DOJ Sues S&P For Allegedly Inflating Mortgage Investment Ratings

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Standard and Poor’s Rating Services has announced that it faces a civil suit from the Department of Justice on accusations of mortgage investment rating inflation. The New York Times reported that the DOJ claims the S&P set the mortgage market up for a crash.

DOJ Sues S&P For Allegedly Inflating Mortgage Investment Ratings

More than 12 state prosecutors could join the federal civil suit, and New York’s attorney general plans to file a separate case. Standard & Poor’s is also being investigated by the Securities and Exchange Commission. The DOJ lawsuit claims that between September 2004 and October 2007, S&P “knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors.” Several pensions funds in numerous states have already filed suits against the S&P.

The stocks of two of the companies involved in the S&P are taking a hit as a result of the lawsuit. Analysts at Piper Jaffray issued a report to investors this morning about shares of Moody’s Corporation (NYSE:MCO) and The McGraw-Hill Companies, Inc. (NYSE:MHP). Both companies took a major double-digit percentage hit on Monday and continued falling on Tuesday. Moody’s Corporation (NYSE:MCO) was down 1 percent on Tuesday, while The McGraw-Hill Companies, Inc. (NYSE:MHP) fell more than 5 percent.

Analysts at Piper Jaffray said they continue to be “long-term bulls” on both of the companies even though the DOJ’s suit “creates new risks” for the two companies. They call the new risks “manageable.”

The analysts point out that the rating agencies have faced many lawsuits since the 2008 financial crisis. Those cases fell into three categories: fraud, underwriter liability and shareholder class action suits. Most of the shareholder and underwriter liability suits and some of the fraud cases were dismissed or withdrawn.

For example The McGraw-Hill Companies, Inc. (NYSE:MHP) has indicated that 30 suits against it have been dismissed and ten of them withdrawn. The company is currently being investigated by the DOJ for its earnings report for the second quarter of 2012. Piper Jaffray analysts don’t believe the case will go to trial for at least a year. The analysts also said they don’t believe that Moody’s Corporation (NYSE:MCO) will be a defendant in the pending suit.

So in light of the DOJ lawsuit, Piper Jaffray analysts said their research indicates a “potential two year upside of $86” or 74 percent for Moody’s and $85 or 69 percent for McGraw-Hill. They said they “like this risk / reward, even acknowledging that the stocks could be ‘dead money’ over the next 3 – 6 months as investors recalibrate their expectations for litigation risk.”

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