Guruge ’14 sounds off on the McGraw-Hill fraud scandal

After four years of sorting through the financial wreckage left behind from the housing bubble, the Department of Justice has decided to bring a five billion dollar civil suit against McGraw-Hill because their rating department, Standard and Poor (S&P), allegedly defrauded investors by giving nearly perfect ratings to subprime mortgage bundles destined to default.

In April of 2007, one S&P analyst subtly expressed just how seriously S&P took their rating responsibly by writing in an instant message “we rate every deal… it could be structured by cows and we would rate it.”

The next month an executive made the point even clearer in a PowerPoint slide explaining that “we look at our raw data and come up with a statistical best fit. When this does not meet our business needs, we have to change our parameters ex-post to accommodate.” These two quotes cut to one of the most fundamental issues of the suit: ratings companies are paid by the companies who produce the CDOs (collateralized debt obligation) they are rating, truly one of the best examples of a conflict of interest.

So, S&P competes for business against two other major ratings companies, Moody’s and Filch, who are just as willing to adjust parameters until the final ratings are favorable for their clients. Both Moody’s and Filch seemed to escape prosecution, though, by merely not being as obvious about it.

In the suit the two major victims mentioned are Citigroup and Bank of America, who experienced billions in losses because of overrated CDOs. Who underwrote those CDOs? Citigroup and Bank of America.

That’s right: One division of Citigroup can underwrite a subprime mortgage bundle, get it rated by S&P, sell it to another division of Citigroup, lose money and then blame S&P for defrauding them on their own merchandise. It’s hard to decide what is more unnerving in this situation. Is it S&P’s disregard for factuality or Citigroup’s and Bank of America’s ignorance about their own products?

Still, there are other victims mentioned in the suit, like M&T Bank Corp., who did not underwrite the CDOs and invested potentially because S&P suggested it was a good idea. But this “suggestion” frames the crux of S&P’s defense. The company claims that because the ratings are their published opinions they fall under the same category as published editorials. In other words, S&P believes their stupidity is protected by the first amendment.

To circumvent this defense, the Department of Justice will have to prove three separate points: (1) S&P understood that their ratings were incorrect, (2) that those high ratings were caused by consumer pressure and (3) that they insisted their ratings were objective and fair.

McGraw-Hill probably cannot afford a five billion dollar loss (they only profit about 1 billion each year) which means that losing this suit could bankrupt the company. But it’s hard to garner up sympathy for a company that was willing to give perfect ratings to subprime mortgage bundles that even a cow could have seen were going to fail but then was willing to downgrade the United States of America’s long term credit rating in 2011 even though the country has the power to print the money it owes.

In the end, the question does not seem to be whether or not S&P defrauded investors purposefully but whether or not it was illegal to do so.