The fraud case Standard & Poor’s doesn’t want you to know about

November 19, 2014

Last week, the Federal Home Loan Bank of Pittsburgh filed a brief opposing summary judgment for the credit rating agency Standard & Poor’s, which the bank has accused of fraud in Pennsylvania state court. The case, which involves FHLB’s investments in supposedly misrepresented mortgage-backed securities, dates back to 2009. The Pittsburgh lender’s doggedness has already pushed JPMorgan Chase into a settlement (on undisclosed terms) last January, after FHLB’s lawyers at Robins Kaplan Miller & Ciresi demanded to see the Justice Department’s draft complaint against JPM. Countrywide and the credit rating agency Moody’s also made deals with FHLB in June to have claims against them dismissed. S&P is the last remaining defendant in the case.

Its strategy in the FHLB litigation is, of course, complicated because S&P is also a defendant in multibillion-dollar suits by the Justice Department and several state attorneys general, which also claim that S&P deceived investors about its MBS ratings. (Technically, the AGs allege that S&P violated state consumer and trade practice laws by lying about its independence and objectivity.) The credit rating agency reportedly began talking to Justice about a billion-dollar settlement this summer, but so far there’s been no announced deal. Those negotiations are undoubtedly one of the reasons why S&P wants FHLB’s case tossed on summary judgment.

For FHLB, meanwhile, the unresolved government suits are leverage. If S&P is worried that revelations from FHLB’s case could prod Justice and the AGs to demand bigger settlements, FHLB can use that concern to extract more money from the credit rating agency.

A key to FHLB’s strategy is to press Allegheny County Court of Common Pleas Judge R. Stanton Wettick to permit the bank to reveal what it has uncovered about S&P’s conduct. At the moment, the public version of its brief is heavily redacted, as is S&P’s summary judgment brief. The FHLB filing is studded with tantalizing headings – “S&P’s policy forbidding written criticisms by employees,” “S&P decided not to use an accurate model for rating RMBS because it knew it would lose market share,” “S&P’s top executives knew its ratings model was based on profits not computer-modeling science” – but they’re all followed by blocks of blacked-out text. FHLB lawyer Stacey Slaughter of Robins Kaplan told me Wednesday that the bank intends to ask Judge Wettick for leave to make public the unredacted version of the filing.

She said the unredacted version will tell the story of how S&P profited from the MBS boom at the expense of investors with richer detail and deeper analysis than the Justice Department complaint or any other case against the rating agency. “No one else has exposed how their model worked – or, I should say, didn’t work,” Slaughter said. FHLB saw everything S&P turned over to the government, in addition to the rating agency’s response to its own discovery demands – more than 2 million documents in all, Slaughter said. The bank deposed seven current and former S&P executives and analysts. It hired two expert witnesses, including a systems engineering professor from the University of Virginia, Peter Beling, who deconstructed S&P’s model for rating mortgage-backed securities. Most of the references to Beling’s report are redacted in the public version of FHLB’s brief, but according to Slaughter, he concluded that the model’s accuracy was “no better than a flip of a coin,” and that S&P deliberately deceived investors about the system’s flaws.

“We’ve put it together in a way no one else has,” Slaughter said. “They should be very worried.”

Obviously, it’s in the interest of Slaughter’s client to stoke S&P’s fear that Justice and the state AGs will be interested in the unredacted version of FHLB’s filing. S&P and its lawyers at Cahill Gordon & Reindel and DeForest Koscelnik Yokitis & Berardinelli already know what’s in there, so it will be interesting to see whether the credit rating agency opposes FHLB’s promised motion to unseal the brief. In a funny way, FHLB could be in a better settlement position now, when it can tout its revelations and promise that the government will be outraged by them, than it might be if the redactions are lifted and no one much cares what the brief says.

The summary judgment hearing is scheduled for Dec. 9 and, according to Slaughter, it is expected to take place in open court. If S&P is really worried about FHLB’s revelations, expect a settlement in the next three weeks.

I sent a detailed email request for comment to S&P. The rating agency declined to comment.

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