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(Reuters) - Regulators disclosed they may take action against Standard & Poor's for securities law violations after the ratings agency gave top grades to a package of securitized mortgages in 2007 that quickly soured.
The possible action could be the first by the United States against one of the major credit rating agencies, which have been accused of enabling the lending excesses that led to the subprime mortgage crisis in 2008.
The disclosure follows S&P's downgrade of the debt of the U.S. government in August, an unrelated move that was not followed by other rating agencies and that drew darts from the Obama administration and a bipartisan group of politicians.
The disclosure came in a statement Monday from McGraw-Hill Cos Inc MHP.N, parent company to Standard & Poor's, which said it had received a Wells notice from the U.S. Securities and Exchange Commission on September 22.
Wells notices give potential defendants an opportunity to explain why civil charges should not be brought. The company said SEC staff are considering recommending that commissioners take action against S&P for violating securities laws in its ratings of a 2007 collaterized debt obligation known as "Delphinus CDO 2007-1."
While Wells notices are not always followed by lawsuits from the SEC, they represent a serious threat. "A Wells notice ups the ante," said Alan Palmiter, professor, Wake Forest University School of Law, Winston-Salem, North Carolina. "It is clear the SEC has identified something it sees as a problem with ratings issued during the subprime mortgage heyday."
If the SEC presses charges, McGraw-Hill would likely try to settle them, and may have to change its ratings practices, Palmiter added.
S&P warned it might have to pay civil penalties in the case.
Shares of McGraw-Hill fell as much as 3 percent on Monday, but recovered to close up 0.63 percent at $43.20.
McGraw-Hill earlier this month announced plans to split into two publicly traded companies to satisfy activist investors unhappy with its depressed value.
S&P is the flagship business of the ratings and market information services company that will be spun off. The other business is being structured around McGraw-Hill's textbook publishing business.
Institutional shareholders, led by Jana Partners, have pushed the conglomerate to take further steps, including completely severing the ratings business from the company's analysis and information operations.
A Senate subcommittee report in April cited the Delphinus deal as a "striking example" of a CDO moving from top ratings to junk in a matter of months.
Spokesmen for Moody's Investors Service and Fitch Ratings, which also rated the CDO, said their companies have not received Wells notices in the case.
S&P issued the CDO ratings in question at a time when the credit boom that had lifted mortgage lending and house prices was already collapsing, said Janet Tavakoli, a structured finance expert at Tavakoli Structured Finance in Chicago.
S&P ratings covered at least $947 million of liabilities in the Delphinus CDO and were issued August 2, 2007. By December, S&P had started downgrading top-rated bonds from the CDO, according to the Senate panel report. By January 4, the deal was in technical default, according to a notice S&P issued at the time. By the end of 2008, S&P's AAA ratings on the bonds were marked down to junk.
The CDO was largely backed by subprime-mortgage securities, according to a Fitch report.
"There is no excuse for rating these deals in the way they were," said Tavakoli.
The CDO was underwritten by Mizuho International, a unit of the big Japanese bank of the same name, according to records kept by Moody's.
Mizuho was among the banking clients that S&P analysts felt pressure to satisfy with more lenient ratings criteria, according to an email cited in the Levin report.
The CDO was among more than two dozen structured finance vehicles used by hedge fund Magnetar Capital LLC to make bets on the mortgage market, according to ProPublica, a non-profit news organization. The deal was managed by Delaware Asset Advisers, according to Moody's.
Tavakoli said "it is a shame" that the SEC investigations are still going on four years after the events in question and months after the Senate subcommittee report came out. "The wheels of justice move much too slowly," she said.
S&P is facing other regulatory pressure as well. Last month a source said the U.S. Justice Department was investigating S&P and Moody's Investors Service actions on mortgage securities.
The major agencies have long successfully defended themselves against lawsuits over flawed ratings by citing their First Amendment rights to state their opinions. So far, they have withstood legal assaults mounted by private lawyers to recover money investors lost in the credit crisis.
"This is yet another challenge to that defense," said Lawrence J. White, a New York University economics professor. White noted that the SEC's investigation of S&P follows steps by Congress in the Dodd-Frank Act to make the agencies more responsible for their judgments.
Wake Forest's Palmiter said it is unlikely that McGraw-Hill would settle an SEC case with any admission of liability that might make it more vulnerable to private lawsuits.
S&P's failures with structured finance ratings were recently cited by Washington politicians as reason to doubt the agency's decision in August to cut its rating on U.S. government debt from AAA to AA-plus. No other major rating agency has downgraded U.S. government debt.
Reporting by David Henry; additional reporting by Jonathan Stempel in New York and Aditi Sharma in Bangalore; Editing by John Wallace, Dave Zimmerman and Bernard Orr