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Friday, May 17, 2024 | Back issues
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Judge Nixes Claims Over Inflated Credit Ratings

(CN) - A Florida credit union failed to prove that fraudulent inducement led it to invest more than $100 million in inflated mortgage-backed securities, a federal judge ruled.

From 2005 to 2007, Eastern Financial Florida Credit Union, a state-chartered credit union, invested more than $100 million in 12 collateralized debt obligations (CDOs). CDOs are structured asset-backed securities collateralized by debt obligations such as bonds and loans. Banks use the money from the notes they sell to investors to buy assets, such as residential mortgage-backed securities, and make payments to investors from the revenue generated by those assets. The notes issued by a CDO offer varying degrees of risk and return so as to meet investor demand.

Eastern Financial bought the CDO notes from Merrill Lynch, Wells Fargo Securities, J.P. Morgan Securities and other investment banks, after two rating agencies rated the notes as low risk. The CDOs nevertheless defaulted on principal and interest payments and became "worthless," according to a complaint filed by Eastern Financial's successor.

Space Coast Credit Union acquired Eastern Financial's assets and liabilities through an emergency merger approved by Florida after the CDOs collapsed.

It sued five investment banks, as well as rating agencies Moody's Investors Service and Standard & Poor's Rating Services, in state court, alleging they had engaged in "systematic fraud" in selling and rating the securities. Space Coast claimed that the defendants had used inflated and unreliable credit ratings, based on unverified data; that they had intentionally mispriced CDO notes to dump bad assets from their own balance sheets onto investors at inflated prices; and that the defendant agencies had made out-of-model adjustments to inflate their own ratings.

With the action removed to federal court, U.S. District Judge James Cohn agreed last week that Space Coast had failed to show in detail how each of the defendants had defrauded it.

Space Coast cited a 2010 academic research paper to support its claim that Standard & Poor's had made secret adjustments to its CDO ratings to make CDOs appear stronger than they actually were, resulting in inaccurate credit ratings. It also alleged that the banks knew of the ratings discrepancies, and had used them to misprice CDO notes.

Cohn found no indication, however, that the research study involved Eastern Financial's CDOs, or that they had deviated from S&P's models.

What's more, the study clearly did not apply to four CDOs that Eastern Financial had bought after April 2007, the date when the out-of-model upgrades allegedly stopped, according to the March 18 ruling.

Cohn also rejected a study Space Coast used to prove that the agencies had rated CDOs more generously than comparable corporate and government bonds, because it provided no information about the specific CDOs bought by Eastern Financial.

As to Space Coast's argument that the CDO ratings were "little more than blind guesses based on pure speculation," the judge found that Space Coast's evidence did not identify any specific CDOs that contained defective loans based on false credit ratings or what percentage of the CDOs' assets were based on such loans.

Even assuming that Eastern Financial's CDOs contained some defective loans, Space Coast failed to allege that they were enough to alter the credit ratings of the notes Eastern Financial had bought, according to the ruling.

Cohn also rejected Space Coast's mispricing allegations, finding that it had not proven that any of the defendant banks had dumped bad assets from their balance sheets onto investors, or that they knew the CDOs sold to Eastern Financial carried false credit ratings.

Space Coast offered no facts to support its claim that short sellers who benefitted from the CDOs' failure had helped issue the CDOs bought by Eastern Financial, the ruling adds.

Cohn gave Space Coast one month to file an amended complaint.

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