By Aruna Viswanatha and Lauren Tara LaCapra

Feb 5 (Reuters) - The U.S. government is seeking $5 billion in its civil lawsuit accusing Standard & Poor's of a flagrant scheme to defraud investors, in one of the Justice Department's most ambitious cases tied to the financial crisis.

The lawsuit is the first by the U.S. government against a ratings agency, and if successful in its use of a little-used law with a lower burden of proof, the Justice Department could use the strategy in other cases.

The United States said S&P misled investors by stating that its ratings on mortgage products were objective and not influenced by conflicts of interest.

Instead, the DOJ contends, S&P inflated ratings and understated risks as the housing bubble started to burst, driven by a desire to gain more business from the investment banks that issued mortgage securities.

"Put simply, this alleged conduct is egregious - and it goes to the very heart of the recent financial crisis," said Attorney General Eric Holder at a news conference in Washington on Tuesday announcing the charges. Sixteen states and the District of Columbia are also suing S&P.

Shares of S&P parent McGraw-Hill Companies Inc have fallen 23 percent in the last two days, wiping out more than $3.7 billion of market value. The company had said on Monday it was expecting the lawsuit.

A source close to S&P said the firm expects a years-long battle with the government over the lawsuit. Settlement talks recently collapsed, the source said, after the government sought a penalty of over $1 billion and admissions of wrongdoing, which would exposed the firm to outside liability.

A settlement could still happen, however. S&P is likely to file a motion to dismiss the case, and any court rulings on the preliminary legal battles could pave the way for another round of negotiations.

A deal could be in the best interest of both sides. It would allow S&P to avoid a costly, drawn-out courtroom battle.

Also, the government may not want to gamble on a jury trial, even though the case was brought in California, one of the states hardest hit by the housing crisis.

The Justice Department does have some advantages. For one, while the federal case still requires the government to prove intentional fraud, it only needs to prove that based on the preponderance of the evidence, rather than the higher threshold for criminal cases of beyond a reasonable doubt.

The government also steered away from attacking individual ratings, which have largely been shielded under free speech protections, and instead focused on proving false just one statement S&P made - that its ratings were objective.

But legal experts said the Justice Department is using a relatively untested interpretation of FIRREA, a federal civil fraud statute passed after the 1980s savings-and-loan scandals, which makes predicting the success of the suit difficult.

While the law has appeared in only a few dozen cases, its low burden of proof, broad investigative powers and long statute of limitations encouraged the Justice Department to dust it off for potential cases, especially after criminal inquiries failed to yield major prosecutions.

It covers fraud affecting federally insured financial institutions but has generally been used when the government was the target of fraud. The Justice Department contends FIRREA applies because S&P's alleged fraud caused a federally insured California credit union to suffer losses.

"It's rare but not unprecedented for the Justice Department to bring a civil fraud suit where the government itself is not the victim of the fraud," said Andrew Schilling, a partner at the law firm BuckleySandler who led the civil division in the U.S. Attorney's office in Manhattan and help build prior cases under FIRREA.

'CHERRY PICKED'

The 2007-2009 financial crisis was due in large part to massive losses triggered by risky mortgage loans packaged and sold to investors, often with top ratings from credit raters.

No individuals were charged in the DOJ's lawsuit, and it was not immediately clear why the government focused on S&P instead of rivals Moody's Corp or Fimalac SA's Fitch Ratings, which were also major raters of such securities.

Nevertheless, nervous investors sent Moody's shares down 8.8 percent on Tuesday.

Beyond the $5 billion that the Justice Department is pursuing from S&P, California is seeking almost $4 billion in damages based on losses to the state's pension funds, attorney general Kamala Harris said in an interview.

S&P said in its statement on Tuesday that the lawsuit is meritless and said it will vigorously defend itself. It said the government "cherry picked" emails to misconstrue analyst activity. "Claims that we deliberately kept ratings high when we knew they should be lower are simply not true," the company said.

S&P lawyer Floyd Abrams told CNBC on Tuesday said the government will have the challenge of disproving that analysts did not believe in the ratings they issued.

He also said that the DOJ's investigation intensified after S&P downgraded the United States in 2011.

Holder said during the press conference that there was "no connection" between the ratings downgrade and the DOJ's investigation, which started in November 2009.

Senator Carl Levin, who led a year-long inquiry into the causes of the financial crisis and singled out credit raters for blame, said in a statement the public was "eagerly awaiting" legal actions tied to the financial crisis.

"The credit rating agencies have yet to acknowledge any blame or make the changes necessary to prevent conflicts of interest from fueling more inflated ratings in the future," the Democrat from Michigan said.

YEARS-LONG BATTLE

Between September 2004 and October 2007, as stress in the housing market was starting to emerge, S&P delayed updates to its ratings criteria and analytical models, which weakened its criteria beyond what analysts believed was needed to make them more accurate, the Justice Department said.

During that period, according to the complaint, S&P issued credit ratings on $2.8 trillion worth of mortgage securities and some $1.2 trillion in related structured products.

It charged up to $750,000 per deal it rated, which meant that S&P viewed the investment banks that issued the securities as its main customers, according to the complaint.

In August 2004, the head of S&P's commercial mortgage-backed securities sent an email to her colleagues and said they planned to meet to discuss adjusting criteria "because of the ongoing threat of losing deals."

Earlier in May, an analyst wrote, "We just lost a huge Mizuho RMBS deal to Moody's due to a huge difference in the required credit support level ... our support level was at least 10% higher than Moody's," the complaint said.

In 2006, S&P loosened assumptions on its ratings of collateralized debt obligations, which one of the firm's analysts described as creating a loophole big enough to drive a Mack truck through.

Asked who came up with the idea, the analyst referred to a couple of colleagues and said: "I am interested to see if any career consequences occur. Does company care about deal volume or sound credit standards?"

By July 5, 2007, as the credit crisis began taking hold, a new S&P structured finance analyst told an investment banking client: "The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody's."

Six days later, the analyst alluded to a climactic scheme in the movie "Trading Places" by adding: "You should see how it is here right now. It's like a friggin trading floor. 'Downgrade, Mortimer, downgrade!!!'"

The next day, July 12, S&P announced a mass downgrade of 2005 and 2006 subprime residential mortgage debt. 

(Additional reporting by Emily Stephenson, David Ingram and Jonathan Stempel and Luciana Lopez)

Follow us on Twitter @ReutersLegal | Like us on Facebook