Financial Models at the Heart of Lawsuit Against S.&P.

The Justice Department’s civil lawsuit against Standard & Poor’s asserts that the firm issued inflated credit ratings contains victims and perpetrators. But there is also a weapon at the heart of the supposed wrongdoing: the computer models S.&P. deployed to help rate securities.

Models are the complex computer programs created to analyze large amounts of data. They often crop up in financial scandals. Enron, the energy trading firm that collapsed in 2001, used them to value its assets. A faulty model led JPMorgan Chase’s derivatives traders to make ill-advised bets that led to $6 billion in losses for the bank.

And, of course, financial models helped stoke the housing bubble. Wall Street packaged trillions of dollars of loans into bonds, attaching overoptimistic credit ratings to them in the process. Models helped create those ratings.

In building and trusting their models, credit raters appear naïve and intellectually lacking. But the Justice Department’s suit takes things a sep further. It contains details that are intended to show that S.&P. employees deliberately used models to produce the inflated ratings that it says were at the heart of the fraud.

The models had their own names, like LEVELS and CDO Evaluator. Like consumer computer software, they had numerical suffixes that changed as they were updated. A version called LEVELS 6.0 plays a particularly interesting role.

S.&P. says the suit is without factual and legal merit. Catherine Mathis, an S.&P. spokeswoman, says the Justice Department had not “shown actual adjustment to the models - or other changes - that were not analytically justified.”

As with all lawsuits, the Justice Department may have presented evidence without important counterbalancing context. One of the Justice Department’s recurring arguments is that S.&P. staff chose not to update computer programs to make them more accurate. The updates, according to prosecutors, would have resulted in harsher ratings, and a potential los! s of business for S.&P.

As early as 2004, S.&P. considered widening the loan pool used by LEVELS in an upgrade that would take it to LEVELS 6.0, from LEVELS 5.6, according to the complaint. In fact, say prosecutors, LEVELS 6.0 never got released, despite press announcements that it was coming.

The Justice Department says LEVELS 5.6 was “slightly updated” three times, but none of the adjustments significantly increased loss projections. In 2006, LEVELS 5.7 was released, and that was meant to be a more realistic version of the model. But the Justice Department says an executive “caused a change to be made” to prevent outputs that could have led to ratings that were lower than Moody’s Investors Service, a rival ratings agency.

Ms. Mathis, the S.&P. spokeswoman, said that the part of the complaint that described the adjustment to LEVELS 5.7 is not accurate. “We are not aware of any changes made to the 5.7 model that were not analytically justified, nor that any changes were made byan individual as opposed to a committee,” she said. In addition, she said the complaint doesn’t contain one of the important reasons that LEVELS 6.0 was not used: It would have predicted that adjustable-rate mortgages were less risky than fixed-rate loans.

The Justice Department’s case also zeroes in on a model used to help rate collateralized debt obligations, the financial vehicles through which investors could buy exposure to pools of securities or derivatives. C.D.O.’s were utterly dependent on ratings and provided a lot of revenue to S.&P. The rating agency had C.D.O. model called E3, but the Justice Department says that it also had a more forgiving submodel called E3 Low that could be used to give certain C.D.O.’s better ratings.

The complaint says S.&P. gave its analysts the following procedure for so-called synthetic C.D.O.’s:

If the transaction passes E3.0, GREAT!! The deal is modeled, rated
and surveilled with E3.0.

If the transaction fai! ls E3, th! en use E3Low.

The Justice Department also says that S.&P. “exempted” so-called cash C.D.O.’s from using E3, and, as the boom was fading, it fed a few of those through E3 Low.

Ms. Mathis says that none of the specific C.D.O.’s listed in the Justice Department’s complaint used E3 or E3 Low.