On February 5th, the Justice Department announced that it is suing Standard & Poor’s for fraud relating to an alleged scheme to defraud investors which played a significant role in causing our financial meltdown and the collapse of the real estate market. Most people are unaware of what this is all about and who S&P actually are.

Historically, lenders made loans to individuals and companies after reviewing their credit status, income, and other factors. The lenders would then either hold these loans as the borrowers paid them back with interest or they would sell them to other investors and get back money to make more loans. But approximately 20 years ago, this began to change as lenders started “bundling” many mortgages into tradable securities that could actually be sold as investments. The process worked fine as long as the mortgages themselves remained in good standing and resulted in more money being made available for more loans.

A problem developed however when the pool of qualified borrowers had already obtained loans and demand – and lender’s income – started to fall. At this point, mortgage lenders began granting loans to unqualified borrowers who, in reality, could not afford them and should not have gotten them. While the real estate market was hot and prices were climbing, demand for loans kept climbing from prospective borrowers who had never before been able to buy a home. Mortgage brokers earned fees for each loan they originated, which gave them an incentive to ignore underwriting standards and write as many loans as possible, and even commit fraud. Because the banks that made the loans were able to sell them off as “investments”, their concern with validating the quality of the loan was reduced since they’d no longer be holding it if something went wrong. Trillions of dollars worth of loans were made this way, building a house of cards that was doomed to fail. When home value to start fall, the home equity many of those borrowers had been counting on evaporated, and default rates skyrocketed. The crash was started.

Before a lender could bundle their loans into an investment to be sold – called a “mortgage backed security” – someone had to review the quality of the loans and assign a “rating” to the quality of the bundle as a whole. This is the role that Standard & Poors played (along with other rating agencies such Moody’s and Fitch). These rating agencies were supposed to be final backstops assuring the quality of the loans that made their way into mortgage-backed securities. The Ratings assigned ranged from AAA (extremely safe) to CCC (highly vulnerable). The Wall Street banks that assembled and sold mortgage-backed securities typically aimed for a triple-A rating, the highest, because pension funds and other big investors followed rules requiring their investments to be in high-quality assets. Anything rated AAA was considered extremely safe, nearly as low risk as U.S. Treasuries.

In short, everyone relied upon the validity of the Ratings. They turned out to be widely off. The 2011 Report of the Financial Crisis Inquiry Commission stated: “The failures of credit rating agencies were essential cogs in the wheel of financial destruction…..This crisis could not have happened without the rating agencies.” The big question, obviously, is why the rating agencies got it so wrong.

The Department of Justice lawsuit against S&P alleges that S&P knowingly made inflated credit ratings for mortgage backed securities, misrepresenting their creditworthiness and understating their risks. The department further alleges S&P “falsely claimed that its ratings were independent, objective, and not influenced by the company’s relationship with the issuers who hired S&P to rate the securities in question” when that was in fact not the case.

U.S. Attorney General, Eric Holder, reported that the department’s three-year investigation showed that as early as 2003, analysts within S&P raised concerns about the accuracy of the agency’s rating system. Those warnings were ignored. Even in 2007, when S&P’s internal data showed a “severe deterioration” in the credit worthiness of these securities, S&P continued to give them their highest ratings. Of course, S&P denies that they did anything wrong.

While we watch this latest Federal action unfold (and no doubt, the various state attorneys general will file their own actions), this will represent one more challenge to the struggling real estate lending market and will likely continue limiting the availability of loans to only the most qualified. This will affect the demand for housing by limiting the supply of qualified buyers. The result may cool off the current bubble of price increases caused by high buyer demand chasing historically low inventory of homes for sale.

If you or someone you know is facing a legal or financial challenge and don’t know what to do, our BPE Law $200 flat fee Consultation Program can offer knowledge of what to expect and form strategies to achieve your best overall resolution. To schedule a Consultation, please contact our office at (916) 966-2260 or e-mail me at sjbeede@bpelaw.com

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are upside-down on your loan, especially if you’re facing a lender lawsuit, get competent legal advice in your State immediately so that you can determine your best options.

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