Pursuit of S&P started when toxic debt masqueraded as AAA

Case was known internally as 'Alchemy'

Math Disputed

The administration disputed S&P’s rationale -- and its math -- when it downgraded the U.S. Treasury credit rating. The administration showed S&P that its 10-year estimate of the U.S. deficit was $2 trillion higher than the nonpartisan Congressional Budget Office. The company revised its figures and still stuck with the reduction from AAA to AA+.

The downgrade proved meaningless in the markets, which still consider the U.S. the safest of bets even as the political gridlock in Washington persists. Yields on 10-year Treasury notes fell to 1.72 percent on Sept. 22, 2011, from 2.56 percent the day of the downgrade. Borrowing costs remain below pre- downgrade levels, at 1.97 percent yesterday.

S&P gave the Treasury a credit rating lower than it had given some of the mortgage-backed securities and collateralized debt obligations that collapsed in 2007 and 2008. The language the administration used to describe S&P’s performance then isn’t much different from how officials now describe the lawsuit.

‘Fundamental Questions’

John Bellows, an acting assistant Treasury secretary for economic policy, said in a blog post the decision to downgrade the U.S. even after being shown errors in its analysis raised “fundamental questions about the credibility and integrity of S&P’s ratings actions.”

The company, as it stood by its decision, said the reaction from Treasury and the White House was typical of a country that had just seen their sovereign credit cut.

The Justice Department says the suit isn’t related to the downgrade or any political decision. It says it took time to build its case that the S&P made false representations, concealed facts and manipulated ratings criteria linked to the financial instruments that helped trigger the financial crisis.

Still, the announcement of the suit puts a level of pressure on S&P that isn’t on other raters -- at least not yet. The $5 billion potential penalty would equal more than five years profit for McGraw-Hill. The company’s shares were battered last week, dropping more than 25 percent, and Fitch put its ratings on watch for possible downgrades.

The White House has declined to answer questions on the lawsuit, directing reporters to the Justice Department.

30 Million

To prepare its suit, lawyers from the Justice Department’s civil division and the U.S. attorney’s office in Los Angeles sifted through more than 30 million pages of documents, including e-mails, according to a department official briefed on the case. Interviews were conducted with more than 100 individuals, including meetings with cooperating witnesses, said the official who requested anonymity to discuss the case.

“Our lawyers and staff served hundreds of civil subpoenas, spent thousands of hours reviewing and analyzing millions of pages of documents, and contacted and interviewed over 150 witnesses, including dozens of former S&P analysts and executives,” Stuart Delery, head of the Justice Department’s civil division, said last week flanked by 7 of the 17 state and District of Columbia attorneys general who have also brought suits against the company.

Settlement Discussions

Government and S&P lawyers had multiple, extensive exchanges in the months before the filing of the lawsuit, the official said. They were unable to come to an agreement.

Two other people briefed on the case described settlement discussions, which started late last year, as unproductive in the weeks leading up to the lawsuit. By the time the case was filed, the two sides remained far apart on any agreement, said the people, who requested anonymity to discuss private talks.

Both sides say they are ready to take the case, filed in California, to court. S&P hired John Keker, the San Francisco trial attorney, who has represented investment banker Frank Quattrone and Enron Corp. executive Andrew Fastow, to join its team defending the company. Quattrone, founder of Qatalyst Partners, won dismissal of all criminal charges that he obstructed a federal investigation into Credit Suisse AG. Fastow pleaded guilty in 2004 to two counts of wire and securities fraud.

‘Meritless’ Lawsuits

Spokeswoman Catherine Mathis said the firm would “vigorously defend S&P against these unwarranted claims” which she said were part of “meritless civil lawsuits.”

“Claims that we deliberately kept ratings high when we knew they should be lower are simply not true,” Mathis said in a Feb. 5 statement.

Holder said the Justice Department “would not have brought this case unless we felt we had a case that we could bring and that we would win.”

“And that’s what I expect to have happen,” he said.

Holder and West declined to comment on whether Moody’s or Fitch might face similar charges.

Penalties for false representations, concealed facts and manipulated criteria linked to ratings on portions of more than $4 trillion of debt securities could reach $5 billion, the Justice Department said. That is more than enough to exhaust New York-based McGraw-Hill’s $1.2 billion of cash on hand and the $1.86 billion of excess funds that analysts project the company will generate this year.

Free Speech

Floyd Abrams has defended S&P’s ratings on free speech grounds. Abrams is the Cahill Gordon & Reindel LLP attorney who defended the New York Times and won a Supreme Court decision upholding the publication’s First Amendment rights in the Pentagon Papers case, and then faced criticism for his work defending reporters in the investigation over the leak of a Central Intelligence Agency operative’s name during President George W. Bush’s administration.

The lawsuit’s approach, alleging that S&P knew its ratings were faulty, will require a different defense, Abrams said in a Feb. 5 Bloomberg Television interview.

“It’s not a First Amendment case,” Abrams said in the interview with Sara Eisen. “The government is alleging that S&P didn’t believe what it said; the First Amendment doesn’t protect against that.”

Abrams, who will be joined by Keker in defending the company as the case moves forward, said the company’s lawyers held settlement discussions with the Justice Department for at least four months.

Former SEC Chairman Arthur Levitt predicted in a Feb. 6 interview on Bloomberg Television there would be “a substantial settlement” between the company and the government.

“The government is trying to win, and McGraw-Hill is foolish not to have made a settlement with them,” said Levitt, who is on the board of Bloomberg LP, the parent company of Bloomberg News.

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