[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]




 
                   THE ROLE OF CREDIT RATING AGENCIES
                    IN THE STRUCTURED FINANCE MARKET

=======================================================================

                                HEARING

                               BEFORE THE

                    SUBCOMMITTEE ON CAPITAL MARKETS,

                       INSURANCE, AND GOVERNMENT

                         SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

                               __________

                           SEPTEMBER 27, 2007

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 110-62


                                     
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                 BARNEY FRANK, Massachusetts, Chairman

PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
MAXINE WATERS, California            RICHARD H. BAKER, Louisiana
CAROLYN B. MALONEY, New York         DEBORAH PRYCE, Ohio
LUIS V. GUTIERREZ, Illinois          MICHAEL N. CASTLE, Delaware
NYDIA M. VELAZQUEZ, New York         PETER T. KING, New York
MELVIN L. WATT, North Carolina       EDWARD R. ROYCE, California
GARY L. ACKERMAN, New York           FRANK D. LUCAS, Oklahoma
JULIA CARSON, Indiana                RON PAUL, Texas
BRAD SHERMAN, California             PAUL E. GILLMOR, Ohio
GREGORY W. MEEKS, New York           STEVEN C. LaTOURETTE, Ohio
DENNIS MOORE, Kansas                 DONALD A. MANZULLO, Illinois
MICHAEL E. CAPUANO, Massachusetts    WALTER B. JONES, Jr., North 
RUBEN HINOJOSA, Texas                    Carolina
WM. LACY CLAY, Missouri              JUDY BIGGERT, Illinois
CAROLYN McCARTHY, New York           CHRISTOPHER SHAYS, Connecticut
JOE BACA, California                 GARY G. MILLER, California
STEPHEN F. LYNCH, Massachusetts      SHELLEY MOORE CAPITO, West 
BRAD MILLER, North Carolina              Virginia
DAVID SCOTT, Georgia                 TOM FEENEY, Florida
AL GREEN, Texas                      JEB HENSARLING, Texas
EMANUEL CLEAVER, Missouri            SCOTT GARRETT, New Jersey
MELISSA L. BEAN, Illinois            GINNY BROWN-WAITE, Florida
GWEN MOORE, Wisconsin,               J. GRESHAM BARRETT, South Carolina
LINCOLN DAVIS, Tennessee             JIM GERLACH, Pennsylvania
ALBIO SIRES, New Jersey              STEVAN PEARCE, New Mexico
PAUL W. HODES, New Hampshire         RANDY NEUGEBAUER, Texas
KEITH ELLISON, Minnesota             TOM PRICE, Georgia
RON KLEIN, Florida                   GEOFF DAVIS, Kentucky
TIM MAHONEY, Florida                 PATRICK T. McHENRY, North Carolina
CHARLES A. WILSON, Ohio              JOHN CAMPBELL, California
ED PERLMUTTER, Colorado              ADAM PUTNAM, Florida
CHRISTOPHER S. MURPHY, Connecticut   MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana                PETER J. ROSKAM, Illinois
ROBERT WEXLER, Florida               KENNY MARCHANT, Texas
JIM MARSHALL, Georgia                THADDEUS G. McCOTTER, Michigan
DAN BOREN, Oklahoma

        Jeanne M. Roslanowick, Staff Director and Chief Counsel
 Subcommittee on Capital Markets, Insurance, and Government Sponsored 
                              Enterprises

               PAUL E. KANJORSKI, Pennsylvania, Chairman

GARY L. ACKERMAN, New York           DEBORAH PRYCE, Ohio
BRAD SHERMAN, California             RICK RENZI, Arizona
GREGORY W. MEEKS, New York           RICHARD H. BAKER, Louisiana
DENNIS MOORE, Kansas                 CHRISTOPHER SHAYS, Connecticut
MICHAEL E. CAPUANO, Massachusetts    PAUL E. GILLMOR, Ohio
RUBEN HINOJOSA, Texas                MICHAEL N. CASTLE, Delaware
CAROLYN McCARTHY, New York           PETER T. KING, New York
JOE BACA, California                 FRANK D. LUCAS, Oklahoma
STEPHEN F. LYNCH, Massachusetts      DONALD A. MANZULLO, Illinois
BRAD MILLER, North Carolina          EDWARD R. ROYCE, California
DAVID SCOTT, Georgia                 SHELLEY MOORE CAPITO, West 
NYDIA M. VELAZQUEZ, New York             Virginia
MELISSA L. BEAN, Illinois            ADAM PUTNAM, Florida
GWEN MOORE, Wisconsin,               J. GRESHAM BARRETT, South Carolina
LINCOLN DAVIS, Tennessee             BLACKBURN, MARSHA, Tennessee
ALBIO SIRES, New Jersey              GINNY BROWN-WAITE, Florida
PAUL W. HODES, New Hampshire         TOM FEENEY, Florida
RON KLEIN, Florida                   SCOTT GARRETT, New Jersey
TIM MAHONEY, Florida                 JIM GERLACH, Pennsylvania
ED PERLMUTTER, Colorado              JEB HENSARLING, Texas
CHRISTOPHER S. MURPHY, Connecticut   GEOFF DAVIS, Kentucky
JOE DONNELLY, Indiana                JOHN CAMPBELL, California
ROBERT WEXLER, Florida               MICHELE BACHMANN, Minnesota
JIM MARSHALL, Georgia                PETER J. ROSKAM, Illinois
DAN BOREN, Oklahoma                  KENNY MARCHANT, Texas
                                     THADDEUS G. McCOTTER, Michigan


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    September 27, 2007...........................................     1
Appendix:
    September 27, 2007...........................................    53

                               WITNESSES
                      Thursday, September 27, 2007

Adelson, Mark H., Adelson & Jacob Consulting, LLC................    12
Bass, J. Kyle, Managing Partner, Hayman Capital Partners, L.P....    11
Kanef, Michael B., Group Managing Director, Asset Finance Group, 
  Moody's Investors Service......................................    14
Mason, Dr. Joseph R., LeBow College of Business, Drexel 
  University.....................................................    17
Mathis, H. Sean, Miller Mathis & Co., LLC........................     7
Tillman, Vickie A., Executive Vice President, Standard & Poor's..    15

                                APPENDIX

Prepared statements:
    Kanjorski, Hon. Paul E.......................................    54
    Adelson, Mark H..............................................    56
    Bass, J. Kyle................................................    69
    Kanef, Michael B.............................................    78
    Mason, Dr. Joseph R..........................................   112
    Mathis, H. Sean..............................................   132
    Tillman, Vickie A............................................   147


