Bloomberg News

S&P Gilded Gemstone With Top Grades as U.S. Mortgages Crumbled

February 06, 2013

S&P Gilded Gemstone With Top Grades as U.S. Mortgages Crumbled

The CDO, issued by Deutsche Bank AG and composed primarily of subprime mortgage-backed securities, is one of the deals the Justice Department named in its Feb. 4 lawsuit accusing the world’s largest credit-rater of deliberately understating the risks of mortgage bonds to win business from Wall Street banks. Photographer: Hannelore Foerster/Bloomberg

Standard & Poor’s stamped 72 percent of a $1.04 billion collateralized debt obligation called Gemstone VII issued in February 2007 with AAA grades, granting the debt the same gilded credit rating it bestowed on the U.S. government at the time.

The ratings company confirmed the ranking the next month, even after the deal’s prospectus warned of “risks of losses” in the securities.

Gemstone defaulted in April 2008.

The CDO, issued by Deutsche Bank AG and composed primarily of subprime mortgage-backed securities, is one of the deals the Justice Department named in its Feb. 4 lawsuit accusing the world’s largest credit-rater of deliberately understating the risks of mortgage bonds to win business from Wall Street banks.

“Keep your fingers crossed but I think we will price this just before the market falls off a cliff,” Michael Lamont, the co-head of Deutsche Bank’s CDO group at the time, said in a Feb. 8, 2007 e-mail regarding the Gemstone transaction, cited in a report released by the U.S. Senate’s Permanent Subcommittee on Investigations in April 2011.

The fate of Gemstone underscores the role the rating companies played in enabling lenders to offload risky mortgages even as the housing market showed signs of imploding. The U.S. is seeking penalties against S&P and its New York-based parent, McGraw-Hill Cos. that may amount to more than $5 billion, based on losses suffered by federally insured banks.

Saddling Investors

The Gemstone transaction saddled its investors, including M&T Bank Corp., Wachovia Corp., Commerzbank AG and Standard Chartered Plc, with “losses in the billions of dollars,” according to a lawsuit filed in New York State court against units of Deutsche Bank and HBK Investments LP in September 2008. The suit didn’t accuse the rating companies of any wrongdoing.

Deutsche Bank was able to sell $700 million of the securities, which lost most of their value within 17 months, according to the Senate report.

In July 2007, S&P downgraded more than 22 percent of the subprime collateral backing the deal, according to the Justice Department’s complaint.

S&P contests the allegations. Despite its best efforts to “keep up with an unprecedented, rapidly changing and increasingly volatile environment,” the severity of “what ultimately occurred was greater than we -- and virtually everyone else -- predicted,” the company said in a Feb. 4 statement.

Deal documents distributed by Deutsche Bank to Gemstone investors at the time of the sale reveal concerns that the U.S. housing market was headed for a precipitous fall.

Losses Risk

“The risk of losses on residential mortgages is particularly relevant now,” underwriters advised investors in the 390-page prospectus.

The document lists numerous contributors to stress in the mortgage market, including declining property values and the failure of mortgage lenders to “apply adequate standards to potential borrowers.” Lax underwriting encompassed everything from neglecting to verify buyers’ employment and income histories, property values and not complying with predatory lending statutes, according to the prospectus.

S&P confirmed its rating on the Gemstone CDO in March 2007, according to the Justice Department’s complaint.

‘Raw Form’

David Tesher, head of one of S&P’s CDO groups, had told colleagues in March that the firm should expect a rush in business partly because some investors might have already signed up for the deals, according to the complaint. Even if the CDOs never were sold, he said, banks were better off creating them rather than holding the underlying securities in “raw form” because write-downs would be smaller.

Some financial institutions won’t purchase securities that don’t carry investment-grade rankings, the complaint states, leaving these investors reliant on S&P and its largest competitor, Moody’s Investors Service, to judge the relative creditworthiness of different securities. S&P, aware of its sway over such institutions, knowingly “devised, participated in, and executed a scheme to defraud investors,” according to the complaint.

The lawsuit also cited deals including Octonian I, Pampelonne CDO II, and Corona Borealis CDO Ltd. S&P said in its statement that all of the CDOs cited by the Justice Department received the same ratings from a competitor. Moody’s gave Gemstone the same grades, according to data compiled by Bloomberg.

CDOs are pools of assets such as mortgage bonds packaged into new securities in which payments on the underlying bonds or loans are used to pay investors.

Downgrade Warning

S&P rated U.S. Treasuries AAA before dropping them one grade to AA+ on Aug. 5, 2011, citing political and financial uncertainty related to the nation’s deficit and debt. Moody’s has retained its top ranking for the securities, while warning that a downgrade might be warranted in the future.

The September 2008 suit brought by M&T Bank states that the Gemstone deal was “marketed with an overwhelming emphasis on the S&P and Moody’s ratings of the notes and the representations of safety and low risk conveyed by those writings.”

The parties agreed to end the case in January 2012 without saying why, court records show.

The Justice Department case is U.S. v. McGraw-Hill, 13- 00779, U.S. District Court, Central District of California (Los Angeles).

To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net


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