California Attorney General Kamala D. Harris filed a lawsuit Tuesday against one of the nation’s major credit rating companies for inflating its ratings of structured finance investments, which caused California’s public pension funds and other investors to lose billions of dollars.
The complaint, filed today in San Francisco Superior Court, alleges that the McGraw-Hill Companies Inc. and Standard and Poor’s Financial Services LLC violated the False Claims Act and other state laws by using a ratings process based on what senior executives described as “magic numbers” and “guesses.”
“For years, S&P placed its priority on maintaining its market share, instead of the investors who trusted in its supposedly objective ratings,” said Attorney General Harris. “When the housing bubble burst, S&P’s house of cards collapsed and California paid the price—in billions. S&P must be held accountable for its conduct that contributed to one of our country’s worst financial crises.”
Investors relied on S&P and its competitors to rate these securities because they had access to only general descriptions of the assets backing their investments, which often included mortgages. California’s public pension funds also relied on S&P because they are often required to buy securities that received a coveted “AAA” rating, signaling that the investment was top-tier and bore minimal risk.
The complaint alleges that, from 2004 to 2007, S&P systematically misrepresented to the public, and to CalPERS and CalSTRS, that its ratings of structured finance securities were based on an independent, objective and reliable analysis, and not influenced by S&P’s economic interests.
In doing so, S&P lowered its standards for rating securities to gain market share and increase profits, and violated the False Claims Act by making false statements about the nature and risk of investments. The complaint also describes the company’s efforts to suppress the development of new and more accurate ratings models.
In mid-2007, the housing bubble burst. After securities that S&P had deemed the least risky began defaulting, S&P downgraded many residential mortgage backed securities investments. The market collapsed, and of those securities issued in 2007, more than 90 percent were downgraded to junk status.
The California Public Employees Retirement System (PERS) and the California State Teachers Retirement System (STRS) – two of the nation’s largest institutional investors – lost approximately $1 billion.
Attorney General Harris today joined the U.S. Department of Justice and 12 other states and the District of Columbia in announcing lawsuits in Washington, D.C. The other lawsuits allege violations of the federal Financial Institutions Reform, Recovery and Enforcement Act and state unfair competition laws.
However, California’s suit is unique because it is being filed not only under California’s unfair competition laws but also under the state’s False Claims Act. This suit includes a claim for triple damages – because when the state makes a purchase based on a false statement, the defendant is responsible for the amount lost times three.
The lawsuit arises from a 20-month investigation into the issuance and rating of mortgage-backed securities by Attorney General Harris’s California Mortgage Fraud Strike Force, which she formed in May 2011 to comprehensively investigate misconduct in the mortgage industry. The Attorney General’s additional efforts to investigate the mortgage crisis include securing an estimated $18 billion for California in the National Mortgage Settlement and sponsoring the California Homeowner Bill of Rights, a package of laws instituting permanent mortgage-related reforms.