                   THE ROLE OF CREDIT RATING AGENCIES
                    IN THE STRUCTURED FINANCE MARKET

                              ----------                              


                      Thursday, September 27, 2007

             U.S. House of Representatives,
                   Subcommittee on Capital Markets,
                          Insurance, and Government
                             Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 2:07 p.m., in 
room 2128, Rayburn House Office Building, Hon. Paul E. 
Kanjorski [chairman of the subcommittee] presiding.
    Present: Representatives Kanjorski, Ackerman, Sherman, 
Baca, Lynch, Marshall; Pryce, Castle, and Manzullo.
    Chairman Kanjorski. The subcommittee will come to order. 
This hearing of the Subcommittee on Capital Markets, Insurance, 
and Government Sponsored Enterprises will take up the question 
of oversight of the mortgage credit market by the reporting 
agencies. First, I will give my opening statement, and then we 
will go down the line to all Members who wish to make an 
opening statement.
    We meet this afternoon to examine a complex but familiar 
issue--the performance and oversight of credit rating agencies. 
Today's hearing also furthers our investigations into the 
recent credit crunch that occurred in our capital markets and 
focuses on the role of credit rating agencies in engineering 
and grading structured finance products.
    A strong, robust, free market for trading debt securities 
relies on the independent assessments of financial strength 
provided by credit raters, entities like Moody's, Fitch, and 
Standard & Poor's. When a company or a debt instrument blows up 
in our capital market, critics will often raise concerns about 
the failures of rating agencies to warn investors, as was the 
case after WorldCom's bankruptcy, Enron's insolvency, New York 
City's debt crisis, Washington Public Power Supply System's 
default, and Orange County's collapse. In recent weeks, many 
marketplace observers have again criticized the accuracy of 
credit rating agencies in anticipating problems with debt 
instruments like mortgage-backed securities and collateralized 
debt obligations, or CDOs.
    As part of the Sarbanes-Oxley Act, Congress required the 
Securities and Exchange Commission to study the performance of 
rating agencies. Congress then used this report to inform its 
debates about how best to register and oversee the work of 
nationally recognized statistical rating organizations. 
Ultimately we approved the final version of the Credit Rating 
Agency Reform Act on the House Floor exactly 1 year ago today, 
and it became law a short while later.
    Throughout these debates, my fellow House Democrats and I 
insisted that the new legislation contain quality controls, 
which the final version did. The new law, therefore, permits 
the Commission to hold the rating agencies accountable for 
producing credible and reliable ratings and following their 
internal policies. It also allows the Commission to prohibit or 
mitigate conflicts of interest. It further provides the 
Commission with the power to examine the financial wherewithal 
and management structures of approved credit raters.
    Additionally, we have seen tremendous growth in our 
structured finance markets in recent years. For example, the 
global sale of CDOs tripled between 2004 and 2006 to stand at 
$503 billion. These CDOs, a financial instrument first 
engineered by Drexel Burnham Lambert, have also grown 
increasingly complex. Because history has a way of repeating 
itself, I am not surprised that the ghosts created by Drexel 
are with us today.
    To help investors cut through the complexity of CDOs, the 
major rating agencies have expanded their services to evaluate 
these products in terms of their likelihood for defaults. Their 
investment-grade stamp of approval helped to provide 
credibility for the CDOs that had the toxic waste of liars' 
loans and problematic subprime products buried deep within the 
deal. In return, the rating agencies also made great sums of 
money from issuers.
    To me, it appears that none of the parties that put 
together or purchased these faulty home loans, packaged them 
into mortgage-backed securities, and then divided these 
securities into tranches and repackaged them into CDOs, CDOs 
squared, and CDOs cubed, had any skin in the game. In the end 
it was a final investor left with this hot potato of prime debt 
and significant losses. In my view the rating agencies helped 
to create this Lake Woebegone-like environment in which all of 
the ratings were strong, the junk bonds good-looking, and the 
subprime mortgages above average. In reality, however, we now 
know that they were not.
    That said, the conundrum facing the rating agencies is much 
like the conundrum facing Fannie Mae and Freddie 
Mac. Even though the securities issued by the two government-
sponsored enterprises explicitly indicate that they are not 
backed by the full faith and credit of the United States, many 
investors believe otherwise. Similarly, even though rating 
agencies only calculate the likelihood of default, many 
investors believe that these grades measure the financial 
strength of the underlying instrument.
    Past cases of criticism about the failure of the rating 
agencies to detect faults generally focused on a single 
issuance or issuer. In this most recent case, however, these 
financial failures seem to have been much more pervasive; they 
occurred across a class of financial product. As a result, I am 
very concerned about systemic failures within the rating 
agencies themselves and the potential for a systemic failure 
within our global capital markets. I hope to explore these 
issues today.
    As we proceed on these matters, I also want to assure 
everyone that I have not yet reached any conclusions. That 
said, we may ultimately decide that we need to revisit last 
year's law and improve upon the quality controls adopted within 
it. Some of the policy options that we could consider include 
requiring more disclosure for rating agencies like those 
required of auditors, instituting rotations in raters like 
auditors, altering the methods by which raters receive 
compensation, mandating simultaneous disclosure of nonpublic 
information to all Commission-registered raters, improving the 
transparency of underlying debt products, and forcing a delay 
in allowing complex products like CDOs to come to market so as 
to allow a deal to season in its performance.
    In closing, I look forward to a lively debate today. We 
have an excellent panel of witnesses with experience in credit 
ratings, valuation, hedge funds and the securitization process. 
They also have a variety of views, and we will likely learn 
much from them.
    Ms. Pryce.
    Ms. Pryce. Thank you, Mr. Chairman. Thank you for holding 
this hearing today. This is another important piece in a series 
of hearings to help us better understand the mortgage crisis 
our country is facing.
    The shockwaves have been felt everywhere across the country 
and throughout the world, but no State has been as impacted as 
my own home State of Ohio. Ohio's foreclosure rates have 
increased 138 percent since August of 2006, and the number of 
foreclosure filings has nearly quadrupled since 1995. There 
seems to be no end to this crisis. An estimated $14 billion in 
adjustable-rate mortgages are expected to reset in Ohio over 
the next 5 years, putting more homeowners at risk of 
foreclosure.
    Last week we looked at ways to help homeowners facing the 
prospect of foreclosures. Today we are here looking at one of 
the primary actors within the structured finance market. Rating 
agencies and their credit risk assessments have become a 
cornerstone of our housing market, in particular as the amount 
of subprime mortgages in the market shot up from $35 billion in 
1994 to $625 billion in 2005. Mortgages sold into the secondary 
market are combined, carved up, evaluated by the rating firms, 
and resold to Wall Street as asset-backed securities. This 
process has provided much liquidity into the housing market and 
helped drive the housing boom and the growth of the subprime 
market.
    As we look at all aspects of this crisis, we should be 
asking tough questions about the rating agencies' role. They 
are uniquely positioned as monitors of the risk associated with 
different mortgage products. Their insight into how these risks 
have changed and how methodologies and ratings have changed to 
meet them will be invaluable to us; their open questions about 
the timing of lowering rating scores, whether original ratings 
appropriately reflected the credit risks presented by 
residential mortgage-backed securities, and whether the rating 
agencies adequately monitor previously issued ratings for 
structured finance products.
    Since June, 2,400 tranches of RMBS have been downgraded. 
This does not fit the model of recent history. Until 2006, 
upgrades outnumbered downgrades, but we have seen a quick 
turnaround of this pattern. There is no doubt that the subprime 
mortgage boom of 2004, 2005, and even early 2006 was unlike 
anything we have ever seen before. We can learn much from 
rating agencies' successes and failures engaging that risk.
    I want to thank our witnesses for testifying today and I 
look forward to your testimony. Thank you.
    Chairman Kanjorski. Mr. Ackerman.
    Mr. Ackerman. Thank you, Mr. Chairman.
    Much of the blame for the current economic mess can sure be 
placed on the shoulders of the subprime mortgage business. Too 
many brokers sold these complex and inherently risky financial 
products to people who had no business being approved for a 
black-and-white TV loan, let alone a six-figure mortgage. A 
handful of these institutions even went so far as to offer 
mortgages with promises of, ``no background checks,'' and ``no 
income verification,'' and advertised in low-income areas 
saying that no one could be turned down for a loan.
    In my view, such business practices, very clearly designed 
to bait the hook with the American dream to entrap economically 
strapped and often less financially savvy customers into 
mortgages that they could not afford were not just 
irresponsible, but they were reprehensible, if not criminal.
    But there is more blame to be apportioned. Loan originators 
took these junk mortgages, packaged them into securitizations, 
and then marketed the collateralized debt obligations, or CDOs, 
on the secondary mortgage market after absent transparency. We 
now know that credit rating agencies by their own admission 
assigned overly favorable ratings to many of these products. 
The why of it is very simple. Some of these firms were double-
dipping. First they profited by helping the originators put 
these shady securities together, and then they collected fees 
for deliberately misrating these risky products at a higher 
value than they were worth. This is what the Arthur Andersens 
of the world did for the Enrons and the WorldComs. The credit 
raters helped put the Spam in the can, made it sizzle, and then 
they sold it as steak. As I noted at a hearing earlier this 
month, that is not the free market at work; that is fraud. And 
fraud is a crime, not a correction.
    Now, nobody here today will argue that the ratings assigned 
by Moody's or S&P's are the sole factors that investors used 
when deciding whether or not to purchase a securitization. In 
fact, many sophisticated investors voiced their concerns about 
CDOs products when the subprime lending spree hit its peak 
about 2 years ago. But nobody can deny that credit ratings 
played a major role in many investors' decisions, and my 
concern here is not that Wall Street players lost money because 
good-faith credit ratings turned out to be bad estimates of 
risk; the outrage here is that the credit rating agencies 
colluded with loan originators and then consciously assigned 
overly favorable ratings and deliberately manipulated the 
market for their own greedy profit.
    Collusion and misrepresentation are not elements of a 
genuinely free market. It is the job of the Federal Government 
to protect the integrity of our markets. And as I said earlier 
this month, the committee, this committee, and this Congress, 
will not be passive speculators as banks, nonbank banks, and 
credit rating agencies use their control of information to fool 
investors into believing that a pig is a cow and a rotten egg 
is a roasted chicken.
    I am pleased that we have some witnesses from the credit 
rating agencies with us this afternoon, and I am hoping that 
their testimony will merit a Triple A rating. In light of the 
industry's recent performance, something closer to a C, might 
be more likely expected. I would caution them that their 
forthrightness today about where their industry went wrong and 
what steps they are taking to ensure that unduly favorable 
ratings are not given to shaky financial products in the future 
may determine their future earnings or losses.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Thank you, Mr. Ackerman.
    The gentleman from Delaware, Mr. Castle.
    Mr. Castle. Mr. Chairman, I have no opening statement, but 
I congratulate you and the committee on a good list of 
witnesses and I look forward to the testimony.
    I yield back.
    Chairman Kanjorski. Thank you, Mr. Castle.
    Mr. Sherman.
    Mr. Sherman. Thank you, Mr. Chairman. You are to be 
commended for your Lake Woebegone reference, a reference to an 
idyllic Minnesota town where the women are strong, the men are 
good-looking, all the children are above average, and all the 
mortgage pools are investment grade.
    When we look at this crisis, we should expect borrowers to 
borrow. Many are optimistic about what will happen to real 
estate prices in their area, and they are optimistic as 
Americans are and should be about their own job prospects. Some 
were sold bad products or misled. But even with perfect 
information, borrowers are going to buy homes that they only 
have an 80 percent chance of really being able to afford. And, 
in fact, when we look at today's subprime loans, even under bad 
conditions roughly 85 percent of the homebuyers are going to be 
able to keep their homes, and most of them couldn't have bought 
those homes without some sort of a subprime loan. So we can't 
blame borrowers for wanting an extra bedroom or wanting to be 
homeowners instead of renters, especially at a time when they 
saw all of these real estate values going up and all their 
friends becoming considerably more wealthy as a result of real 
estate value increases.
    We shouldn't be surprised that intermediaries want to 
intermediate. After all, they package the loans and sell them 
without recourse. And as long as they don't get stuck with 
inventory on the shelf, they do quite well under any market 
circumstances. So we shouldn't be surprised that investors will 
invest. After all, they are buying in a debt, basically a debt 
instrument. They are getting 100, 150 basis points above the 
same rate that is available for equivalent terms of government 
paper, and the rating agencies are saying, ``Hey, it is an A 
instrument.''
    So we have to look at the rating agencies and see why they 
missed. Borrowers were going to borrow, investors were going to 
invest, but the rating agencies don't have to give a high rate 
to every pool of mortgage debt. And I am told that rating 
agencies tended to look at the performance of prior pools. 
Well, a rising tide lifts all boats, so all boats must be 
aircraft or at least levitating hovercraft if the tide is 
rising.
    It is pretty difficult, or often you don't default on a 
loan in a rising real estate market even if you lose your job, 
because all of a sudden, if you have lived there for a few 
years, you have a lot of equity, and somebody will buy the 
house from you before you lose it in foreclosure. Heck, there 
are 17 mortgage brokers ready to loan you more because you have 
so much equity in spite of the fact that you lost your home.
    So you have to look not at--I mean, the first question is 
why so much rating was done looking at the past, looking at 
prior performance; and then, in particular, why you folks 
allowed and gave high grades to such low underwriting 
standards. Because it is only the underwriting standards that 
can protect investors if there is a decline in nationwide 
employment, which, thank God, there really hasn't been to a 
large degree, or a decline in real estate values.
    We don't need rating agencies to tell us what to do in 
great times. We need rating agencies to tell us what 
instruments are investment grade if real estate values level 
off or even decline. What we have seen is you have given, or 
some of you have given, high ratings to stated income loans 
even when your own people called them ``liars' loans.'' And you 
have given high ratings to pools that include what I call--I 
don't know if a term has emerged in this area--teaser rate 
qualification. You go to the borrower and you say, hey, your 
interest rate is only 4 percent for the first 3 years, and then 
you go to the investors and say, that is a qualified borrower 
because for the first 3 years, they can afford to make the 
payments.
    We need better--whether that requires a restructuring of 
the industry, or whether that just requires a change in your 
behavior, I don't know, but I hate to think that teaser rate 
qualification and liars' loans are going to find their way into 
pools that you folks give investment-grade ratings to, and I 
look forward to hearing--I am going to have to leave for part 
of this testimony, but I look forward to hearing much of what 
you have to say.
    Chairman Kanjorski. The gentleman from Illinois, Mr. 
Manzullo.
    Mr. Manzullo. I am looking forward to the testimony.
    Chairman Kanjorski. Okay. The gentleman from Georgia, Mr. 
Marshall.
    Mr. Marshall. Thank you, Mr. Chairman. I would like to 
associate myself with your opening statement; I found myself in 
complete agreement.
    I am open-minded on this subject, though quite concerned. 
It is pretty obvious if you look at the system, the only two 
real weak points are the initial transaction that created the 
debt--and we may need a much more robust Truth in Lending Act 
if nothing else--and then the rating agencies. Those are the 
two really weak points.
    The rating agencies have failed us many times in the past. 
It seems to me that this committee must have looked at this 
problem before today many times. And you mention that 
legislation was passed last year designed to deal with it.
    I hope I don't have to feel like I should have associated 
myself with Mr. Ackerman's very entertaining opening statement, 
because where the substance is concerned, it is pretty damning. 
And if he is correct, some people need to go to jail.
    Chairman Kanjorski. Without objection, all Members' opening 
statements will be made a part of the record.
    And without objection, the statements of the witnesses will 
be made part of the record, and will be recognized, after I 
introduce them, for 5-minute summaries of their testimony.
    The panel will consist of: Mr. H. Sean Mathis, Miller 
Mathis & Co., LLC; Mr. J. Kyle Bass, managing partner, Hayman 
Capital Partners, L.P.; Mr. Mark H. Adelson, Adelson & Jacob 
Consulting, LLC; Mr. Michael B. Kanef, group managing director, 
Asset Finance Group, Moody's Investors Service; Ms. Vickie A. 
Tillman, executive vice president, Standard & Poor's; and Dr. 
Joseph R. Mason, LeBow College of Business, Drexel University.
    First, we will hear from Mr. Mathis.
    Mr. Ackerman. Mr. Chairman, I would just like to exert the 
prerogative of a homeboy here. We are fortunate to have among 
our expert witnesses today a gentleman with over 25 years of 
advisory and principal-side investing experience. Sean Mathis 
is the senior managing partner at Miller Mathis, an independent 
investment bank headquartered in my City of New York. He holds 
an MBA from the Wharton Graduate School of Business, has 
previously served as the president or chairman of any number of 
companies within the financial services industry, and has a 
proven track record of success within the financial markets.
    I had the opportunity to meet with Mr. Mathis a month or so 
ago regarding the role of credit rating agencies in the 
subprime crisis, and I was very impressed with his insight. I 
am sure that the members of our subcommittee will be equally 
impressed listening to his testimony along with the others.
    Thank you, Mr. Chairman.

     STATEMENT OF H. SEAN MATHIS, MILLER MATHIS & CO., LLC

    Mr. Mathis. Mr. Chairman and members of the subcommittee, 
good afternoon. I would like to thank you for inviting me to 
testify here today in the matter of the role of credit rating 
industries in the structured finance market. I do so with 
regard to my experience and that of my colleague Julia 
Whitehead in connection with many companies and public entities 
we have worked with over the years whose pension arms have an 
intense interest in the topic before the subcommittee.
    In the wake of the subprime meltdown, we are facing perhaps 
the most serious crisis of confidence in our domestic and 
international financial market since the Great Depression. I 
submit, however, that the fallout would have never assumed 
these proportions if it were not for the extension of ratings 
issued by our nationally recognized statistical rating 
organizations to structured finance securities.
    In some ways it is easy to blame the rating agencies whose 
willingness to attach investment-grade labels to untested, 
unproven, and, in many cases, deeply flawed structures allowed 
the incidence of these instruments to grow to enormous 
proportions, infiltrating the portfolios of even the most risk-
averse investors. I believe, however, that the true culprit of 
the system that allowed NRSRO ratings to become critical and an 
embedded part of the protections built into our capital 
markets, financial institutions, and pension funds without 
sufficient or appropriate thought given to accompanying 
supervision or accountability. In an age of financial 
engineering where complex, opaque, and off-exchange products 
have outpaced the ability of regulators to understand or 
control them, it is the failure to properly supervise the 
rating agencies that has brought the financial markets to their 
knees.
    For Congress, to focus on finding a villain is only part of 
the effort. If there is a legal or inappropriate behavior, 
these people can be dealt with in the legal process. In part, I 
really believe Congress' focus should be on fixing the 
regulatory structure whose malfunction impeded the ability of 
our markets to function.
    In that vein I draw your attention to the following four 
points. First of all, there is nothing small or self-limiting 
about the current situation. Subprime is not the source of all 
evil, it is merely the first eruption of a disease which has 
been growing in structured finance for some time. Make no 
mistake, the pain that will be suffered from collapses across 
the financial structured finance landscape will not merely be 
borne by well-heeled hedge fund managers or greedy, intemperate 
citizens looking to make a fast trade in a frothy housing 
market. The pain will be felt by regular people whose pension 
funds have been impaired by investments in gold-plated, highly 
rated securities whose performance will turn out to be far 
worse than the promise implied by these ratings.
    Second, the significant flaws in the NRSRO rating system 
which precipitated this crisis are less ones of conception than 
they are of execution. In fact, the motive for the creation of 
NRSROs to give regulators charged with ensuring the capital 
adequacy of financial institutions a way to piggyback on the 
rating agency's designation of highly liquid and stable 
securities was never made explicit in the rating agency 
regulatory construct. As a consequence, moves by rating 
agencies to extend investment-grade ratings to securities that 
are liquid and unpredictable is significantly at odds with the 
original intent, and it was only a question of when, not if, 
they would migrate to these securities. Moreover, the lack of 
accountability placed on rating agencies freed them from the 
normal checks on behavior and judgment that such accountability 
tends to confer.
    Third, as a result of the damage done via the rating 
system, it is critical that Congress view the reestablishment 
of the NRSRO system as its most important objective. As the 
legislative arm of our government, Congress must use its power 
to repair the body of law that has brought us to this point.
    Fourth, to fix the inadequacies of the current NRSRO 
system, Congress must address its two most fundamental 
problems. First, it must seek to draw a line between securities 
eligible for NRSRO investment-grade designation and those that 
are still too new and complex to be modeled appropriately. The 
line will not be a perfect one, but it must be drawn in a way 
not to hamper innovation, while preventing the application of 
investment-grade labels on securities whose structures and 
assets are too unseasoned or volatile to be reasonably 
evaluated.
    Second, it must imbue the system with accountability. The 
functioning of a free market relies on individuals and 
corporate entities being responsible for what they do. Congress 
must see to it that this principle is built into the rating 
system.
    Let me expand. Imprudently granted ratings have been a key 
contributor to the excesses in the extension of credit not just 
in housing, but also, as we are finding, in commercial real 
estate; corporate loans; and complicated, sometime near 
fantastical synthetic bets on credit. The unwinding of all 
these will cause significant trauma in many sectors.
    Additionally, since our system of ensuring the capital 
adequacy of our financial institutions is heavily ratings-
driven, flaws in the award of ratings impact the very bedrock 
of our financial markets. Those flaws, however, do not 
invalidate the purpose for which the rating system was 
initially intended to serve.
    When the SEC created the rating agency regime in 1975, it 
sought to use the rating agency metrics to categorize the 
relative risk of broker-dealer securities for the purpose of 
ensuring capital adequacy. The NRSRO designation was certainly 
not intended to convey any power to the agencies. It was merely 
the result of the SEC's recognition ``that securities that were 
rated investment-grade by credit rating agencies of national 
repute typically were more liquid and less volatile in price 
than securities that were not so highly rated.'' While the SEC 
clearly equated the term ``investment-grade'' with liquidity, 
that fact was never memorialized in legislation, process, or 
definition.
    Notwithstanding that lack of provision, regulators all over 
the world jumped on the SEC bandwagon by referencing NRSRO 
ratings in a multitude of capital requirements and investment 
mandates at every level of the domestic and international 
economy.
    Regardless of the SEC intent or lack thereof, the NRSRO 
designation gave a few fortunate rating agencies enormous 
authority, establishing them as the de facto gatekeepers of the 
investment-grade universe. Moreover, without any sort of 
regulatory or legal definition of investment-grade, the rating 
agencies were free to apply that grade at will. Since, for 
reasons that may have seemed important at the time, the SEC 
enacted various provisions which protected the rating agencies 
from securities liability, and since the rating agencies 
themselves successfully appropriated the freedom of speech 
shield for their ratings, they confidently extended their 
ratings umbrella in a remarkably unfettered fashion. And with 
enormous compensation they received from issuers, the rating 
agencies were handsomely rewarded for these ratings.
    The ultimate result is what we see today, that the 
investment-grade ratings framework has been stretched beyond 
its initial conception to cover uses in instruments which were 
exactly the opposite of what was intended, causing it to 
backfire on the capital structures and investors it was 
designed to protect. There have been warnings before this, 
previous blowups, most notably Enron and WorldCom.
    These fixes, however, remained elusive. The generously 
named Credit Rating Agency Reform Act of 2006, if anything, 
institutionalizes much of the current rating agency activity, 
leaving those firms generally free to do what they are paid to 
do, issue ratings.
    This time the blow-up is not confined to one company or 
security, but an entire asset class of structured finance. What 
we first saw in subprime issuances, dubious assets, faulty 
structures are now appearing in other vehicles whose rapid-fire 
issuance depended on a successful Triple A rating of a large 
part of their capital structure including SIBs and other asset-
backed commercial paper vehicles, CDOs, CLOs, and many 
structures which are not based on money assets, but are based 
mainly on synthetic bets.
    The damage from the collapse of these hastily conceived 
instruments will take years to play out. In recognition of the 
wreckage wrought by not acting sooner, Congress must act to 
repair this framework. There is no question that modifications 
of the current rating structure must be thoroughly and 
carefully evaluated with appropriate input from vested and 
unvested interests to avoid unintended consequences. But if the 
desire is to restore functions to our markets and credibilities 
to our institutions, Congress must address the following:
    Regulatory oversight and supervision of the rating agencies 
must be had. Despite the fact that rating agencies are broadly 
and deeply felt throughout our economy, supervisory authority, 
which is largely vested in the SEC, remains de minimis.
    Applicability of NRSRO ratings. The accelerant fuel fueling 
the growth of this generation of subprime and subprime-linked 
securities was the willingness of the rating agencies to stamp 
them investment-grade so they could be injected into the 
portfolio of yield star fiduciaries. Congress should review the 
use of NRSRO ratings for securities or structures which lack 
liquidity, transparency, and seasoning, as well as the process 
and authority under which new asset classes are brought into 
the investment-grade world.
    Compensation-driven conflicts of interest. The rating 
agencies have been paid enormous sums of money by their 
structured finance clients, which has caused outsiders to 
question the impartiality and objectivity of the ratings.
    Accountability. Unlike other professionals--accountants, 
lawyers and the like--rating agencies have heretofore escaped 
any liability when their ratings opinions proved wrong. 
Requiring the rating agencies to bear responsibility for their 
ratings and performance, perhaps in the manner of other 
professionals who function as experts, must be examined.
    Finally, if Congress wishes to remedy these defects that 
contributed to the near meltdown of our financial markets, it 
must comprehend just how deeply NRSRO influence is entrenched 
in measures intended to protect capital and financial 
institutions and fiduciaries, both domestic and 
internationally, including Basel II, whose provisions to 
regulate international bank capital adequacy are being 
implemented as we speak. We believe past failures to recognize 
the pervasiveness of NRSRO activity contributed to a reduced 
search sense of urgency on Congress' part. Now is the time for 
Congress to take a more deliberate stand. We urge Congress to 
act.
    [The prepared statement of Mr. Mathis can be found on page 
132 of the appendix.]
    Chairman Kanjorski. Mr. Bass.

