The Department of Justice filed a civil lawsuit against Standard and Poor's for fraud.  Will the DOJ finally nail credit rating agency Standards and Poor's for slapping AAA ratings on rigged CDOs backed by mortgage toxic waste?   Or will justice be just another slap on the wrist?

S&P engaged in a scheme to defraud investors in structured financial products known as Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs). The lawsuit alleges that investors, many of them federally insured financial institutions, lost billions of dollars on CDOs for which S&P issued inflated ratings that misrepresented the securities’ true credit risks. The complaint also alleges that S&P falsely represented that its ratings were objective, independent, and uninfluenced by S&P’s relationships with investment banks when, in actuality, S&P’s desire for increased revenue and market share led it to favor the interests of these banks over investors.

 Dealbook quotes insiders saying the reason the suit happened at all is because S&P wouldn't settle for $1 billion and admit anything.   Instead, S&P wanted $100 million and to claim they didn't do nothing wrong, sir...

The DOJ is bringing out the big state guns to join in on the lawsuit and claim they have identified $5 billion in actual losses attributable to S&P's AAA credit rating slaps on worthless garbage.

Attorney General Eric Holder was joined in announcing the filing of the civil complaint by Acting Associate Attorney General Tony West, Principal Deputy Assistant Attorney General for the Civil Division Stuart F. Delery, and U.S. Attorney for the Central District of California André Birotte Jr. Also joining the Department of Justice in making this announcement were the attorneys general from California, Connecticut, Delaware, the District of Columbia, Illinois, Iowa and Mississippi, who have filed or will file civil fraud lawsuits against S&P alleging similar misconduct in the rating of structured financial products. Additional state attorneys general are expected to make similar filings today.

Some of the details in the filing have been documented since 2008.  Still, what S&P did is so outrageous, it deserves repeating:

From 2004 to 2007, the government alleges, S&P was so concerned with the possibility of losing market share and profits that it limited, adjusted and delayed updates to the ratings criteria and analytical models it used to assess the credit risks posed by RMBS and CDOs. According to the complaint, S&P weakened those criteria and models from what S&P’s own analysts believed was necessary to make them more accurate. The complaint also alleges that, from at least March to October 2007, and because of this same desire to increase market share and profits, S&P issued inflated ratings on hundreds of billions of dollars’ worth of CDOs. At the time, according to the allegations in the complaint, S&P knew that the quality of non-prime RMBS was severely impaired, and that the ratings on those mortgage bonds would not hold. The government alleges that S&P failed to account for this impairment in the CDO ratings it was assigning on a daily basis. As a result, nearly every CDO rated by S&P during this time period failed, causing investors to lose billions of dollars.

Nearly every CDO rated failed is really damning. That is systemic fraud if ever we saw it.

The DOJ investigation code name was alchemy and that's about right when it comes to CDOs and many derivatives models.  Dealbook claims the heart of the suit are computer models used to rate the CDOs.  We overviewed the bad computational models of CDOs, as well as the invalid mathematical models behind them previously.  Unfortunately the case does not put  computational models and mathematical formulas on trial.   Dealbook reports the focus is on software updates.  Oh gez, if this is true, Microsoft and Linux are guilty as sin.

We read the case but there is so much more to it than claiming someone didn't update their software. In fact that does not seem to be the DOJ focus.  The complaint is 124 pages, available here and mentions many sources of direct evidence, including phone, email and even S&P strategic objective statements.   All clearly document S&P's brazen fraud.

The DOJ reports some astounding figures in the amount of money involved.  From 2004-2007, S&P rated $2.8 trillion residential mortgage backed securities (RMBS) and yet another $1.2 trillion in CDOs.  For each CDO rated, S&P got $50,000, unless of course the customer didn't care for the rating, then S&P got way less in fees, as in pennies on the dollar.  The DOJ complaint reads like a get rich quick scheme.  The good business of lying really pays, and the profits to be made are off the charts.

In 2007, rating CDO's generated $203 million in ill gotten gains.  In 2006 the S&P MBS rating division made $243 million.

While there is clearly $5 billion on the table from the complaint, we believe S&P will settle and probably for the $1 billion originally demanded or less.  That would still be one hell of a profit for S&P, even with the settlement fees being a glorified 20% kickback to the government.

Will S&P ever admit wrong doing?  We doubt it.  Odds are they will scapegoat a few lower level employees, blame the programmers for bad software and throw a few mathematical modelers to the wolves.