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From Securities Regulation Daily, February 3, 2015

S&P to pay largest federal penalty of its kind over flawed credit ratings; states also gain from deal

By Mark S. Nelson, J.D.

The U.S. Department of Justice has announced that McGraw Hill Financial, Inc. and its Standard & Poor's Financial Services LLC unit have agreed to pay $1.375 billion to end lawsuits brought by the federal government, 19 states, and the District of Columbia over S&P’s ratings for residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) ahead of the 2008 financial crisis. The DOJ made the long-rumored deal’s terms public in an early morning press release.

U.S. Attorney General Eric Holder, speaking at a press conference with DOJ and state representatives, focused on how S&P disregarded the advice of its senior analysts. “As S&P admits under this settlement, company executives complained that the company declined to downgrade underperforming assets because it was worried that doing so would hurt the company’s business,” said Holder. “While this strategy may have helped S&P avoid disappointing its clients, it did major harm to the larger economy, contributing to the worst financial crisis since the Great Depression,” he added.

McGraw Hill said via a press release that the settlement does not include findings of legal violations by it or S&P, and the deal is not subject to court approval. “The Company and S&P Ratings take compliance with regulatory obligations very seriously and continue to make investments in people and technology to strengthen controls and risk management throughout the organization.”

McGraw Hill also said that it has reached a settlement with CalPERS in a separate case. That deal requires the company to pay California Public Employees’ Retirement System (CalPERS) $125 million. McGraw Hill is set to hold a call with analysts on February 12 when it announces its Q4 and full year 2014 results, which will include the impact of today’s settlement.

Ratings methods slow to change. The statement of facts accompanying the settlement agreement paints a picture of an S&P reluctant to make key changes to its credit ratings process in order to preserve its existing ratings business. According to the statement, S&P did too little to deal with potential conflicts of interest in its ratings. S&P also “slowed” upgrades to its CDO model when testing showed its business prospects could worsen versus its competitors for ratings of low-quality CDOs, and that other ratings firms would keep their edge over S&P for ratings of high-quality CDOs.

Moreover, S&P’s inability or reluctance to change it ratings methods tripped up its work on RMBS too. As early as January 2007, S&P’s RBMS surveillance group began to characterize the growing housing crisis as a “Housing Bubble” or a “slowdown” and warned that the “Bubble is deflating.” A month later, S&P’s surveillance staff urged the company to publicly watchlist the subordinate tranches from 30 RMBS deals, and internally watchlist those from 20 other deals.

S&P ultimately rejected this advice, opting instead to watchlist fewer tranches from a smaller set of RBMS deals. Despite the head of the surveillance group’s telling her superiors she was “fine with where we are,” the agreed statement of facts said her coworkers often worried that S&P executives stopped her from downgrading subprime RMBS to avoid hurting S&P’s ratings business.

States can press for compliance. In addition to the $687.5 million McGraw Hill and S&P will pay the federal government, they will pay an equal amount to the 19 states and the District of Columbia, who joined today’s settlement. Most states will get over $21.5 million apiece, while six states each will get over $25 million. California’s $210 million haul is by far the largest amount to be paid to any of the states taking part in the deal.

California Attorney General Kamala Harris focused on the public’s loss of trust in S&P’s ratings. “California’s public pension funds suffered significant losses due to S&P’s failure to honestly and accurately disclose the risk of the very investments that caused an international economic recession. This settlement holds S&P accountable for financial losses caused by these misrepresentations and compensates our pension funds.”

statement by CalPERS noted that it would get a total of $301 million: $176 million from California’s share of the DOJ deal, and $125 million from its own deal with McGraw Hill and S&P in a separate case. CalPERS said it has recovered $900 million so far in various settlements for claims related to the 2008 financial crisis, but its separate deal with McGraw Hill and S&P does not end its claims in that case against Moody’s Investor Service over soured structured investment vehicles.

A review of the deal’s specifics shows how the parties at times went out of their way to cast the amounts McGraw Hill and S&P will pay as penalties, or not. The deal characterizes the U.S.’s entire $687 million amount as a civil monetary penalty imposed under provisions in the Financial Institutions Reform, Recovery and Enforcement Act of 1989. But with comparatively small exceptions for North Carolina, and another for uncharacterized amounts, the vast majority of the amounts paid to the states and the District of Columbia are not penalties.

Moreover, the states will get the power to ask McGraw Hill and S&P to demonstrate their compliance, if they suspect the companies’ efforts have fallen short of the agreed terms. Specifically, the states can request that McGraw Hill and S&P “meet and confer” in good faith about their compliance with the deal. A state taking this route can share any data it gets from its “meet and confer” sessions with other states, if the confidentiality of the data is maintained. The states’ ability to use this method to nudge compliance with the settlement will last for five years.

U.S. says take it back. Another feature of today’s deal requires McGraw Hill and S&P to take back their claim that the U.S.’s lawsuit was spurred by S&P’s downgrade of the U.S.’s credit rating following a threatened government shutdown in 2011. The companies had cast the U.S.’s decision to sue as retaliation for the downgrade. Today’s deal will require the filing of a joint stipulation by the DOJ and McGraw Hill and S&P, in which the companies formally withdraw the affirmative defense in which they made the retaliation claim.

Settlement with SEC. Roughly two weeks ago, S&P inked a separate deal to settle charges brought against it by the SEC over commercial mortgage-backed securities (CMBS). That deal requires McGraw Hill and S&P to pay nearly $80 million to the SEC, New York, and Massachusetts.

The settlement with the SEC also requires S&P to take a one-year timeout from rating some types of CMBS. At the time, McGraw Hill issued a press release emphasizing that the settlement did not impact any of its outstanding ratings or how its conducts credit analysis under the criteria it uses.

Last August, the SEC adopted final rules implementing a series of changes to the rules for nationally recognized statistical ratings organizations (NRSROs), like S&P, to avoid future problems with conflicts of interest in the ratings industry. SEC Chair Mary Jo White noted the rules’ impact on NRSROs’ sales efforts: “Consistent with our mandate under the Dodd-Frank Act, the recommendation therefore also prohibits an NRSRO from issuing or maintaining a credit rating where an analyst involved in the production of the credit rating is influenced by sales or marketing considerations.” Commissioners Daniel M. Gallagher and Michael S. Piwowar dissented from the Commission’s adoption of those rules.

Companies: McGraw Hill Financial, Inc.; Standard & Poor's Financial Services LLC; California Public Employees’ Retirement System; Moody’s Investor Service

MainStory: TopStory CreditRatingAgencies DoddFrankAct Enforcement FraudManipulation RiskManagement

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