S&P Faces Squeeze After $1.3 Billion Countrywide Penalty

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Standard Poor’s 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 SP, 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 SP 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 SP, 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 SP 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. SP 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 SP, argued at a hearing today in federal court in Santa Ana, Calif., 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 SP 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 ruled in March that SP 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 SP’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 and Freddie Mac 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.

SP 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 SP 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 SP 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 SP’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 SP’s ability to pay, Gadinis said.

SP 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% of the CDO market in 2007 was rated by SP?” Gadinis said. “No company in the world could pay that amount of money.”

Ed Sweeney, an SP 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.”

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