Standard & Poor’s (MHFI)’ chances of settling the government’s lawsuit over mortgage-bond ratings for less than $1 billion may have slipped away after Bank of America Corp.’s Countrywide unit was socked with a $1.3 billion fine.
The Countrywide ruling was the first to lay out what penalties financial institutions could face under a 1989 bank-fraud law the Obama administration is using against alleged culprits of the subprime mortgage crisis. It has strengthened the government’s hand against McGraw Hill Financial Inc.’s S&P, said Peter Henning, a law professor at Wayne State University.
“If the starting negotiation point for the Justice Department to settle was $1 billion before, that number has just gone up,” Henning said in a phone interview.
The U.S. sued S&P and Countrywide under the Financial Institutions Reform, Recovery and Enforcement Act, or Firrea, a law passed by Congress in the wake of the savings-and-loan crisis of the 1980s. The administration, which seeks as much as $5 billion from S&P, is using the law to punish alleged misconduct in the creation and sale of residential mortgage-backed securities blamed for the financial crisis two decades later.
For the Justice Department, the case against S&P goes to the heart of the financial crisis, attacking the company’s claims that its ratings — relied on by investors worldwide — were honest and neutral. S&P has countered that the case is really retribution for its downgrade of the U.S. government’s own debt and it has subpoenaed officials including former Treasury Secretary Timothy Geithner in an effort to prove that.
Floyd Abrams, a lawyer for S&P, argued at a hearing today in federal court in Santa Ana, California, that the company should get unredacted copies of Geithner’s notes for his book, “Stress Test: Reflections on Financial Crises,” that are relevant to the company and the downgrade.
“In two instances, they have literally taken out a word in the middle of a discussion of Standard & Poor’s,” Abrams told U.S. District Judge David Carter. “They both appear to be scatological in nature.”
Nicholas Tompkins, a lawyer for Geithner, said at the hearing that S&P got all the material that was relevant to its purported defense and that individual words had been redacted out of concern the notes might get leaked to the media.
Carter ordered both Geithner and the Justice Department to provide him with documents that S&P claims are improperly withheld or redacted so he can determine whether the company is entitled to them.
The judge ruled in March that S&P would be allowed to seek information from Geithner related to what the company said was a “threatening” call he made to Harold W. McGraw III days after S&P’s downgrade of the U.S. debt in 2011. The judge said at the time that he was concerned the call to McGraw Hill Financial’s chairman was intended to have a “chilling effect.”
Countrywide was found liable by a federal jury in Manhattan for lying about the quality of the almost $3 billion in mortgages it sold to Fannie Mae (FNMA) and Freddie Mac (FMCC) in 2007 and 2008. U.S. District Judge Jed Rakoff in Manhattan agreed with the Justice Department that the penalty should be based on how much money the mortgage lender fraudulently induced the companies to pay for the loans.
“The civil penalty provisions of Firrea are designed to serve punitive and deterrent purposes and should be construed in accordance with those purposes,” the judge said in his July 30 ruling.
S&P is accused of defrauding institutions that relied on its credit ratings for residential mortgage-based securities and collateralized debt obligations that included those securities. The government claims S&P lied to investors about its ratings on trillions of dollars in securities being objective and free of conflicts of interest.
Rakoff’s ruling was “very friendly” to the government and will influence other judges because there have been very few cases involving Firrea penalties before the Justice Department started using the statute in its mortgage-fraud litigation two years ago, said Stavros Gadinis, an assistant law professor at University of California at Berkeley.
“The government will definitely try to make this part of the settlement negotiations,” Gadinis said in a phone interview. “It will have a significant impact.”
The S&P case is tentatively scheduled for trial in September 2015.
If the company is found liable for defrauding banks and credit unions and Carter applies the same methodology as Rakoff, the credit rater’s penalty could be based on the amount the alleged victims paid for the securities that they wouldn’t have bought if it hadn’t been for S&P’s investment-grade rating, according to Gadinis.
That would only set a possible maximum range for any penalty, which would also have to take into account S&P’s ability to pay, Gadinis said.
S&P issued ratings on more than $2.8 trillion of residential mortgage-backed securities from September 2004 through October 2007 and $1.2 trillion worth of CDOs, according to the Feb. 4, 2013, Justice Department complaint.
