice of crediting — and paying — investment banks that actually have little do with the deal.

Plaintiffs lawyers said they were taking calls from investors about HP. Darren Robbins, a San Diego-based plaintiff lawyer who represents shareholders, said the tech icon appears to have spent billions on a shoddy company without undertaking the proper due diligence, and thus misrepresented its finances to investors. “I think they have serious troubles,” he said.

But plaintiff lawyers may have difficulty bringing so-called derivative lawsuits against professional services firms, said Brian Quinn, an M&A professor at Boston College Law School. In those cases, plaintiff lawyers can sue third parties, such as auditors, on behalf of HP — but they must convince a judge that HP’s board is unfit to pursue those claims itself. In this situation, though, HP’s board disclosed the alleged fraud itself, Quinn said. Even if the bankers and lawyers escape any legal problems, they could suffer a reputational hit.