(CN) - Standard & Poor's inflated its ratings of mortgage-backed securities, ignoring the inherent credit risks that brought the financial sector to its knees in 2008, the U.S. government says in Federal Court.
Filed late Monday in the Central District of California, the complaint alleges that the McGraw Hill-owned credit-rating agency defrauded investors in structured financial products known as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs).
Federally insured financial institutions and other investors lost billions of dollars on the misrepresented CDOs, the government said.
Standard & Poor's Financial Services also lied that its ratings were the product of "objectivity, independence, and freedom from influence by any conflicts of interest posed by its relationships with issuers," according to the complaint.
"As S&P knew, contrary to its representations to the public, S&P's desire for increased revenue and market share in the RMBS and CDO ratings markets, and its resulting desire to maintain and enhance its relationships with issuers that drove its ratings business, improperly influenced S&P to downplay and disregard the true extent of the credit risks posed by the RMBS and CDO tranches in order to favor issuers in its ratings of those tranches," the government added.
S&P allegedly inflated its ratings by weakening the criteria and models from what its own analysts believed would make the ratings more accurate.
Attorney General Eric Holder said S&P's "egregious" conduct "goes to the very heart of the recent financial crisis."
Attorneys general from California, Connecticut, Delaware, the District of Columbia, Illinois, Iowa and Mississippi filed or will file civil fraud lawsuits against S&P alleging similar misconduct in the rating of structured financial products, the Justice Department said.
It added that more state attorneys general will make similar filings today.
The government noted that the Central District of California is home to the now defunct Western Federal Corporate Credit Union, which was the largest corporate credit union in the country.
"Following the 2008 financial crisis, WesCorp collapsed after suffering massive losses on RMBS and CDOs rated by S&P," the Justice Department said in a statement.
U.S. Attorney for the Central District of California Andre Birotte Jr. described the "significant harm" that S&P's conduct caused in greater Los Angeles.
"Across the seven counties in my district, we had huge numbers of homeowners who took out subprime mortgage loans, many of which were made by some of the country's most aggressive lenders only because they later could be securitized into debt instruments that were given flawed 'AAA' ratings by S&P," Birotte said in a statement. "This led to an untold number of foreclosures in my district. In addition, institutional investors located in my district, such as WesCorp, suffered massive losses after putting billions of dollars into RMBS and CDOs that received flawed and inflated ratings from S&P."
The complaint seeks civil penalties from McGraw-Hill and Standard & Poor's under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.
It alleges mail fraud, wire fraud and financial institution fraud.
"To date, the government has identified more than $5 billion in losses suffered by federally insured financial institutions in connection with the failure of CDOs rated by S&P from March to October 2007," according to the Justice Department's statement.
It added that the underlying federal investigation, code-named "Alchemy," that led to this week's complaint was initiated in November 2009 in connection with the President's Financial Fraud Enforcement Task Force.
"With more than 20 federal agencies, 94 U.S. attorneys' offices and state and local partners, it's the broadest coalition of law enforcement, investigatory and regulatory agencies ever assembled to combat fraud," the Justice Department said.
In the past three years, the Justice Department has purportedly filed nearly 10,000 financial fraud cases against nearly 15,000 defendants including more than 2,900 mortgage fraud defendants.
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