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S&P E-Mails on Mortgage Crisis Show Alarm and Gallows Humor

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The executive at Standard & Poor's was clear: "This market is a wildly spinning top which is going to end badly."

That sober assessment of certain mortgage-related investments, delivered to colleagues in a confidential memo in December 2006, is now part of a trove of internal e-mails and documents that have come to light in a federal suit against S&P, the nation's largest credit ratings agency.

The correspondence, made public in court documents late Monday, provide a glimpse at the inner workings of an institution that the Justice Department says fraudulently inflated credit ratings, with dire consequences for the entire economy. In a series of e-mails, tensions appeared to be escalating inside the firm's headquarters in Lower Manhattan as it publicly professed that its ratings were valid, even as the home loans bundled into mortgage-backed securities, or M.B.S., were failing at accelerating rates.

One comes from an S&P analyst in March 2007 borrowing from the Talking Heads song "Burning Down the House," creating new lyrics: "Subprime is boiling over. Bringing down the house." S&P said prosecutors cherry-picked e-mails and that it would vigorously defend itself from "these unwarranted claims."

In another 2007 e-mail, an analyst responds to a question about his new job: "Job's going great. Aside from the fact that the M.B.S. world is crashing, investors and the media hate us and we're all running around to save face … no complaints."

Together, the documents show a portrait of some executives pushing to water down the firm's rating models in the hope of preserving market share and profits, while others expressed deep concerns about the poor performance of the securities and what they saw as a lowering of standards.

The United States attorney general, Eric H. Holder Jr., joined by attorneys general from 16 states, unveiled the case on Tuesday in Washington, accusing S&P and its parent, the McGraw-Hill Companies, of intentionally propping up ratings of shaky mortgage investments and setting them up for a crash when the financial crisis struck.

The government is seeking $5 billion in penalties to cover losses to investors like state pension funds and federally insured banks and credit unions. The amount would be more than five times what S.& P. made in 2011.

"The action we announce today marks an important step forward in the administration's ongoing effort to investigate — and punish — the conduct that is believed to have continued to the worst economic crisis in recent history," Mr. Holder said.

The government, by bringing the civil fraud charges under a 1989 law created after the savings and loan crisis, faces a lower burden of proof when the victims are federally insured banks. But prosecutors could still face a high bar in convincing a jury by a preponderance of evidence that S&P knew that its ratings were faulty and that it intended to deceive investors.

"If the facts prove out, it certainly seems like Standard & Poor's intentionally cooked its models in order to make the ratings higher than they otherwise thought they should be, in violation of the firm's own policies and standards," said Neil Barofsky, a former federal prosecutor who served as the special inspector general for the United States Treasury's Troubled Asset Relief Program from 2008 to 2011.

"What we don't know yet is, what's the other stuff that could be out there?" he added, noting that the vast body of internal documents might also contain exculpatory material for S.& P.

The ratings agency said in a statement: "Claims that we deliberately kept ratings high when we knew they should be lower are simply not true."

The company said that it had always been committed to "providing independent opinions on creditworthiness based on available information," and that its actions reflected its best judgments about the investments at the heart of the suit — about 40 collateralized debt obligations, or C.D.O.'s, an exotic type of security made up of bundles of residential mortgage-backed securities, which in turn were composed of individual home loans. Those securities were packaged by banks, rated by S.& P. and sold to investors in 2007.

"Unfortunately," the company's statement said, "S&P, like everyone else, did not predict the speed and severity of the coming crisis and how credit quality would ultimately be affected."

Remarks that S&P employees made in internal memos and electronic communications show that as early as spring 2004, certain executives wanted to change the firm's rating methodology, but only after polling "an appropriate number of issuers and investment bankers" as to the "rating implications."

The idea of asking bankers what they thought about a change in the firm's methods shocked some S&P analysts and executives, including one who fired back, "What does 'rating implication' have to do with the search for truth? Are you implying that we might actually reject or stifle 'superior analytics' for market considerations?"

In May 2004, an analyst warned that S&P had just lost to its competitor Moody's Investors Service the chance to rate a very large deal by being too hard-nosed about the amount of collateral that would be required to get a good rating. More collateral would mean less profit for Mizuho, the bank putting that deal together.

"We must address this now," she said — otherwise the firm would lose more deals.

The complaint describes a debate in 2004 and 2005 about whether S&P should change its model for rating C.D.O.'s and what effect the proposed changes might have on its business. The change was scheduled for July 2005, but before it could happen, an analyst sent an e-mail saying that according to the investment bank Bear Stearns, the older model "had been the 'best' " at rating weaker pools of mortgages, compared with Moody's and Fitch.

As the housing market deteriorated in early 2007, the gallows humor in the e-mails intensified. Banks that had created mortgage-backed securities were unloading them quickly, to avoid being stuck with any duds.

"That means the market will crash," one analyst told another in an instant message. "Deals will rush in before they take further loss."

"Yes," said the analyst's colleague. "We should not push criteria," continued the first, "but we give in anyway. Ahahhahaha."

About a month later, another S.& P. employee wrote in another instant message, reproduced in the complaint: "We rate every deal. It could be structured by cows and we would rate it."

In its statement Tuesday, S.& P. said that the cow e-mail "had nothing to do with R.M.B.S. or C.D.O. ratings or any S.& P. model, and the analyst had her concerns addressed with the issuer before S.& P. issued any rating."

S.& P. said that there was a robust internal debate about how a rapidly deteriorating housing market might affect the C.D.O.'s, "and we applied the collective judgment of our committee-based system in good faith," adding, "The e-mail excerpts cherry-picked by D.O.J. have been taken out of context, are contradicted by other evidence, and do not reflect our culture, integrity or how we do business."

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It was unclear whether the Justice Department was looking at the other two major ratings agencies, Moody's and Fitch. Tony West, the acting associate attorney general, said he would not discuss actions against other ratings agencies.

Settlement talks between S.& P. and the Justice Department broke down in the last two weeks after prosecutors sought a penalty in excess of $1 billion and insisted that the company admit wrongdoing, several people with knowledge of the talks said. S.& P. had proposed a settlement of about $100 million, while the government pressed for an admission of guilt to at least one count of fraud, said the people.

McGraw-Hill shares fell nearly 11 percent on Tuesday. Moody's shares fell about 9 percent, to $45.09.

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