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Shifting Blame Muddles S&P Suit

02/15/2013 | The Wall Street Journal
By Jeannette Neumann

Like many other collateralized debt obligations, Delphinus CDO 2007-1 got a triple-A rating and then defaulted within months, causing painful losses to investors. Who is responsible for the mess?

Last year, the Securities and Exchange Commission blamed Mizuho Financial Group Inc., and the Japanese bank paid $127.5 million to settle a lawsuit filed by the U.S. agency. The U.S. Justice Department sees things differently. The Delphinus deal, which means “dolphin” in Latin and is the name of a small constellation in the Northern Hemisphere, was one of more than 30 CDOs included in the federal government's lawsuit against Standard & Poor’s Ratings Services last week.

Federal prosecutors say that S&P, a unit of McGraw-Hill Cos., disregarded its own standards when rating Delphinus and the other CDOs, misled investors and should cover losses suffered by federally insured banks and credit unions that bought the securities, which included bundles of subprime mortgages.

The discrepancy could give S&P a way to counterattack the Justice Department as the two sides gird for a battle that legal experts say will be grueling.

U.S. Attorney General Eric Holder is seeking more than $5 billion in damages from S&P, which claims the allegations are “meritless.”

The U.S. government’s conflicting opinions about the Delphinus deal might be a problem if the civil-fraud suit goes to trial. The ratings firm probably will argue that “these banks aren’t victims,” says Samuel Buell, a former federal prosecutor who now is a law professor at Duke University.

Representatives from the Justice Department and S&P declined to comment.

Another inconsistency: In the text of the complaint, prosecutors cited Delphinus and six other CDOs created and sold before the housing bubble burst in late 2007 as examples of fraudulent ratings by S&P. But those deals aren’t on separate lists of CDOs at the end of the suit, where the U.S. alleges losses at a specific financial institution because of S&P’s fraud.

Legal experts said that isn’t necessarily a problem for the government because the lists aren’t meant to be comprehensive.

Still, lawyers for S&P are likely to make an issue of the mismatch, some legal experts say. On Tuesday, McGraw-Hill General Counsel Kenneth Vittor told analysts and investors in a conference call that the suit outlines only $500 million of alleged investor losses. “The government has not explained where the other $4.5 billion in alleged losses come from,” he said.

S&P will be required to respond to the allegations in the complaint within 90 days, Mr. Vittor said Tuesday.

Mizuho created Delphinus as the housing market was taking a turn for the worse. S&P, Moody’s Corp.’s MCO +1.54% Moody’s Investors Service and Fitch Ratings, now a unit of FimalacSA and Hearst Corp., also gave most of the deal a triple-A rating in August 2007. The ratings firms downgraded Delphinus to “junk” status in early 2008. Soon, some investors stopped getting payments on their securities. Delphinus was liquidated in 2010.

Last July, SEC officials alleged that some Mizuho employees “provided S&P inaccurate and misleading information” by having S&P rate assets that weren’t in the deal sold to investors. “Mizuho sold securities based upon those ratings, which in turn misled investors to believe that the Delphinus notes were of higher credit quality,” the SEC alleged.

Mizuho neither admitted nor denied wrongdoing. A bank spokesman couldn’t be reached for comment.

In last week’s suit, the Justice Department alleged S&P ignored its internal standards when rating Delphinus because the firm didn’t consider the deteriorating quality of residential mortgage loans backing the deal.

S&P analysts ran the portfolio of loans backing Delphinus through the firm’s “CDO Evaluator” model in July 2007, and found that four slices of the deal failed a test, the Justice Department alleges. S&P analysts then tweaked the ratings on those underlying loans until just one slice was failing the test. S&P rated Delphinus on July 19, 2007 “notwithstanding the continuing” failure of one slice of the deal, the Justice Department alleges.

Legal experts said S&P is almost certain to highlight that the SEC blamed Mizuho for investor losses on Delphinus, while the Justice Department blames S&P. The same experts cautioned, though, that two different defendants could be found legally responsible. S&P disclosed in 2011 that it received a so-called Wells notice from the SEC for the way it rated Delphinus. A Wells notice is the agency’s warning to financial institutions that they could face civil charges.

The investigation is ongoing, according to people familiar with the matter.

Plaintiffs in other CDO lawsuits against banks that created those deals are watching the S&P case closely. Space Coast Credit Union of Melbourne, Fla., sued Barclays PLC in 2011 to recover losses in Markov CDO I Ltd., one of the deals in the government’s case against S&P.

“We are very interested to see the evidence that the government has to show S&P’s level of complicity in the selling of these inherently flawed products,” says David Bishop, a lawyer representing the credit union.

Write to Jeannette Neumann at