LOS ANGELES – A federal judge yesterday rejected Standard & Poor’s bid to dismiss a Justice Department suit claiming the Wall Street rating agency intentionally ignored its own standards rating risky investments sold to WesCorp FCU and Eastern Financial Florida CU, and others, moving the landmark case closer to trial.

In a 19-page ruling issued by the U.S. District Court for the Southern District of California, Judge David Carter said the Justice Department has sufficiently pleaded an intent to defraud investors who were fooled by their ratings, including WesCorp, the one-time $34 billion corporate, and Eastern Financial, a $2.4 billion Miami credit union, both of which were taken over by NCUA in 2009. “Any dispute over the veracity of these claims, or contested facts, are properly challenged at a later stage of litigation,” wrote Judge Carter.

In its suit filed in January, the Justice Department claimed that S&P knew the alleged scheme to defraud by issuers of the collateralized debt obligations, or CDOs, would result in the rating agency earning lucrative fees from investors who were fooled by their ratings.  S&P, according to the Justice Department, knew, the costs of those fees “were passed through to the investors who purchased CDO tranches.” They allege the motive for doing so was “to maintain and increase its share of the market for credit ratings of RMBS and CDOs and the high fees and profits those ratings generated,”

CDOs are mortgage-backed securities constructed of other mortgage-backed securities.

S&P, in its motion to dismiss the civil fraud charges, called the Justice Department’s allegations  a “stretch” that were based on loosely connected charges with little specificity. “Each of the representations identified by the Government is the type of vague, generalized statement that court after court—in this District, this Circuit and elsewhere across the country—has held to be non-actionable in a federal fraud case such as this,” argued the S&P lawyers, who said S&P ratings are not hard and fast but “predictions about how securities might perform in the future”.

WesCorp lost almost all of its $609 million investment in CDOs, making up the brunt of its $1.2 billion of losses in 2009. Projected losses on the corporate credit union failure are as much as $7 billion.

Eastern Financial was taken over by NCUA after it lost 99%l of its $150 million investments in CDOs, making it the biggest natural person credit union failure ever. Space Coast CU, which acquired the remnants of the failure, is suing several Wall Street banks over the sale of the CDOs. The Space Coast CU suits cite some of the same deals included in the Justice Department suit.

WesCorp and Eastern Financial were the only two credit unions authorized by regulators to purchase CDOs.

The Justice Department alleges that S&P falsely represented that its ratings were objective, independent, and uninfluenced by S&P’s relationships with investment banks when, in actuality, S&P’s desire for increased revenue and market share led it to favor the interests of these banks over investors, thereby giving unwarranted ratings to certain securities.  

Other buyers of the CDOs cited in the Justice Department suit were Citibank, M&T Bank, Bank of America and First Midwest Bank, but the majority of the deals cited in the suit involved either WesCorp or Eastern Financial.

The government sued S&P under the 1989 Financial Institutions Reform, Recovery and Enforcement Act, passed after the savings and loan crisis that lets the government seek penalties for losses affecting federally insured financial institutions.

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