  STATEMENT OF J. KYLE BASS, MANAGING PARTNER, HAYMAN CAPITAL 
                         PARTNERS, L.P.

    Mr. Bass. Thank you. Chairman Kanjorski and Ranking Member 
Pryce, this is an incredibly complex issue that is very 
difficult to distill into a 5-minute remark, so I will refer 
you to my written testimony for a more detailed explanation of 
my position.
    I am here today as an investor and participant in the 
residential mortgage-backed securities market, the RMBS market. 
In total I manage or advise over $4 billion of investments in 
the RMBS marketplace. I am here today because I am worried 
about the recent behavior of the ratings agencies and their 
work that has been irresponsible and flawed.
    The two things I would like to talk about are: one, the 
instrument that should never have been invented, the Mezzanine 
CDO; and two, the operating duplicity of the ratings agencies.
    Mezzanine CDOs are arcane structured finance products that 
were designed specifically to make dangerous, lowly rated 
tranches of subprime debt deceptively attractive to investors. 
This was achieved through some alchemy and some negligence in 
adapting unrealistic correlation assumptions on behalf of the 
ratings agencies. They convinced investors that 80 percent of a 
collection of toxic subprime tranches were the ratings 
equivalent of U.S. Government bonds. This entire process 
completely ignored the fact that these assets had a near 
perfect correlation of homogenous collateral as home prices 
declined nationwide.
    Within this new vehicle the tranches were rebundled, marked 
up, and upwardly rerated. Now, in Mezzanine CDOs, anything less 
than Triple A is likely to be completely wiped out, and the 
Triple As will be severely impaired on average. This structure 
has made a mockery of the Triple A ratings, which contributed 
to the loss of faith in the ratings agencies that has frozen 
financial markets worldwide.
    There is a gross inconsistency of modeling assumptions, and 
it still exists today. While the provisioning of Triple A 
ratings to Mezzanine tranches of subprime debt is the most 
egregious example of the flaws in the current ratings process, 
the clearest and easiest error to correct is the ratings 
agencies' refusal to acknowledge historical mistakes in the 
application of model assumptions.
    In 2007, the ratings agencies changed many of their inputs 
into their structured securities ratings for mortgage-backed 
securities. Those changes were sweeping changes in many of the 
model inputs of their black box. And while they made those 
changes prospectively and tried to solve the problem going 
forward, where they stand today and where their duplicity lies 
is those model assumptions that changed in 2007 have not been 
input into their models for 2006, and 2005, and 2004. And they 
haven't put those assumptions in and subsequently rerated those 
prior transactions. They take the stance of the prior 
transaction and say, well, we will wait and see how they 
perform, and we will downgrade them as they happen. Well, until 
the ratings agencies plug their model assumptions in from 2007 
to the prior ratings, no one will have faith in the ratings 
agencies.
    With great power comes great responsibility. All 
participants in the fixed-income market recognize the enormous 
power the ratings agencies wield over pricing with their 
ability to bestow universally recognized ratings. This power 
has turned the ratings agencies into de facto for-profit 
regulatory bodies. This role is both explicit in the reliance 
on the benchmark of what constitutes investment-grade debt and 
implicit in the power to dictate the life or death of a 
monoline financial guarantor with a simple ratings action.
    I will tell you why and how regulators completely missed 
the epic size and depth of this problem in the credit markets 
today. An important concept to appreciate is that each 
securitization is essentially an off-balance-sheet bank. Like a 
regular bank, there is a sliver of equity and 10 to 20 times 
leverage in a securitization or CDO, and 20 to 40 times 
leverage in the CDO Squared and Bespoke instruments. The 
booming securitization market has in reality been an 
extraordinary growth of off-balance-sheet banks. However, the 
securitization market has no Federal and State banking 
regulators to monitor its behavior. The only bodies that 
provide oversight or implicit regulation are the ratings 
agencies, the bodies that are inherently biased towards their 
paymasters, the securitization firms. Without sufficient 
oversight, this highly levered, unregulated off-balance-sheet 
securitization market and its problems will continue to have 
severe ramifications on global financial markets.
    My belief is that the following two policy principles are 
an important step in addressing the issues I have raised above. 
First, we need additional disclosure by the ratings agencies to 
their regulator, the SEC, to ensure the consistency of economic 
assumptions for models across all securitizations and vintages, 
as well as a requirement to rerate securities based on any new 
model assumptions.
    Second, I think we should sponsor and facilitate the 
creation of a buy-side credit rating consortium funded by a 
limited fee on each fixed-income transaction in the fixed-
income market, similar to an SEC fee on equities transactions. 
Ultimately something must be done to resolve the problem of a 
market that is forced to rely upon the ratings agencies that 
are only paid to rate securities, and they are not paid to 
downgrade them.
    Thank you.
    [The prepared statement of Mr. Bass can be found on page 69 
of the appendix.]
    Chairman Kanjorski. Mr. Adelson.

 STATEMENT OF MARK H. ADELSON, ADELSON & JACOB CONSULTING, LLC

    Mr. Adelson. Thank you Mr. Chairman.
    Mr. Chairman, I have been in the structured finance 
business for my whole career, 22 years, first as a lawyer on 
mortgage-backed securities, and then I worked at Moody's for 
almost 10 years. For the last 6 years, I was at Nomura 
Securities, heading up structured finance securitization 
research. And now I have a little consulting company with my 
ex-boss, my partner, and we consult on securitization and real 
estate.
    Thank you for inviting me here to give some testimony. 
Obviously, I can't cover everything that I addressed in my 
written testimony in 5 minutes, and so I recommend that you 
take a look at my written statement.
    There are two points I want to particularly emphasize, 
though, and a couple of little things that have come up from 
your remarks and the remarks of the witnesses who already 
spoke. The first is the transparency of the ratings, of the 
rating methodologies. In my view, it is entirely clear that the 
rating methodologies are fully transparent. The evidence of the 
transparency of rating methodologies is in the voluminous 
reports that come from the agencies; the fact that they make 
the actual quantitative models available; the fact that 
analysts, hundreds of analysts, leave the rating agencies each 
year to take jobs with issuers, underwriters, etc.; and most 
important of all, the spirited debate about the pros and cons, 
the strengths and weaknesses of the methodologies that takes 
place in the open from individuals like me writing research 
reports. I have cited many of those reports in my written 
testimony, as you will see.
    So they are not black boxes, but they are also not totally 
simple. They are actually quite technical, and you have to have 
the right kind of technical background to grasp it. I mean, if 
my watch was broken, I couldn't fix it to save my life. But if 
I went to watch repair school, eventually I would learn how to 
fix a self-winding mechanical watch, and then I could do it. So 
it is a technical area. It is not going to be graspable by 
everyone. But to folks in the business, it is perfectly 
graspable.
    The second thing that I want to emphasize is the issue of 
conflicts of interest. One kind of conflict of interest that 
gets talked about with respect to rating agencies is the exact 
same kind that any publishing company, a regular old magazine, 
would have. Motor Trend takes advertising money from car 
manufacturers and then writes about those cars. Does that mean 
that all the reviews in Motor Trend are worthless or tainted? 
Of course not. They do--like publishers have done since the 
beginning, they have a reasonable separation to preserve 
editorial independence. Rating agencies also do that.
    Another aspect of conflict of interest, though, that is a 
little different is that rating agencies--or different for the 
rating agencies--is that the rating agencies can come under 
pressure to loosen their standards for a whole sector. And this 
can happen from a behavior by the issuers called rating 
shopping, where the issuers, an issuer let us say, shows a deal 
to multiple rating agencies and then picks one or two that have 
the easiest standards to rate the deal. Then the other rating 
agencies that had tougher standards become invisible, and, once 
more, they don't make any money, because the way you make money 
rating a deal is you rate the deal and charge the issuer. So it 
puts pressure on the rating agencies to loosen their standards, 
and we call this competitive laxity.
    Years ago the way rating agencies combated the pressure of 
competitive laxity--I want to emphasize, there is no conclusive 
evidence that the competitive laxity was actually practiced by 
the major rating agencies. It is a potential, it is clearly a 
potential. Rating shopping is undisputable; it happens, and it 
has been happening for more than 15 years. But the way the 
rating agencies used to combat it was by doing unsolicited 
ratings. They would call each other out. If one put a triple-A 
on a security that another thought should be single-A, they 
published a report that said, we think that is a single-A 
security, and then the market would see it and deal with it.
    In the 1990's, that practice was abandoned because it was 
bad relations with issuers. One of two rating agencies said 
they wouldn't do it, and then the others had to stop.
    I would say if you want to really address that issue and 
clean it up, you want to encourage or require unsolicited 
ratings even though that is something that you have viewed as a 
bad thing before.
    I see I am out of time, so I will stop there, but if you 
ask me questions, I will have something to say about some of 
your remarks and the remarks of the other witnesses.
    Thank you.
    Chairman Kanjorski. Thank you, Mr. Adelson.
    [The prepared statement of Mr. Adelson can be found on page 
56 of the appendix.]
    Chairman Kanjorski. Mr. Kanef.