“What if 60 percent of the CDO market in 2007 was rated by S&P?” Gadinis said. “No company in the world could pay that amount of money.”
Ed Sweeney, an S&P spokesman, declined to comment on the effect Rakoff’s ruling might have on the case.
Rakoff’s calculation of the Countrywide penalty reduced the total value of the mortgages sold to Fannie Mae and Freddie Mac during a nine-month period under a so-called High Speed Swim Lane program, which was $3 billion, by the percentage of loans that didn’t turn out to be defective.
The judge’s analysis, using the nominal value of the transactions as a starting point to determine the penalty, was “out of whack” and will probably be appealed by Bank of America to the U.S. Court of Appeals for the Second Circuit in New York, said David Reiss, a professor at the Brooklyn Law School.
“The Second Circuit has no problem reversing Rakoff,” Reiss said in in a phone interview. “The ruling pushes the balance of power in favor of the government by expanding the definition of a civil penalty.”
While other judges aren’t obliged to follow Rakoff’s reasoning, they will pay close attention to the decision because the federal court in Manhattan is the leading business law jurisdiction in the country and the ruling was clearly explained, Reiss said.
Rakoff, nominated by President Bill Clinton in 1995, has been critical both on and off the bench of the federal government’s policing of financial fraud.
He has twice rejected U.S. Securities and Exchange Commission settlements that let banks end probes without admitting wrongdoing.
In 2009, Rakoff rejected a $33 million SEC settlement with Bank of America over alleged misstatements about the purchase of Merrill Lynch & Co., saying it suggested “a rather cynical relationship between the parties.” He signed off on the deal when it was increased to $150 million. In an SEC case accusing Citigroup Inc. (C) of misleading CDO investors, he refused in 2011 to approve a $285 million settlement that didn’t document any proven or admitted facts.
The appeals court overruled Rakoff in the Citigroup case, finding that he had abused his discretion.
The judge’s reputation doesn’t mean the appellate court is likely to overturn his decision on the civil penalty against Countrywide if Bank of America appeals, Henning said.
“Rakoff comes across as a bit of a gadfly but he’s highly regarded by the Second Circuit,” Henning said. “He’s no dummy.”
Associate Attorney General Tony West, who led the Justice Department’s civil cases against banks involved in selling mortgage-backed securities, said last year that S&P may face as much as $5 billion in civil penalties based on losses suffered by federally insured financial institutions. West announced he is leaving the department on Sept. 15.
S&P, based in New York, has denied the allegations and has argued it was singled out by the government because it was the only credit rating company to downgrade the U.S. debt in 2011. The government has denied there is a connection between the downgrade and the decision to sue S&P in 2013.
Bank of America last month asked Rakoff to throw out the jury’s verdict that Countrywide defrauded Fannie Mae and Freddie Mac. Lawrence Grayson, a spokesman for the Charlotte, North Carolina-based bank, said in July that the penalty bore no relation to a Countrywide program that lasted several months. The bank hasn’t appealed the $1.3 billion penalty.
Separately, Bank of America agreed last month to a $5 billion Firrea fine as part of a settlement totaling about $16.7 billion to end federal and state probes into mortgage bond sales.
Carter, a 1998 appointee of Clinton, hasn’t shied away from imposing hefty penalties in high-stakes litigation.
In 2011 he awarded toymaker MGA Entertainment Inc. $225 million in punitive damages, attorney fees and costs after it prevailed on most of the claims Mattel Inc. (MAT) had brought in a second trial over the rights to Bratz dolls. A federal appeals court partly overturned Carter’s ruling but left intact his award of $137.2 million to MGA for having to defend Mattel Inc.’s copyright infringement claim, which Carter said was “stunning” and “unreasonable.”
The Countrywide penalty may galvanize S&P to contest the Justice Department’s fraud claims as vigorously as possible to avoid the judge having to reach the question of penalties, said John Richter, a lawyer with King & Spalding LLP in Washington.
S&P wasn’t a direct issuer of the securitized mortgages it rated and would be less culpable for any losses to federally insured financial institutions than the banks, including Bank of America, Citigroup and JPMorgan Chase & Co. (JPM), that issued the securities and admitted they misled investors, according to Richter.