S&P May Face SEC Charges Over CDO Rating

US regulators have warned Standard & Poor’s that they may file civil charges against the credit rating firm, alleging that it violated federal securities laws in connection with its rating of one of the structured finance instruments that was at the heart of the financial crisis.

McGraw-Hill, which owns S&P, said it had received a so-called Wells notice from the Securities and Exchange Commission on September 22 concerning its rating of a $1.6bn deal known as Delphinus CDO 2007-1. Such collateralised debt obligations bundle together debts and slice them into tranches of varying return and risk.

The Wells notice marks the first time the SEC has sought to pursue charges against a ratings company in connection with its rating of a CDO, linked to pools of residential mortgages.

Such a notification allows the company to address regulators’ concerns before the SEC brings formal charges. “S&P has been co-operating with the commission in this matter and intends to continue to do so,” McGraw-Hill said. The SEC may seek monetary penalties.

S&P has also come under SEC scrutiny for its controversial decision to downgrade US debt in August.

Delphinus, named after a constellation of stars, was structured at the request of Illinois hedge fund Magnetar Group by Mizuho International, a unit of Japanese bank Mizuho Financial Group. Delaware Asset Management served as collateral manager on the deal.

Rating agencies have been under scrutiny for issuing their safest rating, triple A, to scores of mortgage-related securities, many of which were downgraded only months later and went into default after the housing bubble burst. An investigation by the US Senate Permanent Subcommittee on Investigations found that the original ratings on many CDOs were “deeply flawed”.

The SEC is looking at what S&P knew about the housing market at the time it issued the high-quality ratings to Delphinus and whether it misled investors who bought the product, according to people familiar with the matter.

S&P gave triple A ratings to parts of the Delphinus CDO that closed on July 19 2007, according to the Senate report.

Nine days earlier, S&P had put $7.35bn of residential mortgage-backed securities on credit watch, kicking off a series of downgrades. The Senate report criticising credit rating agencies highlights Delphinus as a “striking example” of a deal that was downgraded within a few months of its initial high-quality rating.

The Wells announcement comes as McGraw-Hill is looking to restructure its educational publishing division and S&P and markets information unit into two separate businesses.