 STATEMENT OF MICHAEL B. KANEF, GROUP MANAGING DIRECTOR, ASSET 
            FINANCE GROUP, MOODY'S INVESTORS SERVICE

    Mr. Kanef. Thank you. Good afternoon, Chairman Kanjorski, 
Ranking Member Pryce, and members of the subcommittee. I am 
pleased to be here on behalf of my colleagues at Moody's 
Investors Service to speak about the role rating agencies play 
in the financial markets and to discuss some of the steps that 
we believe rating agencies and other market participants can 
take to enhance the effectiveness and usefulness of credit 
ratings.
    Moody's plays an important but narrow role in the 
investment information industry. We offer reasoned, 
independent, forward-looking opinions about relative credit 
risk. Our ratings don't address market price or many of the 
other factors beyond credit risk that are part of the 
investment decision-making process, and they are not 
recommendations to buy or sell securities.
    Let me briefly address the subprime mortgage market, which 
has been part of the broader residential mortgage market for 
many years. While subprime mortgages originated between 2002 
and 2005 have generally continued to perform at or above 
expectations, the performance of mortgages originated in 2006 
has been influenced by what we believe are an unprecedented 
confluence of three factors: First, increasingly aggressive 
mortgage underwriting standards in 2006. Numerous resources 
also indicate that there have been instances of 
misrepresentation made by mortgage brokers, appraisers, and 
others; second, the weakest home price environment on a 
national level since 1969; and third, a rapid reversal in 
mortgage lending standards which first accommodated and then 
quickly stranded overstretched borrowers needing to refinance.
    Moody's response to these increased risks can be 
categorized into three broad sets of action. First, beginning 
in 2003, Moody's began warning the market about the risk from 
deterioration in origination standards and inflated housing 
prices, and we published frequently and pointedly on these 
issues from 2003 onward.
    Second, we tightened our ratings criteria, steadily 
increasing our loss expectations for subprime loans and the 
credit protection we look for in bonds they backed by about 30 
percent between 2003 and 2006. While Moody's anticipated the 
trend of weakening conditions in the subprime market, neither 
we nor most other market participants anticipated the magnitude 
and speed of the deterioration in mortgage quality by certain 
originators or the rapid transition to restrictive lending.
    Third, we took prompt and deliberative action on specific 
securities as soon as the data warranted it. We undertook the 
first rating actions in November 2006 and took further actions 
in December 2006 and April and July 2007, and will continue to 
take action as appropriate. In addition, we are undertaking 
substantial initiatives to further enhance the quality of our 
analysis and the credibility of our ratings. These include 
enhancing our analytical methodologies, continuing to invest in 
our analytical capabilities, supporting market education about 
what ratings actually measure in order to discourage improper 
reliance upon them, and developing new tools to measure 
potential volatility in securities prices, which could relieve 
stress on the existing rating system by potentially curtailing 
the misuse of credit ratings for other purposes. We also 
continue to maintain strong policies and procedures to manage 
any potential conflicts of interest in our business.
    Among other safeguards, at Moody's, ratings are determined 
by committees not individual analysts. Analyst compensation is 
related to analyst and overall company performance and is not 
tied to fees from the issuers and analyst rates. Our 
methodologies as well as our performance data are publicly 
available on our Web site, and a separate surveillance team 
reviews the performance of each mortgage-backed transaction 
that we rate.
    Finally, beyond the internal measures we undertake at 
Moody's, we also believe that there are reforms involving the 
broader market that would enhance the subprime lending and 
securitization process. These include licensing of mortgage 
brokers, tightening due diligence standards to make sure all 
loans comply with law, and strengthening and enforcing 
representations and warranties.
    We are eager to work with Congress and other market 
participants on these and other measures that could further 
bolster the quality and usefulness of our ratings and enhance 
the transparency and effectiveness of the global credit 
markets. Thank you. I will be happy to answer any questions you 
have.
    Chairman Kanjorski. Thank you very much, Mr. Kanef.
    [The prepared statement of Mr. Kanef can be found on page 
78 of the appendix.]
    Chairman Kanjorski. Ms. Tillman.

   STATEMENT OF VICKIE A. TILLMAN, EXECUTIVE VICE PRESIDENT, 
                       STANDARD & POOR'S

    Ms. Tillman. Mr. Chairman and members of the subcommittee, 
good afternoon. I appreciate this opportunity to address S&P's 
role in the financial markets, to discuss our record of 
offering opinions about creditworthiness, and to assure you of 
our ongoing efforts to improve.
    Before I do so, however, I would like to offer a brief 
comment on the testimony of SEC Chairman Cox at yesterday's 
hearing before the Senate Banking Committee. The Chairman 
testified that pursuant to recently adopted regulations under 
the 2006 Rating Agency Act, the SEC is examining various 
allegations that have been leveled at the rating agencies. 
Chairman Cox further shared his view that the 2006 act struck a 
sound balance between regulatory oversight and analytical 
independence. S&P agrees with the Chairman and will continue to 
work with the SEC on the examinations.
    Let me turn to S&P's excellent record of evaluating the 
credit quality of RMBS transactions. As a chart on page 6 of my 
prepared testimony demonstrates, we have been rating RMBS 
transactions for 30 years, and over that period of time, the 
percentage of defaults of transactions rated by us as Triple A 
is 4/100ths of 1 percent. Even our lowest investment-grade 
rating, Triple B, has a historical default rate of only 
slightly over 1 percent.
    That said, we at S&P have learned some hard lessons from 
the recent difficulties in the subprime mortgage area. More 
than ever we recognize it is up to us to take steps so that our 
ratings are not only analytically sound, but that the market 
and the public fully understand what credit ratings are and 
what they are not. Our reputation is our business, and when it 
comes into question, we listen, we learn, and we improve.
    Credit ratings speak to one topic and only one topic: the 
likelihood that rated securities will default. When we rate 
securities, we are not saying that they are guaranteed to 
repay, but, in fact, the opposite; that some of them will 
likely default. Recognizing what a rating constitutes is 
critical given that the recent market turmoil has not been the 
result of widespread defaults on rated securities, but rather 
the tightening of liquidity and a significant fall in market 
prices. These are issues our ratings are not meant to and do 
not address.
    Ratings do change, in our view, if a transaction can and 
doesn't evolve as facts develop often in ways that are 
difficult to foresee. This has been the case with a number of 
the recent RMBS transactions involving subprime. In these 
transactions a number of the behavioral patterns emerging are 
unprecedented and directly at odds with historical data.
    At S&P we have been expressing in publications our growing 
concerns about the performance of these loans and the potential 
impact on rated securities for over the last 2 years. We have 
also taken action, including downgrading RMBS transactions more 
quickly than ever before. Moreover, we continue to work to 
enhance our analytics and processes by tightening our criteria, 
increasing the frequencies of our surveillance and modifying 
our analytical models.
    We take affirmative steps to guard against conflicts of 
interest that may rise out of the fact that we, like most every 
other major rating agency, use an issuer pay model. This issue 
was thoroughly debated in Congress during the consideration of 
the 2006 act. Independent commentators, including the head of 
the SEC's Division of Market Reg, agreed that the potential 
conflicts of interest can be managed. At S&P analysts are 
neither compensated based on the number of deals they rate, nor 
are they involved in negotiating fees. These controls and 
others are set forth in our code of conduct. Every employee 
receives training in this code and must attest to its 
compliance.
    Equally important, Standard & Poor's has not and will not 
issue higher ratings so as to garner more business. From 1994 
through 2006, upgrades of U.S. RMBS ratings outpaced downgrades 
by approximately seven to one. This pattern surely would not 
exist if S&P issued inflated ratings to please issuers.
    Mr. Chairman, the issuer pays models help bring greater 
transparency to the market as it allows all investors to have 
realtime access to our ratings. Unlike under a subscription 
model, the issuer pay model allows for broad market scrutiny of 
our ratings every day.
    Others have questioned how pools of subprime loans can 
support investment-grade securities. The reason is the presence 
of credit enhancement, such as excess collateral in these 
transactions. We do not simply take a pool of subprime loans 
and rate the issued securities Triple A. Instead, drawing on 
our expertise and experience, we carefully analyze the 
appropriate amount of credit enhancement or cushion needed to 
support a particular rating. Without this cushion of additional 
collateral protection, we simply could not and would not issue 
what some consider high ratings on securities backed by a pool 
of subprime loans.
    Let me end by reiterating our commitment to do all that we 
can to make our analytics the best in the world. Let me also 
assure you again of our desire to continue to work with the 
subcommittee as it explores developments affecting the subprime 
market.
    Thank you, and I would be more than happy to answer any 
questions that you may have.
    Chairman Kanjorski. Thank you, Ms. Tillman.
    [The prepared statement of Ms. Tillman can be found on page 
147 of the appendix.]
    Chairman Kanjorski. Dr. Mason.

