Moody’s Swoons After Saying U.S. Will Sue for Crisis-Era Ratings

(Bloomberg) -- Echoes of the financial crisis sent Moody’s Corp. shares reeling to their worst drop in four months after the company disclosed that its simmering dispute with the U.S. over residential mortgage securities ratings is headed to court.

The Department of Justice, which has been investigating allegations that Moody’s inflated ratings to win more business, is preparing a civil complaint, and states are expected to make similar claims, according to a Moody’s statement today. What’s more, the probes may expand to more assets, activities and time periods, the company said.

Moody’s is expecting the U.S. to cite a statute that’s been used to extract billions of dollars from companies tied to the 2008 mortgage meltdown. That helped push the stock down 5.4 percent to $102.24 at 4:01 p.m. in New York, its biggest drop since June. The New York-based company is continuing to respond to subpoenas and inquiries, it said. Michael Adler, a spokesman for Moody’s, declined to elaborate on the statement, and Mark Abueg at the Justice Department declined to comment.

Sloppy mortgage underwriting and lax bond ratings contributed to the financial crisis that caused at least $1.9 trillion in credit losses and writedowns at banks worldwide as home loans defaulted at record rates. The Justice Department has been investigating Moody’s role for years, including allegations that it inflated ratings on mortgage bonds and collateralized-debt obligations at the heart of the 2008 meltdown to win more ratings contracts.

Bond Rating

Both Moody’s and its biggest rival, now known as S&P Global Ratings, were key players in Wall Street’s bond-making industry. Banks made loans to homeowners and then bundled them by the thousands into securities whose interest payments and collateral were guaranteed by the those homes. The banks and other lenders then paid S&P and Moody’s to provide ratings on the bonds, which often received the highest grade even though many mortgages were made to people very likely to default, sometimes with fraudulent documents that were never checked.

S&P paid $1.5 billion last year to resolve U.S. allegations that it inflated ratings to gain business from the banks during the housing boom. S&P said at the time it settled to avoid the “delay, uncertainty, inconvenience, and expense” of litigation.

Even after the crisis, complaints have persisted that “ratings shopping” is still going on in asset-backed bond markets. Senator Al Franken, a Minnesota Democrat who pushed unsuccessfully for sweeping reforms of the ratings industry, said he’s pleased the DOJ is pursuing legal action.

“We’ve known for years that conflicts of interest at credit rating agencies were a significant factor in causing the 2008 financial crisis,” Franken said in an e-mailed statement. “We can’t let Wall Street be above the law.”

Missed Signals

Brad Hintz, a former chief financial officer at Lehman Brothers Holdings Inc. and now an adjunct professor at New York University’s Leonard N. Stern School of Business, said it may be a mistake to hold ratings firms accountable when so many other experts missed the dangers in subprime mortgages and securities linked to them.

"This is a show trial to place blame on the rating agencies -- not a history examining why mistakes occurred," he said in an e-mail. “Moody’s will pay a fine and not admit guilt and the Justice Department and the participating state AGs will announce a victory. None of the money will go to the investors who paid the price of the mistake."

Kevin Callahan, a spokesman at the Securities and Exchange Commission declined to comment on Moody’s statement and Franken’s remarks.

Top Ratings

Investigators in Congress found that in some cases, ratings firms were giving top-shelf credit ratings to junk debt in an effort to win the business from the banks preparing the securities. Subsequent loan defaults and ratings downgrades helped wipe out almost $11 trillion of household wealth, the Financial Crisis Inquiry Commission said in its 2011 report.

The actions that prompted previous allegations of ratings inflation date back more than a decade. In troves of industry e-mails made public by Congress, executives at rival companies were caught criticizing their own practices. "We rate every deal. It could be structured by cows, and we would rate it," read one e-mail exchange between executives at Standard & Poor’s. The Justice Department later included that exchange in its own lawsuit against S&P.

Legal Claims

Lack of similar e-mails has stoked speculation that the Justice Department could have a harder time proving misconduct of Moody’s, which has already faced some legal action tied to its mortgage-bond grades from other sources. Analysts expect Moody’s to settle with the U.S. for less than the $1.5 billion that S&P paid.

In March, Moody’s agreed to pay $130 million to settle claims by the California Public Employees’ Retirement System over allegedly inflated ratings on residential-mortgage bond deals. A former Moody’s managing director who oversaw ratings of subprime mortgage CDOs, Ilya Eric Kolchinsky, sued in 2010, alleging that he was admonished for raising concerns to his bosses about business practices that he described in a complaint as "fraud."

Kolchinsky sought the Justice Department’s help under the False Claims Act, but his request to intervene in his whistle-blower suit was turned down. The case was dismissed in February, although the ruling said he could try to re-plead one claim. The rest of the claims were filed too late, the judge ruled.

"The falsely rated securities had a face value of over $2.3 trillion, and Moody’s fraudulent conduct with respect to these securities threatened the stability of the U.S. financial system," Kolchinsky’s complaint said. "During the relevant time period, Moody’s did not believe these ratings to be true."

The disclosure about the U.S. action came in Moody’s third-quarter earnings report, which showed net income and revenue rose 10 percent. Record global revenue in the third quarter of $612 million was driven by gains in its ratings business. Chief Financial Officer Linda Huber said during the earnings conference call that she wouldn’t comment on expected legal costs.

S&P and Fitch affirmed their ratings of Moody’s after the announcement, with Fitch saying Moody’s could absorb $2 billion to $3 billion of settlements.