In March 2007, as the subprime mortgage market was collapsing, an analyst at the bond rating agency Standard and Poor’s decided to lighten the mood around his office: According to a federal lawsuit filed against the company late Monday, he went from cubicle to cubicle singing an ode to American real estate.
"Housing market went softer/Cooling down/Strong market is now much weaker/Subprime is boi-ling o-ver/Bringing down the house," the analyst sang to the tune of Talking Heads song "Burning Down The House," according to the 128-page complaint filed by the Justice Department. The impromptu show played out “before an audience of laughing S&P co-workers," the lawsuit says.
That moment of levity stands out as a sign of the differing perspectives on American housing offered by S&P’s bond analysts, depending upon their audience, as described by the federal lawsuit: To the public at large -- and especially to buyers of securities constructed of mortgages -- all was supposedly wonderful in housing, making mortgage-backed securities rock-solid. But inside S&P, gallows humor reigned -- along with the fat profits derived from allegedly looking the other way.
The federal lawsuit, which accuses S&P of misrepresenting the quality of its ratings “knowingly and with intent to defraud," is seeking $5 billion from S&P parent company McGraw Hill to compensate investors and taxpayers who were hurt when securities that the company had rated highly later defaulted.
In a statement, S&P said it "will vigorously defend" itself against the lawsuit. The company said that its ratings have always "reflected our current best judgments," a statement it has declared repeatedly since the housing market collapsed, turning the piles of debt it had once branded safe into worthless mounds of paper.
But the picture of S&P painted in the lawsuit -- one constructed with a bevy of internal emails -- sharply challenges that assertion.
In an April 2007 email, an analyst quoted in the lawsuit told an investment banking client that the priorities inside S&P were not centered on providing accurate ratings, but rather were focused on not “p*ssing off too many clients and jumping the gun ahead of [competitors] Fitch and Moody’s.”
In reply to that email, the unnamed investment banker agreed with the analyst.
“I mean come on we pay you to rate our deals, and the better the rating the more money we make?!?! What’s up with that? How are you possibly supposed to be impartial????,” the banker emailed back.
That conversation is one of several cited in the complaint purporting to show that analysts were aware of how little quality control was valued at S&P.
"We rate every deal … it could be structured by cows and we would rate it,” an analyst inside the firm said in an instant message to a peer, also in April of 2007, according to the lawsuit.
The concerns about the degree to which competitive pressures were trumping the integrity of the agency's ratings process were obvious much earlier than that, according to the government’s complaint.
As far back as early 2004, analysts had complained that changes in ratings methodology were threatening the legitimacy of the company, the lawsuit says. Managers within the unit that handled ratings for certain bonds ignored those complaints, the government alleges, and sought to minimize them.
In a July 1, 2004, memo included in the lawsuit, S&P allegedly instructed analysts to only bring up concerns with the integrity of the process in person, and not over email.
Still, those recorded complaints trickled in with some regularity. In March 2005, a senior analyst noted that a change in methodology seemed designed to “massage the subprime and Alt-A numbers to preserve market share.”
Later that month, two quantitative analysts had an email exchange where they complained that the new models were “cobbled together on considerations of market share and profit, not analytics.”
Further changes to the ratings scheme for certain bond products known as collateralized debt obligations caused one analyst to reportedly quip that the managers had created “a loophole big enough to drive a Mack truck through”
“Who was the genius who came up with this?” the analyst told a peer in 2006, according to the lawsuit.
The lawsuit from the government seems to answer that question by pointing to several mid-level managers who were driven to increase S&P’s revenues, even if it meant gutting the risk models.
The complaint references a meeting that was supposedly held in August 2007 -- as turmoil raged in the financial markets -- in which managers discussed changing the methods used to assign rates: They described building “a better mousetrap” -- a euphemism for giving bankers greater access to the ratings process, allowing them to influence the grades of the products they aimed to sell. At the same meeting, they described this new process as a “two-way street,” according to the complaint.
According to the complaint, managers were clear on potential dire consequences that could stem from how they rated the bonds they were paid to analyze.
According to the lawsuit, David Tesher, co-director of CDO ratings at the time, wrote in an email from December 2006 that “this market is a wildly spinning top which is going to end badly.”