 STATEMENT OF DR. JOSEPH R. MASON, LeBOW COLLEGE OF BUSINESS, 
                       DREXEL UNIVERSITY

    Mr. Mason. Mr. Chairman, Ranking Member Pryce, and members 
of the committee, thank you for the opportunity to be here 
today.
    By way of introduction, I am an associate professor of 
finance at Drexel University. I am a senior fellow at the 
Wharton School. Before joining Drexel University, I worked at 
the Office of the Comptroller of the Currency, studying 
structured finance. Since I moved to academics, I have advised 
bank and securities market regulators, as well as many industry 
groups and the press, on recent difficulties with structured 
finance. And I am also an expert in the economic dynamics of 
financial panics and crises of which the most recent market 
difficulties are a shining example.
    My own academic research has shown that the leading 
contributor to financial crises historically, this one 
included, is information transparency. Market participants 
recently discovered that they do not know all that they thought 
they did. Investors are, therefore, rationally applying 
discounts to all banks and investment funds indiscriminately 
until they find out who is holding the risk. Hence, investors 
need more information about the value and the holdings of 
structured products.
    Note that funds rate cuts, increased agency mortgage 
limits, FHA programs or even, as in the U.K., blanket deposit 
insurance coverage will solve that information problem. The 
solution lies in changes to the manner in which information 
about structured finance investments is gathered and 
disseminated. Today's hearing on the role of NRSROs is, 
therefore, a good start in gathering information that can be 
used to make meaningful changes that will reduce information 
problems.
    NRSROs like to say that investors are free to avoid their 
products if ratings are not useful. Not so. Issuers must have 
ratings even if investors do not find them very accurate. When 
the government stipulates that BBB or better-rated instruments 
are acceptable for public pension fund investments, the 
government confers on NRSROs the unique power to act as 
regulators, not mere opinion providers. Thus, the NRSROs are 
the gatekeepers to the majority of the investment world.
    The problem is that a letter rating can mask an extremely 
wide range of risk. For instance, a Moody's Baa rating can 
indicate a 5-year, 24 percent default rate for CDOs or a 0.097 
percent default rate for municipal bonds, a 250-times magnitude 
of economic difference. Hence, the BB rating cutoff for ERISA 
eligibility is no longer meaningful. Using ratings for the 
Basel II framework of banking supervision will only worsen the 
problem.
    While the general statistical methods for NRSRO ratings 
criteria are disclosed, the NRSRO ratings criteria are not 
disclosed to a level of replicability. The reason is that the 
NRSROs do not release the economic assumptions they include in 
the models. When pressured, the NRSROs have divulged 
assumptions that differ significantly from reasonable forecasts 
issued by the NRSRO's own economic research affiliates. NRSROs 
have not strived to keep their models up to date, refusing to 
incorporate data on subprime mortgage products into their 
models until recently, while at the same time warning investors 
about the risks since 2003 and selling those investors tools to 
evaluate the difference.
    Even when models are improved, NRSROs apply changes only 
prospectively, not retrospectively to the deals that they have 
admittedly misrated. Furthermore, while NRSRO ratings criteria 
are somewhat transparent, the NRSROs do not issue criteria for 
rerating securities and do not have systematic methods for 
doing so, presumably because they are not paid to do so. 
Rerating, however, is crucial in structured finance.
    In their reluctance to adequately monitor structured 
finance, the NRSROs have also been complicit in allowing 
servicers to use aggressive modification and reaging practices 
to manipulate cashflows on behalf of structured finance 
noteholders. Since roughly half of modifications result in 
consumer redefaults, it appears that many loan modifications 
may be for the sole purpose of extracting money from consumers 
who still cannot afford even lower loan payments.
    While the NRSROs do not play a formal role in the 
development of new products in structured finance, the 
integrity of the financial engineering plays a crucial role in 
establishing the credit risk of the investment securities. In 
structured finance, therefore, ratings serve as a seal of 
approval issued after NRSROs inspect the safety and soundness 
of the financial engineering. In that financial engineering, 
collateral types that are very heterogeneous and/or do not have 
a long history of demonstrated performance cannot be expected 
to allow as fine a slicing and dicing of risk as collateral 
types that are very homogenous and have a long history in 
credit markets. The NRSROs, however, overlooked the crucial and 
well-known characteristics of collateral risk and heterogeneity 
and supported the rapidly growing sector by rating complex and 
lucrative security structures for subprime mortgages as if the 
collateral were typical prime conforming mortgages.
    Going forward, enforcement of SEC Regulation AB and FAS140 
will alleviate significant problems in structured finance, but 
the NRSROs themselves need to be monitored if they are to 
continue to fulfill a regulatory role for pension funds and see 
that expanded to banks under Basel II. But how? The solution is 
fairly simple.
    Basel II already proposes that bank regulators monitor bank 
internal credit models, but it allows banks that do not build 
their own models to use NRSRO ratings. I merely propose that if 
NRSRO models are to be used in the same manner as bank internal 
models they be subjected to the same supervision. The NRSRO's 
regulatory responsibility, however, cannot be maintained, much 
less expanded, without accountability.
    [The prepared statement of Dr. Mason can be found on page 
112 of the appendix.]
    Chairman Kanjorski. Thank you very much, Doctor.
    Way back in the early dealings with the computer rates, I 
remember people arguing that anything could be done with 
computers, and then some very smart person came up and made the 
simple statement, ``Garbage in, Garbage out.'' It seems to me 
you put a finger on why we have jurisdiction in this matter.
    You know, as far as I am concerned, I am not worried about 
wealthy people losing money. They know what they are doing. 
That is their game. As a matter of fact, I will be happy to go 
to the casino with them. My problem is that we are dealing here 
with pension funds and other important funds, which you have 
just indicated in some instance because of these rating 
circumstances the risk of these CDOs are 250 times worse than 
other rated bonds or securities, so that they miss the mark on 
what the rating is supposed to do in the protection of these 
various areas of money. Is that correct?
    Mr. Mason. I would say that they purposefully miss the mark 
in order to satisfy the investment manager and, in some cases, 
those who were looking for the fat yields that come from 
structured products.
    Chairman Kanjorski. All right. So, I guess I am trying to 
get to the measuring of where do we have jurisdiction. What 
jurisdiction should we utilize and for what purposes? We are 
not the cure of the world, and we are not to guarantee people 
profits or even that they do not get taken. I mean Nigeria is 
running a very strong economy and is getting people to send 
money to protect their rights and checks.
    Mr. Adelson, I am not going to attack you, but I notice you 
are an attorney by profession.
    Mr. Adelson. I am still admitted to the bar, but I have not 
practiced law--
    Chairman Kanjorski. But you have never heard of that 
pleasurable thing about what sirens do to lawyers?
    Mr. Adelson. No.
    Chairman Kanjorski. Well, you have heard of the concept of 
``ambulance chasers.''
    Mr. Adelson. Yes. Oh, sirens. Yes.
    Chairman Kanjorski. Sirens. What causes ambulance chasing? 
It is profit motive, isn't it?
    Mr. Adelson. Sure.
    Chairman Kanjorski. So that would indicate that even people 
of supposedly a higher ethical calling respond to that ugly 
thing called ``profit'' and sometimes abuse their ethical 
standards in order to obtain a profit. Wouldn't that be a 
logical conclusion from that humorous statement about ambulance 
chasers?
    Mr. Adelson. I think the reason that we would say is that, 
you know, ambulance chasing is improper conduct and that it 
violates a lawyer's code of ethics to engage in it. It is not 
the right thing to do. I mean--
    Chairman Kanjorski. It is not the right thing to do because 
the object is money as opposed to performing your professional 
activity. Let me give you another example. Have you ever heard 
about orthopaedic surgery in hospitals? In September and 
February, the operation rate gets to be the highest, and there 
are correlation studies--I think Drexel did one of them--of 
when tuitions of orthopaedic specialists are due. Now, I am not 
saying all orthopaedic surgeons are driven by money, but there 
is an unusually high surgery performance at the particular 
times when monies are necessary for tuition. There could be 
other causes, I grant you.
    Mr. Adelson. But you are not saying that you would expect 
either lawyers or orthopaedic surgeons or anybody else to be 
working for free, right?
    Chairman Kanjorski. No, they should not be working for 
free, but you used an example of Motor Trend Magazine. 
Honestly, would you buy an automobile from Consumer Reports if 
you knew that General Motors was paying them millions of 
dollars to write the recommendation?
    Mr. Adelson. Well, actually, I like to read both Consumer 
Reports and Motor Trend Magazine because I value getting 
different points of view.
    Chairman Kanjorski. Are you familiar with the publications 
across America of the 100 Best Lawyers? They show you pictures 
of them, and they give you writeups of them. Whenever I am, you 
know, in a waiting room and waiting for something, these are 
interesting things for me to read because I know a lot of these 
people, and I have come to the conclusion that there is a 
tremendous correlation between how great these 100 lawyers in 
each of the States are and how much they pay for ads in the 
book that publishes the 100 Best Lawyers. It is just an unusual 
correlation. The best lawyers seem to be the best advertisers. 
I am not certain why or what the exact relationship is, but 
what I am getting to is how can we miss profit motive here as a 
problem? I am beginning to believe we have to take profit out 
of some of these areas.
    It is not unusual that Moody's and Standard & Poor's showed 
almost 50 percent of their revenues coming out of this rating 
area, and if we had just been--if somebody had been perceptive 
enough to watch how their profits were growing in that area, 
they probably could have detected a little earlier that the 
ratings may not be reflecting the true picture.
    Ms. Tillman. Mr. Chairman, could I make a comment?
    Chairman Kanjorski. Sure, Ms. Tillman.
    Ms. Tillman. Two comments--one in terms of Dr. Mason's 
statistics. I cannot speak to where he came up with his 
statistics, but if you take the same statistics on an 
investment grade CDO--okay?--at a Bbb level over a 5-year 
period, the average default rate is somewhere around 2\1/2\ 
percent. If you look at a corporate bond--okay?--rated by 
Standard & Poor's in the same time period rated Bbb, then you 
have approximately 2\1/2\ to 3 percent of a probability of 
default.
    So I think we have to be very careful in terms of using 
statistics and understand really, you know, the other element 
that I think that the act was getting at is to have diverse 
opinions, and because Moody's or Fitch or someone else may have 
a different methodology than Standard & Poor's, I would assume 
that is part of the competitive environment that we are looking 
for.
    Chairman Kanjorski. Ms. Tillman, what I am getting at is 
maybe we have to do several things, and of those several 
things, probably information and transparency are the most 
important. I am absolutely convinced that in this computer age 
we could have a system in which these structured financial 
deals, by the push of a button, could give you the reflection 
of performance to the moment. That would allow people who are 
advisers, people who are buyers in the field, and individual 
investors to find out what the relative position of their 
security is at any given moment. I think that is very 
important. The fact that somebody gets away without that, they 
are really selling a pig in a poke.
    Ms. Tillman. I agree wholeheartedly with you, Mr. Chairman.
    Chairman Kanjorski. I think, from a prior discussion, I 
cannot understand why the rating agency has not come forward 
and recommended to the Congress or to the SEC that we do 
something about that. We cannot wait until the horse has 
escaped from the barn all the time and then come up here and 
try to do remedial legislation. Some of these things are 
anticipatory, and I think this is very clearly anticipatory.
    I wanted to make one other comment--and I know I am a 
little over my time.
    I had a great conversation with the CEO of one of the major 
accounting firms in the United States that no longer exists, 
and that is as far as I am going to go to disclose who it was, 
and I remember sitting on the edge of my chair, asking, ``How 
could this happen?'' Now I am going to tell you why.
    I am a lawyer by profession, and I know a lot of the bad 
eggs in the legal profession, and I know some of the bad eggs 
in the medical profession, but I always had this incredibly 
high respect for the accounting profession. Why? Because I did 
not understand their field too well, and I knew that all of us 
relied on them to be absolutely correct if we wanted to know 
what was happening in a business. Finally, in weakness, when we 
were talking about WorldCom, he looked at me and he said, 
``Congressman, you have to understand, I have an organization 
throughout the world that I need $12.5 billion a year in 
revenue to operate.'' That was the justification of why this 
special allotment of making accounting principles warp, to 
allow WorldCom to do this, and that was it.
    That is scary to me. It is scary to me that the rating 
agencies are all profit-driven from the companies that own 
them, up to the holding company, all the way down. I am sure 
you can say there is separation, and maybe I am getting gun 
shy, but even the New York Times? Now in years past, we used to 
have a great deal of respect for the standards and ethics of 
the New York Times. Didn't they run an ad for $65,000 when it 
should have been billed at $170,000, and it was attacking 
personalities that were against their stated position in 
advertising? It is amazing how, if it is their political 
conviction or for profit or for whatever reason, that 
corporations, companies, and other entities in America today, 
mostly profit-driven, are starting to make significant changes 
and are lessening their standards.
    If the rating agencies are the only thing between absolute 
fraud, do we have to make them nonprofit and take the profit 
motive out of it? I do not know, but we certainly have to have 
disclosure. I agree with Dr. Mason on that. That is easy to do, 
and I expect the agencies to come to the Congress with 
recommendations of how it can be done. We could very quickly 
put that in place, or get the regulators to put it into place, 
but we have to do something about this.
    You know, I want to close and let my good friends get their 
time in, but to those of you whom I have talked personally 
about, I have constantly mentioned what really scares me about 
our whole economic system today--over the last decade or two, 
the very sophisticated people in the field of finance have 
learned how to take their skin out of the game, and they have 
no risk. They only have the upside. They make a profit if they 
sell a mortgage. They do not lose anything if the mortgage 
fails. They make a profit if they sell the securitization. They 
do not lose any money if the securitization fails. All of the 
people who sell the securitization rates, they all make 
profits. They risk nothing if it fails. We have to find a way 
of putting skin back in the game, and if we do not, all we are 
doing is creating a market out there that pretty soon people 
just will not believe in.
    Now, I had a discussion with a European Parliament member 
yesterday, and he was telling me about the run on the bank in 
England and how the Bank of England stepped up with total 
insurance, which is an interesting concept since I think I just 
read--or did I hear it in your testimony, Dr. Mason?--that 10 
percent of the banks of America's securities involve these 
types of securities that are in their vaults. That could be 
very serious if they collapsed. That would take down the entire 
banking system in the United States, as I understand it. They 
do not have the equity to withstand a 10 percent total failure, 
do they?
    Mr. Mason. No. Neither does the FDIC have the funds to 
cover the outlays.
    Chairman Kanjorski. So the last thing. For the last several 
weeks, I have had a terrible feeling that we are in a serious 
condition in this country. Is there anybody at the witness 
table who thinks this is not a serious problem, and it will 
pass? Or do you agree--you do not think it is a serious 
problem, Mr. Adelson?
    Mr. Adelson. No, Mr. Chairman. With respect to the 
securities on the subprime side, the amount of securities are 
very small by dollars. One of the other members referred to the 
number of bonds. The dollar amount of the affected securities 
from subprime deals is actually very modest in relation to the 
total amount.
    Chairman Kanjorski. You do not see cross-pollenization or 
pollution occurring?
    Mr. Adelson. You are talking about where the problem is 
now. You can have a problem, which we have not gotten into at 
all, about the derivatives guys and the CDO sector's using 
derivatives to create $130 billion of exposure when there was 
only $40 billion of actual triple-B paper created in the 
subprime area that has been put under pressure. Even CDOs, 
themselves, are just not that big a piece of the pie.
    I think you do have a problem. I will agree with you that 
you have a problem in how lenders made subprime loans, but you 
guys make the laws. You have computers, too. You see the little 
