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

Case was known internally as 'Alchemy'

Justice, scales Justice, scales

When the U.S. Justice Department charged Standard & Poor’s with fraud earlier this month and demanded $5 billion in restitution, it was the culmination of the Obama administration’s four-year pursuit of alleged financial chicanery masquerading as sacrosanct credit ratings.

Two dozen lawyers were assigned to a probe they called “Alchemy,” for the medieval pseudo-science that tried to turn lead into gold, as the department modeled a federal case on an analogy for failed mortgage-debt packages. They dug into 30 million documents, found cooperating witnesses and say they’ve got the evidence to win in court on an issue President Barack Obama since 2009 has been saying helped bring the U.S. economy to the brink of collapse.

“From the beginning of our effort to deal with the crisis, we had the ratings agencies high on the list,” former Representative Barney Frank, a Democrat and co-author of the 2010 Dodd-Frank financial regulation law, said in a telephone interview. “Our only frustration is that we couldn’t come up with better ways to deal with them, but we did everything we could think of in the legislation to restrict them.”

A review of legislative and regulatory documents and interviews with current and former administration officials shows that frustration with New York-based S&P, the nation’s largest ratings firm, Moody’s Corp. and Fitch Ratings has existed almost since Obama took office.

‘Brink of Collapse’

What started as an effort by Obama’s Treasury Department to right a system reeling from the worst financial breakdown in eight decades has now become a Justice Department lawsuit seeking $5 billion from S&P’s parent, McGraw-Hill Cos., after months of failed settlement talks.

The Justice Department, 16 states and the District of Columbia are suing the firm for fraud. Attorney General Eric Holder called its practices “egregious” and his deputy Tony West, the department’s third-ranked official, said the company played “a significant role in helping to bring our economy to the brink of collapse.”

The fight has so far cut more than $3.9 billion off McGraw- Hill’s market value, pushed the yields on its $400 million of bonds due November 2037 to the highest level since March 2011 and may threaten company’s viability.

S&P says it will “vigorously” defend itself from claims the company says are without merit. The Justice Department says it’s ready for court. It also doesn’t rule out renewed talks.

Because S&P is the only ratings company sued by the U.S. so far, some in the financial community say the case is retribution for the 2011 decision by S&P to downgrade U.S. debt.

Downgrade Questioned

“Why S&P? They didn’t do anything that Moody’s or Fitch didn’t do,” said Peter Schiff, chief executive officer of the brokerage firm Euro Pacific Capital Inc, based in Westport, Connecticut, in a telephone interview. “The whole thing to me stinks and looks like it’s their way of getting back at S&P.”

Holder, the attorney general who has been in the Obama administration since 2009 as officials first started figuring out what to do about the ratings companies, denies any link.

“They did what they did assessing what the creditworthiness was of this nation,” Holder said at a Feb. 5 press conference in Washington announcing the S&P suit. “But they are not in any way connected.”

The administration’s criticism of the quality of S&P and other raters’ products predates the downgrade, starting soon after Obama took office.

“Credit ratings often failed to accurately describe the risk of rated products,” the Treasury Department said in the financial regulationWhite Paper presented by then-Treasury Secretary Timothy F. Geithner to lawmakers.

Administration Proposal

The white paper, developed in the first months of 2009, Obama’s first year in office, would serve as the basis for the congressional proposals to come. One stated goal was to “reduce the incentives for over-reliance on credit ratings.”

The administration proposed the creation of an office to supervise ratings firms at the Securities and Exchange Commission. It would require the companies to disclose preliminary ratings of companies and use different symbols for structured products, to make investors more aware of the risks that may be associated with asset-backed securities and similar financial instruments.

S&P, which had made internal changes before Obama took office to address its failures in the subprime mortgage crisis, supported parts of what would become the Dodd-Frank Act. Aimed at preventing a repeat of the $700 billion bailout of the banking industry, the law created a mechanism to seize and wind down the largest banks, the Consumer Financial Protection Bureau and a new regulatory structure for the $639 trillion global swaps market.

Ratings Lawsuits

During the debate, S&P resisted a proposal that would allow the government to choose which ratings firm would rate each offering, as well as proposals that would make judges less likely to dismiss lawsuits against ratings firms.

In March, 2010, a company lobbyist sent an e-mail to Senate Republican staffers suggesting that lawmakers band together to block the proposal from reaching the Senate floor, according to a copy of the e-mail obtained by Bloomberg News. McGraw-Hill spent more than $3 million lobbying lawmakers in 2009 and 2010, the two years of the financial regulation debate in Congress, according to federal disclosures.

Mandated Reliance

While the Financial Crisis Inquiry Commission concluded the ratings firms were “key enablers of the financial meltdown,” Congress and the administration struggled to find consensus on how to reduce the reliance on ratings. Corporations, banks and even governments were required to seek a stamp of approval before bond offerings primarily from just three firms: S&P, Moody’s and Fitch, half-owned by Fimalac SA of Paris and half owned by Hearst Corp.

Michael Barr, the Treasury Department official who led the administration’s efforts to rewrite financial rules, said Dodd- Frank has helped increase transparency in the ratings, gave the Securities and Exchange Commission oversight, removed an existing legal liability shield attached to the companies, and reduced the mandated reliance on their work.

It stopped short of a complete restructuring of the industry dominated by just three firms, pushing against proposals that that would have placed the government in a dominant role in the marketplace, he said.

New Rules

“You can’t just change it completely overnight,” Barr, a former assistant Treasury secretary and now professor at the University of Michigan, said in a telephone interview.

The SEC has adopted new rules and modified others. It has created an office to oversee and develop rules for the industry.

Still, “fundamental reform of the credit-ratings agencies was an area where Dodd-Frank fell short,” said Aaron Klein, a former Senate and Treasury Department staff member involved in the drafting and implementation of the law. Klein, now director of the FinancialRegulatory Reform Initiative at the Bipartisan Policy Center, said he hoped the lawsuit would force lawmakers and regulators to take a fresh look the industry model.

While the SEC was working worked to carry out the changes, aimed at reducing reliance on credit ratings, political gridlock gripped Washington.

Government debt reached $14 trillion and Republicans were trying to force the administration to cut spending. That’s when S&P reached its Aug. 5, 2011, decision to downgrade the U.S. for the first time in the nation’s history.

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