Is S&P out of the woods in the SEC’s Delphinus investigation?

July 20, 2012

It was big news last September when Standard & Poor’s disclosed that it had received a Wells Notice in connection with the Securities and Exchange Commission’s investigation of the $1.6 billion Delphinus collateralized debt obligation. The SEC sends Wells Notices to potential targets, not mere witnesses, so there was a lot of speculation that the Delphinus investigation might be the government’s long-awaited attempt to hold a rating agency accountable for colluding with a bank to misrepresent the quality of a mortgage-backed instrument.

But based on the complaint the SEC filed Wednesday against the Delphinus sponsor, Mizuho Bank, it looks to me like S&P is off the hook.

Mizuho, which earned $10 million in fees on the Delphinus deal, agreed to pay $127.5 million to settle the SEC’s case, which claimed investors were deceived by the ratings S&P, Fitch and Moody’s gave to the CDO. Four Mizuho executives involved in Delphinus structuring and marketing also settled, via administrative proceedings that imposed sanctions and fines. The settlement documents make it clear that Delphinus investors were misled about the quality of the mortgage-backed securities that served as collateral for the CDO.

So, however, were the rating agencies, according to the narrative the SEC laid out in its complaint against Mizuho, which was filed in federal court in Manhattan. In the SEC’s telling, the Delphinus offering materials required particular ratings from S&P. The agency could issue a preliminary rating on the CDO even before the portfolio of referenced securities was finalized, but the indenture documents said that if the CDO didn’t obtain final ratings based on the actual collateral in the referenced portfolio within 30 days of the closing, Delphinus would go into a form of default known as “effective date” failure.

All of the referenced securities for the CDO were actually selected by July 17, 2007, two days before the deal closing. That’s not what Mizuho told S&P and the other rating agencies, though. According to the SEC, Mizuho knew the CDO wouldn’t receive the ratings it needed if the bank showed the actual portfolio of underlying securities to S&P, which had just toughened its CDO rating standards. So instead, on July 18, 2007, the bank sent various “dummy portfolios” containing imaginary assets to S&P, promising that it intended to back the CDO with securities of similar quality.

The submissions allegedly made it seem that the Delphinus portfolio hadn’t been finalized – even though it had – and that Mizuho intended to back the CDO with higher-quality securities than the subprime dreck the portfolio actually contained. S&P proceeded to rate Delphinus on the dummy assets, and investors who bought into the CDO on July 19 never knew the ratings were obtained through (alleged) deception.

But what about the requirement that the CDO obtain a final rating based on the actual securities in the referenced portfolio within 30 days of the close? Did S&P look the other way when it got a look at the real portfolio in order to save the CDO from failing?

Here, again, the SEC complaint against Mizuho seems to absolve the rating agency of responsibility. According to the SEC, when the bank requested the final rating, S&P analysts realized that the portfolio they’d rated on July 18 didn’t reflect the true Delphinus assets. They also realized that those assets wouldn’t have justified the rating the CDO needed to close, and informed Mizuho that there was a problem. Mizuho responded by meddling with the effective date of the deal, asserting to S&P that the effective date for its final rating wasn’t the July 19 close of the CDO transaction, but Aug. 6. (The SEC complaint doesn’t explain why Aug. 6 was a beneficial effective date, but presumably the portfolio looked stronger on Aug. 6 than it did on July 19.)

The SEC said that Mizuho delivered a letter from the CDO accountant to S&P, calling for an Aug. 6 effective date. The CDO trustee, meanwhile, sent S&P an Aug. 6 effective date portfolio. “These actions,” the SEC complaint said, “facilitated S&P’s issuance of an effective date (rating) for Delphinus.”

There’s some bagginess in the SEC’s account that could leave room for allegations against S&P in Mizuho’s post-closing conduct. We don’t know why the rating agency agreed to the Aug. 6 effective date, or why the portfolio as of Aug. 6 passed muster when the July 19 portfolio didn’t. But the tone of the complaint suggests that S&P witnesses cooperated with the SEC, and that they persuaded regulators they’d been duped by Mizuho.

SEC spokesman John Nester and S&P spokesman Edward Sweeney both declined to comment.

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