dancing robot telling people they can get a loan for no money 
down. It is not like anyone at this table was seeing anything 
that you were not, okay? If you want banks to have skin in the 
game when they make loans--right?--and if you want to temper or 
to restrain the ongoing process or evolutionary trend of 
financial disintermediation, you are the guys to stop it. You 
just make a law that says whenever you make a loan, you must 
retain 10 percent of it forever.
    Chairman Kanjorski. Let me say this to you. I am one Member 
here. I have preached a little, but that does not exonerate me 
from responsibility.
    The Congress of the United States adopted a policy of 
maximum homeownership even when we knew financial literacy was 
lacking, and capacity performance was lacking, and managerial 
capacity was lacking. It made us all feel so good to say 
everybody has a perfect cure if they own a home. I think this 
may be the beginning of understanding that is not true. I hope 
it is. We are responsible for that.
    Yes.
    Mr. Mathis. Mr. Chairman, could I respond to this not being 
a big issue?
    Chairman Kanjorski. Yes?
    Mr. Mathis. The main issue--and you brought up North Rock. 
North Rock was an institution that by most measures was not in 
financial trouble. This is an issue of trust.
    Chairman Kanjorski. Right.
    Mr. Mathis. These securities have been issued, not only 
CDOs and mortgage-backs but also CLOs that number in the 
trillions. They are across the marketplace. When the 
marketplace loses the trust in the rating system that it had 
come to trust and it believes that ratings do not mean 
anything, you are going to have essentially the run on the bank 
that you had in the U.K., and that is why this is a significant 
problem. There is a contagion that comes from a lack of faith 
in what is in a security and what it means. This is the thing 
that I say--this is one of the bigger crises to face the 
financial markets since the Depression because there were not 
tangibles. These were intangibles. People just lost their trust 
in those securities, and if it happens on a larger scale, God 
forbid.
    Chairman Kanjorski. I agree with you, and I will get back 
to you.
    Ms. Pryce, you have all the time in the world.
    Ms. Pryce. Thank you, Mr. Chairman. I will not take too 
much time.
    Mr. Chairman, you talked about skin in the game. I think 
some of the skin that the rating agencies have is their 
reputation. I mean your reputation is what the trust of the 
world markets has relied on. I think that you have lost some 
skin in this game, and I might be wrong, but let me ask a 
question.
    Mr. Bass and Dr. Mason both brought up the point that the 
2007 home prices assumptions have been changed prospectively 
but not retrospectively for products needing rerating, and that 
goes to the chairman's point, that is because you are not being 
paid to rerate, but your reputation is at stake.
    Is there a reason you do not rerate? Don't you want to 
regain some of these layers of skin that you have lost? So why 
are they not being rerated? Will you address that in some 
depth?
    Mr. Kanef. Congresswoman, could I answer that question, 
please?
    Ms. Pryce. Sure.
    Mr. Kanef. The one thing I would like to say--and I would 
like to, actually, try to correct the record here--is that, 
contrary to some of the statements that have been made at 
Moody's--and I can only speak for Moody's--when we have gone 
through on the review of this subprime RMBS transactions that 
we have rated, the assumptions that have been used for ongoing 
transactions, transactions on a going-forward basis, are the 
assumptions that are used by our monitoring team to monitor the 
existing and the outstanding subprime RMBS transactions.
    We held a teleconference in July when we had downgraded a 
substantial number of subprime RMBS transactions, a small 
percent of the total outstanding but a substantial number of 
transactions. During that teleconference, we did explain the 
methodology that we were using for the surveillance and for the 
rating downgrades of those transactions, and that process 
involved an application of the forward-looking assumptions to 
the existing transactions.
    Ms. Tillman. May I respond, as well?
    Ms. Pryce. Yes. Then we will go back to Mr. Bass.
    Ms. Tillman. I wanted to sort of reiterate what Mr. Kanef 
has said. We have both a new issue group and a surveillance 
group that seem to have gotten lost in some of the criticism 
here at the table. What our surveillance group does, which is 
totally separate from the new issue deal, is we get information 
in on a monthly basis from servicers, and we review the 
performance of how these deals are operating because on a 
primary deal the new deal, you are really rating against what 
your expectations are. On the surveillance side, you are 
reviewing what is actually happening and what the behavior is 
of those loans in their portfolio.
    In addition, we change our models that we utilize both 
internally as well. That is totally accessible to anyone in the 
marketplace, and it has been for quite a period of time. We 
have changed the model multiple times as we have changed our 
assumptions.
    Ms. Pryce. Well, would either one of you say that you are 
doing this retroactively or just prospectively?
    Mr. Kanef. Well, I think, again, there is a separate 
monitoring team, and the monitoring team needs to look at two 
aspects of the previously rated transactions. I mean they do 
that monthly. Data usually comes in on these transactions once 
a month, and so every month every transaction is reviewed by 
the separate monitoring team that we have.
    Ms. Pryce. It is reviewed. Is it rerated?
    Mr. Kanef. When I say ``reviewed,'' what I mean is the 
performance of the loans underlying the securitization is 
reviewed, and it is compared to our original expectations and 
to the enhancement levels that are in place to protect the 
bonds, and to the extent that the analyst reviewing the 
transaction believes that the performance or the enhancement 
levels have changed in a material way, there is a committee, 
and each and every deal that requires it is rerated. Yes.
    Ms. Pryce. Okay. Mr. Bass and Mr. Adelson and Mr. Mason, 
then, if you want to jump in.
    Mr. Bass. Let us be clear here.
    I have met with your--specifically yours, Mr. Kanef--
surveillance team numerous times. Your surveillance team drives 
in the rear view mirror. They look at the performance; they 
look for outliers, and they downgrade the outliers after the 
performance. My comments as to your operating duplicity are 
specifically aimed at your global assumptions on the front end 
of rating those securitizations. When those global assumptions 
change--let us say the two most important assumptions for this 
asset class, I would say, are home price appreciation 
assumptions and loss severity assumptions. When you change 
those assumptions from an up 6 to 8 home price for the next 3 
years--flat to down--and you slightly raise your loss severity 
assumptions for 2007 deals, all of a sudden, the OC that you 
are requiring in these transactions balloons and makes them 
much less profitable, but more importantly, if you were to take 
those assumptions and drop them in your 2006 models, you would 
have to rerate the entire securitization that day. You guys are 
not rating them using your modeling expectations, you know, 
retrospectively. You are driving with the rear view mirror 
retrospectively.
    Ms. Pryce. Mr. Adelson.
    Mr. Adelson. I think there is a little bit of confusion. 
Maybe it is the terminology here.
    When the rating agencies are called on to rate a new deal, 
it usually involves brand new mortgage loans that have no 
performance history on them. So the analysis goes, in very 
large measure, off of the measurable characteristics of the 
loans--the loan-to-value ratio, the borrowers' FICO scores, the 
kind of loan product it is. On a deal that has been rated and 
has been closed and has been in the market for a while, that 
stuff becomes a lot less important. What is really important is 
seeing how those loans are doing month after month, right? It 
is much less meaningful, if you have a pool of loans that are a 
year old, to take your new rating model--let us say you have 
upgraded it and changed it somehow--and put the pool of loans 
through it as if it had no history at all, because in fact you 
can do a lot better by looking at the actual performance of 
these loans, this honest to God pool right in front of you.
    I think that is what the witnesses from the rating agencies 
are saying, that when you have a deal that is out there for a 
while you are doing it differently because you have more 
information.
    Ms. Pryce. Mr. Mason, do you want to have the last word on 
this? My time has expired.
    Mr. Mason. I have trouble with ``rerating'' being entirely 
in the rear view mirror. If ``rating'' is prospective and 
``rerating'' is in the rear view mirror, let us call it 
something else. ``Review'' is not the same function. The 
important thing to remember is in the context of structured 
finance, and partially relating to the chairman's previous 
question, this is a structured finance problem, not a subprime 
problem; the structures have fallen apart. Whether it is 
subprime, leverage buyouts, or other new collateral types, the 
structures are falling apart because the structures have been 
stressed too much, like a bridge that was underengineered.
    There are certain cumulative dynamics to these pools. These 
are pools of mortgages. You take 5,000 mortgages and put them 
in a pool. Now, the pool will demonstrate some dynamics as it 
goes, but if a loan defaults and a loan goes into foreclosure 
and the property is sold and we book a 40-cents-on-the-dollar 
loss from that one, that money is not going to be recovered 
from somewhere. So we book a certain percentage loss in the 
pool, and that rises, certainly, early in the deal because we 
are not sure of what loans are going to do. They generally 
default in the first couple of years of life, and that is the 
way things go, and then they start tailing off and they start 
leveling out. The issue is where that tail-off and that 
leveling-out goes, but the point is the cumulative loss never 
goes down. Those cumulative dynamics do not come back. It is 
not like a corporate bond on--I do not know--some company, 
because I do not want to name a company inappropriately--but a 
corporate bond on some company that has an ongoing operation. 
Maybe they are getting some losses--okay?--and those losses are 
tailing up, but then they rejigger their investment program, go 
into a new product area, start some new plants, raise some 
capital, and they earn some money that can offset those 
earnings, and the curve can go back down. This does not happen 
in structured finance. This is the pool. That is all there is. 
It is static, done. So to look in the rear view mirror in that 
environment is really misleading because in the context of 
these mortgage-backed securities today and these other 
structured investments it is not going to get any better. We 
have what we have.
    Secondly, I think that part of the incentive conflict that 
has to do with this industry is that structured finance brought 
to the industry a great number of repeated transactions, and 
one of the first things you learn in grad school in economics 
and in micro-game theory is that repeated games have very 
different outcomes than single, individual games. So, if one of 
the ratings agencies is thinking about downgrading an issuer's 
deals, that has dramatic implications for that issuer going 
forward and also as to what choice of ratings agency that 
issuer uses going forward in their new deals next month and 
next quarter and ongoing.
    I had a very interesting discussion with a researcher at 
one of the ratings agencies. I have always been interested 
because these loans are supposed to be truly, indeed, sold 
under FAS140 (which I will not go into, but FAS140 has not been 
enforced and has been overlooked for years, but they are 
supposed to be sold); they are supposed to be separate from the 
bank that originated a loan. So what happens to the bank or to 
the originator when the deals are downgraded? I had been 
interested in researching the stock price effect on the 
financials, and the researcher laughed and said, ``They die. 
They are done. It is the end of the road.''
    So is it surprising to see that the downgrades that we saw 
last summer were of New Century, American Home--the other 
originators had already died--that there was no reputational 
hit, that there was no problem with new business coming up the 
pipe because there was no new business from those originators?
    Ms. Pryce. Well, it is all very fascinating, and I think we 
really have not even touched on how to change if we need to, 
and it may be the subject for a whole new hearing or for a 
whole new discussion group.
    So thank you all. It certainly is not less than 
complicated, so I appreciate.
    Thank you, Mr. Chairman.
    Chairman Kanjorski. Mr. Ackerman.
    Mr. Ackerman. I had a car once. It said on the rear view 
mirror that ``Objects you see in the rear view mirror may be a 
lot closer than they look.'' A couple of observations.
    Fascinatingly, I have not heard anybody uttering the words 
``the market can correct itself''--it is just an observation--
because the debate that we have is whether or not we should be 
trying to fix the market or whether we should keep our hands 
off the market because the market is going to take care of this 
situation. Nobody came charging up here saying that. 
Interesting.
    Somebody mentioned the word ``faith.'' It is very, very 
interesting how much trust we place in the hands of others upon 
whom we rely. Cookies. These are Girl Scout cookies as it turns 
out. There are people who are, as a principle of their faith, 
orthodox Jews, who have to keep laws that are the kosher laws, 
the Kosheret laws. They have to know that the foods they eat 
are kosher by the law that they have to adhere to. That means 
they have to know, as the consumer of edible products, how the 
process was done, what went into the process and that each of 
the ingredients meets the specifications according to the 
standard, the ``standard.'' Girl Scout cookies meet that 
standard. The average person not familiar with Kosheret laws 
does not know to look for a little thing somewhere in the small 
print. Within a little, tiny circle, there is a ``u.'' That is 
the clue that the people who manufacture it choose to put on to 
signal to those people who are interested in doing their due 
diligence that this meets the standard that they have to by law 
uphold, and they put a lot of faith into that. One of the 
reasons is they cannot see into this. It is not a black box, 
because nothing is a black box in any of the markets. They are 
fancy boxes with beautiful pictures, and they are gussied up to 
make them appealing. This is not even translucent, let alone 
transparent, and the only thing that a person has to rely on, 
who needs to keep the law, is someone else's word.
    I think--and you can comment on it--that faith that we have 
had in the markets, because we have been relying on the rating 
agencies to keep the deals kosher, is a faith that has been, in 
this case, misplaced. If I wanted to take these cookies apart 
and eat them one by one, I would know they are all still 
kosher. If somebody repackaged this package by taking 50 
percent of this package and combining it with 20 percent of 
another package--the ingredients of which might all be listed--
and then down the road someone else repackaged that repackage 
and that kept going on, there would be no way for anybody to 
certify the processes by which the ingredients were assembled 
and whether or not the package that they were buying met the 
standards that they were required to keep. That is why you 
cannot rerate, because even you in a fourth generation of a 
package of securitized mortgages could not tell me what was in 
it. You could not even tell me, of the subprime people's 
mortgages that were in it, how many of them might have lost 
their jobs, how many of them were mortgaged together with their 
husbands as co-borrowers and the breadwinner died without 
insurance. There is no way of knowing the viability of that 
package. Maybe I am missing something.
    How does a prudent consumer know?
    Ms. Tillman. Can I make a comment, sir?
    Mr. Ackerman. Please.
    Ms. Tillman. When we look at a mortgage-backed security, on 
average, there are about, probably, around 3,000 loans in each 
of the pooled packages. We evaluate over 70 characteristics of 
each of those loans, including--
    Mr. Ackerman. Each of the 3,000?
    Ms. Tillman. Each of the 3,000.
    There are 70 characteristics that range from what kind of 
loans they are, the FICO score of the borrower, the employment, 
and so forth and so forth. We run those.
    Mr. Ackerman. When you review the employment for 3,000 
people in the package--
    Ms. Tillman. Well--
    Mr. Ackerman. --how many people have lost their jobs? Do 
you reinvestigate that?
    Ms. Tillman. No, we do not reinvestigate it.
    Mr. Ackerman. It was not investigated to begin with, so how 
do you know that--
    Ms. Tillman. Well, can I finish, sir?
    Mr. Ackerman. Please.
    Ms. Tillman. Basically, it is the originators. It is their 
responsibility, obviously, in terms of not only making the 
loans but in ensuring that they meet the underwriting standards 
there. There is due diligence. There is a responsibility of 
both the underwriters and of the investment bankers in terms of 
reviewing them, and they have to--
    Mr. Ackerman. And you--
    Ms. Tillman. Let me finish.
    Mr. Ackerman. I just want to understand what you just said. 
Please, do finish.
    You are relying on the original underwriter?
    Ms. Tillman. No. What I said is that what we look for is--
it is the originators. It is the originators of the loans' 
responsibility to ensure that the loans that are being lent to 
the borrower are meeting their underwriting standards, at which 
point in time the investment banker, if they are working with 
an investment banker--
    Mr. Ackerman. Some of those are the underwriters who helped 
participate in the ``no background check'' thing?
    Ms. Tillman. Yes, they are the originators of the loan.
    Mr. Ackerman. And that is what you are relying on?
    Ms. Tillman. It primarily the non--
    Mr. Ackerman. It is a pretty high standard to rely on 
somebody else's ``no please lie to me'' standard.
    Ms. Tillman. Well, I am just telling you--
