US Justice Department officials Tuesday accused Standard & Poor's of fraud for inflating the ratings of mortgage bonds, costing US-insured banks at least $5 billion in losses in the financial crisis.
Announcing a suit against S&P and its parent, The McGraw-Hill Companies, Attorney General Eric Holder said the powerful rating agency knowingly exaggerated the ratings on financial securities, misrepresenting their true credit risk.
"Put simply, this alleged conduct is egregious -- and it goes to the very heart of the recent financial crisis," said Holder, flanked by justice officials from several states joining the suit.
"Today's action is an important step forward in our ongoing efforts to investigate and punish the conduct that is believed to have contributed to the worst economic crisis in recent history," he said.
S&P called the lawsuit "entirely without factual or legal merit, and an S&P lawyer hinted that it was political retribution for the agency's historic downgrade of the US credit rating from triple-A status in August 2011.
"Is it true that after the downgrade the intensity of the investigation significantly increased? Yes," Floyd Abrams, a lawyer representing S&P, said on CNBC television.
"I'm sure the government would say it has nothing to do with it."
The government accused the credit rater of knowingly inflating its ratings on collateralized debt obligations and residential mortgage-backed securities in 2007 in order to win revenue from issuers.
S&P "knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors," the civil suit, filed in California, said.
S&P was specifically charged with wire fraud, mail fraud and financial institution fraud. The government did not say what damages it was seeking, but media reports citing knowledgeable officials put it at least $1 billion.
The suit alleges S&P repeatedly compromised its independence in executing ratings to please issuers of the securities, who paid as much as $750,000 for its ratings.
It lays out internal communications in which S&P considered the need to update its analytic models to keep up with the securities in the changing market, only to continue with the weaker models that permitted higher ratings to go through.
S&P's modus operandi was to "limit, adjust and delay those updates" to favor issuers and "maintain and grow S&P's market share and profits," the complaint alleges.
S&P staff debated how many securities to downgrade as more of the loans came up delinquent and the housing market began to sink.
As the troubles became more widely apparent, one S&P analyst likened the situation to "Burning Down the House" in an email to several analysts in which he satirized the problems with mock lyrics of the famous Talking Heads song.
"Strong market is now much weaker. Subprime is boi-ling o-ver. Bringing down the house."
But at the same time, S&P continued to rate new CDOs "without making adjustments to account for continuing deterioration" in the investments, the complaint alleges.
S&P said the Justice Department took statements out of context.
"There was robust internal debate within S&P about how a rapidly deteriorating housing market might affect the CDOs -- and we applied the collective judgment of our committee-based system in good faith," S&P said.
"The email excerpts cherry-picked by DOJ have been taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business," S&P continued.
S&P also argues that it was far from alone in its failure to predict the scale of the housing collapse.
But the government has not taken any action against S&P's competitors Moody's -- which remained quiet on the subject Tuesday -- and Fitch, which told AFP that it has "no reason to believe Fitch is a target of any such action."
S&P is a unit of McGraw-Hill, whose shares were down 7.7 percent in afternoon trade after losing nearly 14 percent Monday.