California Attorney General Kamala Harris on Tuesday joined the U.S. Justice Department and 12 other states in suing Standard & Poor's credit rating agency for allegedly inflating its ratings of mortgage-backed securities.
The suit claims that S&P's inaccurate ratings caused California's public pension funds and other investors to lose billions of dollars.
"They misrepresented their objectivity and they were inaccurate in the way they measured the rating," Harris told KQED's Paul Lancour. "So the lawsuit that we have filed makes claims under a number of theories that includes false claims and the False Claims Act. It is about false advertising, which S&P engaged in, and also about unfair competition."
In a written statement, S&P denied inflating ratings and called the lawsuits "meritless."
Investors relied on S&P and its competitors to rate these securities because they had access to only general descriptions of the assets backing their investments, which often included mortgages, Harris charged.
California's public pension funds also relied on S&P because they are often required to buy securities that received the coveted "AAA" rating, signaling that the investment was top-tier and bore minimal risk.
The lawsuit alleges that, from 2004 to 2007, S&P systematically misrepresented to the public, the California Public Employees Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS), that its ratings of structured finance securities were based on an objective analysis when they were actually influenced by S&P's economic interests.
S&P responds that it reached the same conclusions as other ratings agencies and even the U.S. government:
The fact is that S&P's ratings were based on the same subprime mortgage data available to the rest of the market – including U.S. Government officials who in 2007 publicly stated that problems in the subprime market appeared to be contained. Every CDO [credit default obligation] cited by the Department of Justice also independently received the same rating from another rating agency.
As evidence, Harris quoted emails from S&P executives in which they said their ratings were based on "magic numbers" and "guesses."
In its statement, the ratings agency said the emails were not representative of the discussions it held.
There was robust internal debate within S&P about how a rapidly deteriorating housing market might affect the CDOs -- and we applied the collective judgment of our committee-based system in good faith. The email excerpts cherry picked by DOJ have been taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business.
The complaint also says the company tried to suppress the development of new and more accurate ratings models.
In mid-2007, the housing bubble burst. After securities that S&P had deemed the least risky began defaulting, S&P downgraded many residential mortgage backed securities investments. The market collapsed, and of those securities issued in 2007, more than 90 percent were downgraded to junk status.
CalPERS and CalSTRS – two of the nation's largest institutional investors – lost approximately $1 billion, according to the lawsuit.
Other lawsuits by the federal government, 12 other states and the District of Columbia allege violations of the federal Financial Institutions Reform, Recovery and Enforcement Act and state unfair competition laws.
However, California's suit is unique because it is being filed not only under California's unfair competition laws but also under the state's False Claims Act. This suit includes a claim for triple damages – because when the state makes a purchase based on a false statement, the defendant is responsible for the amount lost times three.
The lawsuit arises from a 20-month investigation into the issuance and rating of mortgage-backed securities by Attorney General Harris's California Mortgage Fraud Strike Force, which she formed in May 2011 to comprehensively investigate misconduct in the mortgage industry. The Attorney General's additional efforts to investigate the mortgage crisis include securing an estimated $18 billion for California in the National Mortgage Settlement and sponsoring the California Homeowner Bill of Rights, a package of laws instituting permanent mortgage-related reforms.