    Mr. Ackerman. If somebody says to me ``no background 
check,'' man, you know, I am Rockefeller.
    Ms. Tillman. Well, to that point, sir, actually the 
Mortgage Bankers' Association commissioned a study, and it did 
find out, in fact, sir, that, especially in the 2006 loan 
originations, there were substantially higher 
misrepresentations and fraudulent information in those sets of 
loans, where you had a FICO score for an individual borrower in 
the 2006 that acted more like an individual borrower of a much 
lower FICO score in previous times.
    So I totally agree with you relative to the transparency, 
in terms of the types of loans that we are seeing, the 
enforcement of underwriting standards, and due diligence, but, 
sir, we get this information. We state very clearly that it is 
this information that we look at, and then we run it loan by 
loan through our models, again which are totally available to 
the public and to the investment banker's rep, and warrant to 
the accuracy of that information. You know, we are not 
accountants. We depend on the accuracy of what is given to us. 
Our job is to really look at the probability of default, and we 
do a very extensive review of all of those loans.
    In essence, to your point about the kosher box and the 
``u,'' our criteria and the models that we put out are so 
transparent that just about everybody in the marketplace knows 
exactly what it is that our models are saying and the types of 
things that we are looking for, and so it is not a great 
mystery to the marketplace how Standard & Poor's views 
particular kinds of residential mortgage-backed securities.
    Mr. Ackerman. Thank you.
    If I put different cookies in this box, the three chief 
rabbis in Jerusalem could not tell me they were still kosher.
    Ms. Tillman. I agree, but that is why we have a 
surveillance group that surveils those deals that have been 
rated so that we can look at the performance of the deals after 
the fact, not only at the time of the sale.
    Mr. Ackerman. Mr. Mathis.
    Mr. Mathis. One of the things, I believe, that one of the 
people from a rating agency said is that, when they looked to 
rerate, they did not look at those original FICOs because they 
did not mean as much anymore, and as to the whole process you 
have to ask yourself--and I believe the chairman sort of 
alluded to that with the metaphor of the ambulance. Here you 
have investment bankers who are--you know, these are private 
offerings; these are not public offerings, and they are 
warranting to them that these loans are going away; they are 
going to make a big fee in selling them; the originators they 
are talking about are never going to hold these loans; they are 
going away; they are never going to see them again. The only 
person who is going to see them again or who will be with them 
are the pension funds, and what they depended on was that mark 
that you were talking about, which in this case happens to be a 
AAA.
    I mean one of our suggestions is that maybe one of the ways 
to deal with this--and this was alluded to by the people from 
the rating agencies, that you do not know for a couple of 
years. Well, maybe one of the ways is that everybody who makes 
these loans has to live with them for 3 years, that you cannot 
issue some structured finance along these lines until they are 
seasoned for about 3 years. So that means that everybody who 
made these loans, including the originators and the investment 
bankers and all of that, would have to live with them for 3 
years. Just think about common sense. Do you think you would 
have a different world if they had to live with these for 3 
years? I think you would. I think it would be a different 
world.
    Chairman Kanjorski. Thank you.
    Mr. Sherman is going to jump off this platform.
    Mr. Sherman. Thank you.
    I would point out that the little ``u'' issued by the rabbi 
who is paid--compensated--by the people who put the cookies in 
the box could claim a conflict of interest, but the rabbi has 
to answer to a higher power. Then again, so do you. In addition 
to Wall Street, you have to answer to the tort system, and 
while some have argued that God is dead, the rock is only in 
jail.
    So let us say: You guys get paid--what?--about one or two 
basis points? On average, what is the fee that you charge for 
rating them? How many basis points?
    Mr. Mathis. I would like them to answer, but it is a little 
higher than--
    Mr. Sherman. Okay. How many basis points? Can you give me 
an answer quickly on average?
    Mr. Kanef. I can give you a rough dollar. Very, very 
roughly for all of RMBS--so it would include prime and subprime 
both--it is, roughly, $130,000 per rating, sir.
    Mr. Sherman. Per rating. You are rating how large a pool?
    Mr. Kanef. That would be for a pool of anywhere from 
several hundred million to several billion dollars. That would 
be the total fee for all of the bonds issued relating to that 
pool.
    Mr. Sherman. Okay. So, of the folks who are from rating 
agencies, raise your hand if you are not currently getting sued 
as a result of what has happened with these mortgage pools over 
the last 2 months.
    For the record, no hands are going up.
    So we do have what economists call the ``moral hazard.'' 
That is you are subject to lawsuits by the investors who have 
lost money, and that is the best argument for our not changing 
the system in that there is a way to hold you folks 
accountable.
    I would like to focus--I believe Ms. Tillman was talking 
about how you have transparent standards. When you rate a pool 
of mortgages and over 5 percent of them are stated income 
mortgages, what does that do to the rating?
    Ms. Tillman. Well, basically, as we look at each 
characteristic--and as stated incomes, we understand that those 
are more risky, and so, as to each of the pools, if they have a 
certain number of stated income, they would basically have to 
have more credit protection built in that deal than if you did 
not have it, so we go through each one of these 70 different 
characteristics and estimate not only the probability of 
default because of those characteristics but the estimated 
loss.
    Mr. Sherman. Now, your modeling, was that based on stable 
real estate prices or declining real estate prices?
    Ms. Tillman. Actually, declining real estate prices.
    Mr. Sherman. Declining real estate prices.
    So you did your model for the market that we face today. So 
why are investors losing money?
    Ms. Tillman. What I said was is we based it on declining 
prices, but what I will tell you is there has been an 
unprecedented housing decline since the late 1960's, and we 
have already published--
    Mr. Sherman. Unprecedented in housing declines?
    Ms. Tillman. In prices.
    Mr. Sherman. Prices. A price decline.
    Ms. Tillman. Price declines, and we publicly stated that--
    Mr. Sherman. Well, since you faced an absolutely 
unprecedented, in-over-a-century increase, didn't you model for 
the possibility that you would have an unprecedented decrease? 
That which goes up, up, up real high goes down real, real low?
    Ms. Tillman. Well, sir, we used both external and internal 
economic data that we have received like everybody else 
receives about the housing market, and if the housing market 
were going to be, you know, growing, whether it was going to be 
declining 8 percent or 5 percent, we would stress it even more 
than that, so we were extremely conservative, but obviously the 
declines happened a lot faster. In fact, in 2006--and we are 
talking about the 2006 loans--we started downgrading these 
loans only 6 months after these loans were originated. I mean 
that is an unprecedented quickness in downgrade.
    Mr. Sherman. You would think that you would have been--Mr. 
Mathis, I see you have something to say.
    Mr. Mathis. Well, I think that is remarkable. Did things 
change so much in that 6 months? We have housing prices now 
that have been more under pressure in the more recent period, 
but until the end of 2006, housing prices were going up; they 
just started to move down. Unfortunately, I think the right 
word is they just started to go down.
    Ms. Tillman. Yes, but that is not the only thing we look 
at. We look at 69 other things, sir.
    Mr. Mathis. Well--but you were saying it was unprecedented. 
You were saying it was unprecedented.
    Ms. Tillman. Well, it was.
    Mr. Mathis. The ``unprecedented'' only just started when 
you were doing those ratings, and what was going on is you were 
putting into your models, in your original models 6 months 
before, that housing prices would go up at the same rate they 
have been going.
    Ms. Tillman. No, sir. I said that they were going down.
    Mr. Sherman. If I can reclaim my time--and I know you folks 
could have the hearing without us up here. As a matter of fact, 
we are about to vote. You folks are welcome, with the 
chairman's permission, to continue without us.
    I am just flabbergasted that you folks would allow any 
stated income or teaser rate loans at all into something that 
you would rate as investment grade, and I know you have models, 
but those models have failed.
    Secondly, if you look at the value of houses as a percent 
of GDP and inflation adjusted for the last 100 years, etc., 
every single chart shows unprecedented increases over the last 
5 years. I would like to see models. I do not know if Mr. 
Marshall has--I want to be quiet just in case you have 
something--
    Chairman Kanjorski. Well, we will break now, Mr. Sherman.
    This is a great panel. Myself, I would just suggest that we 
come back. We have about a 40-minute vote on the Floor.
    Would that terribly inconvenience the panel if we kept you 
waiting for 40 minutes before we get back or would you like to 
conclude it now? Mr. Marshall has not had a chance, and he has 
been a soldier here all day, waiting.
    Mr. Marshall. Mr. Chairman.
    Chairman Kanjorski. Yes.
    Mr. Marshall. It is me.
    Chairman Kanjorski. Yes.
    Mr. Marshall. I have spent a lot of time preparing for 
this. The written testimony is something I have not had an 
opportunity to read. It is very thorough. It seems to me that 
we ought to ask them to stay.
    Chairman Kanjorski. All right.
    Mr. Marshall. If there are not too many people here, let us 
go ahead and have more of a conversation amongst you so that we 
can better understand. If I had all of the knowledge that each 
of you has, I would be better able to question each one of you 
about your positions, and given a little bit of time here, I 
suspect that we can clear up, maybe, this dispute between Mr. 
Bass, Dr. Mason, and the two representatives of the industry. I 
think that is a pretty important dispute.
    Chairman Kanjorski. Is there any objection to staying on 
and taking a break now? We will be back. We will even try and 
get you coffee if you would like. You all go and have a drink.
    With that in mind, we have about 2 minutes to get to the 
vote. The subcommittee will stand in recess until we reassemble 
after the last vote on the Floor in approximately 30 to 40 
minutes.
    [Recess]
    Chairman Kanjorski. The committee will come to order.
    I will now hear from Mr. Marshall from Georgia.
    Mr. Marshall. Thank you, Mr. Chairman. Since it is just you 
and me, I would invite you to chime in, as you have questions 
to follow up on.
    I am hoping that I can get a little bit more conversation 
among the panelists. And if it winds up being feisty, that is 
fine with me.
    Mr. Bass, I think you started it off with your suggestion 
concerning rerating and said something to the effect that the 
industry was not going to regain its credibility until it does 
that. And while you were saying that, Mr. Kanef sort of stood 
up, turned around and talked to somebody behind him.
    And as I understand it now, your contention, Mr. Kanef, I 
guess the industry's contention, is that there is rerating. But 
then Mr. Bass would say that is only with regard to those 
issues that they actually check that have previously been 
rated, and that there is not a wholesale going back and 
rerating when the industry is aware of the fact that some of 
the fundamental assumptions that it made were either wrong at 
the time or are no longer valid.
    And I assume you are referring to, not the list of 70, the 
ones that would be particular to that particular issue, but, of 
those 70, the ones that are global and apply to all of these 
investments. And so, could you just go ahead, quickly tell us 
what are the global ones, assumptions concerning market 
conditions?
    Mr. Bass. Sure. My contention is when you look at the 70 
inputs, in my opinion, it boils down to two. And we are just 
going to talk on a larger scale here. The home price 
appreciation assumption built into their models is the single 
most important input in the model, in my personal opinion.
    Mr. Marshall. Now, could I ask you this: In your view, that 
home price appreciation assumption is not one that varies from 
issue to issue or rating, group.
    Mr. Bass. Right. At any one point in time, whatever their 
opinion of home prices is. In 2005--
    Mr. Marshall. You apply it across everything that they are 
rating.
    Mr. Bass. In 2006, let's say it was significantly positive, 
meaning they set it for the rest of 2006, 2007, 2008, and 2009. 
They model in assumptions as to how much home prices will be 
going up. And then they factor that into their model to figure 
out how the models should be rated, how every class of security 
should be rated.
    Mr. Marshall. And what weight would you assume they put on 
that?
    Mr. Bass. In 2006, I think it was around 6 percent.
    Mr. Marshall. Six percent.
    Mr. Bass. They won't tell you exactly--
    Mr. Marshall. No, no. I asked weight. Of all the factors 
they are taking into account, what weight would you say that--
    Mr. Bass. I would say it is more than half.
    Mr. Marshall. More than half of the weight in making the 
evaluation.
    Mr. Bass. And it is more complicated than that, because the 
way they get there is--and I will let them speak--
    Mr. Marshall. I just want to make sure that everybody 
understands what you are saying they should be doing.
    Mr. Bass. The point I am trying to make is whenever they 
rate a securitization, they have an HPA, home price 
appreciation assumption, built in.
    On October 4, 2006, Moody's chief economist, or Moody's 
economy.com's chief economist, Mark Zandi, did a detailed 
report on every metropolitan statistical area in the country on 
what he thought home prices were going to do, and it differed 
markedly from their expectations they were building into their 
models from securitization. It was significantly lower, and 
their models were saying significantly higher. They started 
implementing his recommendations on where he thought home 
prices were going some time in mid-2007, and, you know, they 
can speak to exactly when they implemented that.
    My point being that if your home price assumption goes from 
up-6 to down-2, there is an exponential change that happens in 
the securitization. It is not a linear change. It is massively 
sensitive to that assumption.
    So, in 2007, when they started putting negative home price 
assumptions into their models, they didn't put the negative 
assumption in the 2006 models and see where those securities 
should be rerated. What they are doing in 2006 is they have 
surveillance teams and their surveillance teams look for 
outliers on how bad things are performing.
    And, you know, Mr. Kanef and I talked afterwards; they did 
up some of the loss assumptions in the pool--
    Mr. Marshall. Could I ask--let me interrupt here. I think I 
get your point. I think everybody does at this point.
    It is just an observation that if one person in Moody's, 
somebody who is probably pretty sharp, no doubt about it, 
thinks that things are going south doesn't necessarily mean 
that the entire team does. It might take the team some time to 
get there. So that might defend the fact that they didn't 
simply adopt in October of last year that the--
    Mr. Bass. Yes.
    Mr. Marshall. Are there people out there who are hedging, 
who are going short, on the assumption that, if there is a 
rerating that is across the market, they are going to make a 
fortune? If you are successful in persuading Moody's to do what 
you would like, is a whole bunch of money going to change 
hands, the derivatives that people are betting?
    Mr. Bass. We are in the marketplace. We own securities and 
we bet against securities. We do both in the mortgage 
marketplace.
    Mr. Marshall. Right.
    Mr. Bass. We were very lucky to have identified this 
problem in the beginning of 2006. We didn't believe their 
ratings, and we met with them--
    Mr. Marshall. Let me ask you, if they rerated as you 
request, what happens to your portfolio?
    Mr. Bass. Well, clearly--
    Mr. Marshall. You would make a bunch of money?
    Mr. Bass. Absolutely.
    Mr. Marshall. Okay. Now, back to Moody's. Why shouldn't you 
do what they are requesting? I mean, if, in fact, you have in 
the rating, whatever you call it, a model that you use, factors 
such as price appreciation assumptions that apply across the 
board, and you just uniformly do them, why not just, as soon as 
you come up with a change, why not go ahead and plug that into 
your rating for all these different things? If you have a 
computer, it is all set up; it can't be that much work to do. 
And then you quickly notify those who are holding those 
instruments that they have been rerated, that they are not--you 
know, from AAA they have gone to whatever they have gone to. I 
guess that is bad news for the people who are caught holding 
them. It at least warns those investors that they might get 
passed to that, in fact, these are no longer a AAA.
    In other words, you are doing a great service for the 
industry, in a sense, by rating these things as rapidly as 
possible, either going up, going down. And if you have the 
ability to do it across the board, just do it across the board.
    Mr. Kanef. Congressman, there are really two components to 
the surveillance process for an existing transaction.
    One process is looking at the performance of the pool to 
date. And the performance of the individual loans within the 
pool over a period of time, the seasoning of those loans, can 
be a very important factor and a predictive factor of the 
performance of the pool as a whole.
    Then there is also the fact that you need to think about 
the change in the environment and how that might have changed 
your original assumptions.
    At Moody's, we have done both things. And so we have, in 
fact, changed our original assumptions to reflect the fact that 
the deals we are rating on a going-forward basis are looking at 
new assumptions. So we have, in fact, looked back and changed 
our expectations based upon the new assumptions. But we also 
have considered the performance of the pool to date and the 
seasoning and predictability of that information in the 
ratings.
    Mr. Marshall. Mr. Bass?
    Mr. Bass. Yes?
    Mr. Marshall. Can you come back to that?
    Mr. Bass. The point I am trying to make is, when you change 
an assumption as important as any assumption that you apply on 
your deals going forward, it just makes sense to me and it 
makes sense to the rest of the marketplace to restore 
credibility in the ratings. If you plug in the new assumptions 
into your 2006 models, the deals would look completely 
different than you originally rated them. We have had 
exponential changes in these numbers.
    Mr. Marshall. Well, back to Mr. Kanef, you are not 
interested in doing what he is suggesting because?
    Mr. Kanef. Sir, we have made significant rating changes.
    Mr. Marshall. But he is suggesting a much broader--I think 
I understand, though I am not that familiar with your industry, 
but he is suggesting that a much broader brush be used here. I 
mean, as you get this information, you hit the computer button 
that says ``all.''
    Mr. Kanef. That is correct, sir. And there are many people 
who place bets both positive and negative on the way in which 
these securities move. It is our job to provide our best 
possible forward-looking opinion as to the credit strength of 
each and every security that we rate, by not only applying the 
past information we have, but also the updated information. And 
that includes--
    Mr. Marshall. I am sorry. If you are answering my question, 
I can't really follow the answer. I think the question was, why 
don't you do as he suggests? What is the objection to doing 
this?
    Mr. Kanef. The performance of the pool itself of each of 
the loans--so if a pool was originated in January of 2006, for 
example, the performance of that pool over the past 18, 20 
months of time is an extremely important predictor of how that 
pool will continue to perform on a going-forward basis.
    Mr. Marshall. So you are saying that if you simply 
applied--price appreciation assumptions have changed, and so 
consequently we are going to go back to the model that we used 
in January of 2006 with regard to that particular pool, plug in 
the new price appreciation assumption, see what the rating 
would be, and then notify everybody that the new rating is B 
instead of AAA, that would not be the right thing to do, you 
say, because the 18 months of history is a better predictor of 
the likely future performance? And, in fact, it would be 
misleading not to take into account that 18 months of history 
and various other things, is that what you are saying?
    Mr. Kanef. That is correct, sir. It is also an important 
predictor.
    Mr. Marshall. Mr. Bass?
    Mr. Bass. You can go back and look at how the 
securitization has performed to date. On the 25th day of every 
month, you see exactly what is happening in the securitization. 
You see what the cumulative loss and delinquency numbers are.
    And all I am saying is we have had an exponential change in 
home price assumptions. And the ratings agency have a business 
disincentive to cut ratings.
    Mr. Marshall. What is the business disincentive to cut 
ratings now?
    Mr. Bass. It will upset the entire--
    Mr. Marshall. I mean, initially I could see that there 
would be a business disincentive to give bad ratings, because 
then that would dampen the entire sector and there wouldn't be 
as many issuances and consequently not as many future ratings.
    And they say, and I accept them at face value, that is not 
what drives them. But then others would say that is kind of odd 
if that is not a significant factor in your decisionmaking.
    Mr. Bass. Right. When you look at what they have cut to 
date in just the RMBS marketplace, in general--and, again, you 
have to make general comments here, because every deal is a 
little bit different--but the deals that they have cut to date 
have been mostly below the investment grade line. They have cut 
the BB's to B's. The all-important investment grade line, when 
you start cutting the BBB- and BBB bonds--and this gets into 
what I said in my oral remarks to lead off today.
    I keep getting back to this mezzanine CDO. And I know I am 
digressing from your question, but I think this is a really 
important point that I am not sure everybody understands what 
is going on here. A mezzanine CDO, when you have a 
securitization, you have a traditional securitization that we 
have been discussing all of today that has AAA all the way down 
to collateralization. The investment grade piece just above the 
investment grade line is considered mezzanine. That is about 4 
percent of the capital structure of these deals.
    These mezzanine CDOs collected all of those mezzanine 
tranches--so the riskiest tranches of subprime debt--they took 
all of those tranches, packaged them up, levered it 20 times, 
and 80 percent of that structure is AAA. They can't defend 
themselves that that was a great structure. That structure, in 
itself, is flawed, regardless of your opinion of HBA.
    Chairman Kanjorski. These buyers are pretty sophisticated, 
are they not?
    Mr. Bass. The buyers of those assets--the reason the 
mezzanine CDO business came about--and I have met with the 
heads of structured products marketing of some of the biggest 
securities firms in the world, so this comes from them. The 
reason that those mez CDOs ever came about was that no one in 
the United States, from 2003 on, the real money buyers in the 
United States wouldn't buy those bonds. They were too risky for 
them. So Wall Street had to figure out a way to package up the 
risk opaquely. With the aid of the ratings agencies, were able 
to magically rerate 80 percent of those bonds AAA, and then 
they sold them to Asia and Central Europe.
    Chairman Kanjorski. Okay. So we peddled that product to 
Asia and Central Europe.
    Mr. Bass. It was a way to get all the risk off the book.
    Chairman Kanjorski. Even when they perfumed it, it did not 
sell.
    Mr. Bass. Correct.
    Mr. Marshall. How are they making money right now by not 
dropping the ratings?
    Mr. Bass. And this goes to--
    Mr. Marshall. It seems to me they are probably not doing a 
lot of ratings of these things because these things don't sell 
right now. There is a future market for them--
    Mr. Bass. Now, all of a sudden, people realize what is in 
there.
    But to Mr. Mathis's point earlier--and when you ask about 
the size of the problem, it is not the dollars that we are 
talking about here; it is the loss of faith in the ratings 
agencies, because AAA is not AAA anymore. They bestowed 80 
percent of that particular securitizations ratings AAA. AAA, I 
mean, that implies it is a U.S. Government bond. Right? AAA is 
the lowest--
    Chairman Kanjorski. Did they lose faith in the United 
States, or did they lose faith in the ratings agencies, the 
Asian and European buyers?
    Mr. Bass. Basically, what you are seeing with the ABCP 
markets freezing, the commercial paper markets, to Mr. Mathis's 
point, the reason they are failing is, all of a sudden, people 
aren't buying AAA because it is AAA anymore; they realize that 
it is not what it was cracked up to be.
    Mr. Marshall. It might not be.
    Mr. Bass. Right. So that is the crisis that the United 
States and the world is facing today. And the reason that is--
it is not just because of subprime. Subprime was the spark that 
set it off.
    Mr. Marshall. Do you suppose that the rating agencies here 
going back and rerating, in a sense, with the new assumptions, 
all of the issues that have been made so far, would enhance our 
credibility? Wouldn't it just be more extremely bad news? If 
you are worried about somehow globally sending bad news, 
wouldn't we, in fact, be sending really bad news if they did 
that?
    Mr. Bass. Would we rather sit here and let the opacity 
continue and take the pain over time, or would you rather take 
the pain all at once and try to restore credibility? I will ask 
you the question. How would you handle it?
    Mr. Marshall. I get to ask the questions, by the way. That 
is the way it works.
    Mr. Bass. I'm sorry about that.
    Mr. Marshall. I have nowhere near your expertise. Part of 
me asking questions is to try to get some information here. You 
don't need information from me. I am not going to tell you 
anything you don't know.
    So it seems to me, though, that your central argument is 
that somehow we would restore credibility by doing this. And 
now what you are saying is that, well, you can either dribble 
out the loss of credibility or you can have it all right now, 
but it is going to be a loss of credibility either way.
    Mr. Bass. Correct.
    Chairman Kanjorski. Well, has anybody estimated faced this 
issue right square? Has anybody figured out what the actual 
loss is out there? Is there some way you can total up what that 
loss would be?
    I get all these weird figures. And generally they are in 
the range of $150 billion to $200 billion.
    Mr. Bass. I think that loss figure is directly related to 
just subprime cumulative losses. When you get into the 
structured finance markets, the synthetic markets for CDOs, I 
haven't found anyone to give me a hard number, but I will tell 
you--
    Mr. Marshall. Dr. Mason is going to offer some. That is 
what academics do. They sort of think about things like this.
    Mr. Mason. I just want to--I am going to be straight. I 
can't give a dead-on number, but I can give some perspective on 
these situations that we have faced, before because this is 
nothing new.
    We started the thrift crisis with about $10 billion of 
losses that the FSLIC could have absorbed.
    Chairman Kanjorski. $10 billion to $15 billion.
    Mr. Mason. And we ran that up to about $100 billion.
    Chairman Kanjorski. $150 billion.
    Mr. Mason. By allowing the losses to dribble out, as it 
were, is to forebear on the closures.
    Chairman Kanjorski. Now, all we did was we contaminated 
good organizations with bad assets. And ultimately those assets 
failed and dragged down the good organizations, so that we had 
to have a bail-out. We call that supervisory goodwill or 
something.
    Mr. Mason. Which the lawsuits are still going on.
    Chairman Kanjorski. See, our big problem, Doctor, is that 
there are only three or four of us left up here who remember 
that crisis. So we like to relive history so these youngsters 
down here can--
    Mr. Marshall. I wish I was as young as he is; all of us 
were studying exactly this problem back then.
    Chairman Kanjorski. Here is what I am worried about. I am 
going to jump in, and you jump into this thing, too.
    I am not one of these people who are saying we ought to 
uncap the ceiling for Fannie Mae and Freddie Mac so they can go 
in and buy these things up and do a quasi-rescue, like in 1989 
in the S&L crisis, because that is really what it would be. And 
we would be taking two fairly decent organizations and 
encouraging them to create much greater equity risk out there 
that does not cover these bad obligations they would be buying 
in. And then the temptation politically is to do it, because if 
you can make 3 years and we do not have a recession or if the 
real estate bubble is not as bad as it could be, we will make 
it out, and nobody will know the difference. And we will have 
just made a tremendous recovery, and everybody will say how 
brilliant the Administration and the Congress was, and 
particularly the regulators.
    On the other hand, if we get into a 20 or 30 percent 
depreciation in real estate in the hot markets of California, 
Florida, Texas, Virginia--which, to my way of thinking, it 
looks to me like it may be moving in that direction--and you 
tap on a recession over the next year to 18 months, then all 
hell is going to break loose, and we are going to go into a 
meltdown. But in order to fix that, it would seem to me, using 
the mathematics of the S&L, would cost several trillion 
dollars, which we do not have. And I don't know anybody in Asia 
who is going to dig in their pockets and give it to us. So 
currency, as weak as it is today, will look terribly strong 
when everybody bails out of American currency. And, literally, 
we could collapse the whole world system.
    I do not particularly like that scenario or that risk 
factor. And I think it is sufficiently high enough that we have 
to protect the Fannie Maes and Freddie Macs and others that 
would come to their rescue from themselves and from the 
politicians, which is probably the most important thing. And 
then, we just have to find another vehicle to address this 
issue and try and straighten it out without constructing an 
RTC, which would come later on if that is the only thing left 
as a last resort. But there are other things here. I mean, we 
can make a couple more tranches, can't we?
    Mr. Mason. Oddly enough, that is something that was done in 
the U.K. recently.
    Chairman Kanjorski. No, I think if we get some tranches 
that are paying 35 or 40 percent, like credit card interest, we 
will find somebody in the world who will buy them.
    Mr. Sherman. Mr. Chairman, if I can interject on your idea, 
I don't think we should let Fannie and Freddie take unwarranted 
risks. I hope we can rely on OFHEO to make sure that doesn't 
happen.
    Chairman Kanjorski. No, they are on their way there now. 
The recommendations are to lift the portfolio restrictions.
    Mr. Sherman. I could think that portfolio restrictions 
could be lifted--I may differ a bit from you--if they are not 
overpaying or taking excessive risks. I think we originally set 
those portfolio limits in part because other competitors in the 
market didn't want to face too much competition.
    If it is just banks screaming that they don't like the 
competition, or the securities industry screaming they don't 
want the competition, that is one thing. If, on the other hand, 
you are right and what Fannie and Freddie have planned is a 
risk to the solvency of those institutions--
    Chairman Kanjorski. Well, unless they are going to do some 
new offerings for equity, it seems to me if they go into the 
marketplace to get more capital to buy these securities they 
are thinning out their equity support system.
    Mr. Sherman. If they sell more stock, then they will have 
more equity to--
    Chairman Kanjorski. I do not hear that is their intention; 
now, of course, I am not sitting on their board.
    But I look at what everybody is talking about in town, and 
I do not want to attribute this to Fannie and Freddie. I think 
they are standing there saying, ``Can we be helpful, and what 
can we do?'' I think many of us in government, whether it is in 
the Congress or the Administration, do not want to face a bad 
situation now, and would rather cover it up.
    A government-sponsored enterprise is going to try and 
appeal to take care of us. They are a dangerous 
instrumentality, from that standpoint. There is a very close 
relationship between the government, so we force them to live 
with us, in a way. They know that; they are very conscious of 
it. So they are going to try and create an S&L bail-out of some 
sort of the first order that we had, and I think it is going to 
be very dangerous. Now, I do not want to suggest that is going 
to happen. I am just trying to send a message, ``Do not even 
think about it happening.''
    But along that line, I would like to get to some--Deborah 
Pryce mentioned it before she left. You know, we really should 
talk about--obviously, we have here a wealth of intelligence, 
of thought process. And I may have given the impression earlier 
on that I was going to use some old tacks and crosses on the 
rating agencies. I do not want to impart that to you. I will 
fight to my damnedest to hope we can get you all back to 
resuscitation so that you are believed. I would have a hard 
time believing--I mean, maybe I am harsh that way. Fool me 
once, shame on you. Fool me twice, boy, I am never coming to 
your house to eat again. It is just not worth taking the 
chance.
    And I think that is where the rating agencies, for whatever 
reason that you did not go back, whatever reason that you say 
you wrote all these learned articles that nobody read, or all 
the whistles that you blew that nobody listened to, now it is 
absolutely incumbent upon the rating agencies to be part of the 
recommenders of what we do.
    And my recommendation, if nothing else, is that you should 
live up here and camp out with us and get the best academics in 
the world to help us out of this maze and to get it done and 
get it done quickly. Because I think, we are not going to know 
about the real estate for another 18 months or so.
    That is a question I wanted to ask you, on the real estate 
question. When you do these 70 questions to set up these pools, 
one of the significant questions would be where this mortgage 
is issued, what state, what county?
    Ms. Tillman. Absolutely, yes.
    Chairman Kanjorski. So how do you take into consideration, 
for instance, the California principle that you just hand your 
keys in and that forgives the mortgage obligation, as opposed 
to Pennsylvania, that we not only have a mortgage on the 
property, we have a judgment note on all your assets? You know, 
a Pennsylvania mortgage is a lot more secure than a California 
mortgage. So how do you rate that?
    Mr. Sherman. Mr. Chairman, I resemble that remark.
    Ms. Tillman. Well, we certainly look for geographic 
dispersion, because, obviously, if a pool is concentrated into 
one specific area, it is probably going to be more risky. 
Because if something happens, obviously, in the California 
market, it is going to impact everything exponentially across 
the board. And we do take into consideration the different loan 
characteristics and what the underwriting practices and 
practices are in each of the States.
    But you still are getting a pool, and they are generally 
dispersed, and, again, dispersing the risk. And we look at them 
and then assign an appropriate probability of default to each 
of the characteristics and the expected loss on each of those. 
And when we look at it, depending on what kind of tranche it 
is, there is certain overcollateralization--
    Chairman Kanjorski. I am going to stop you right there. I 
want you to give me your honest answer, not as an employee of 
Standard & Poor's. I am not suggesting it was not an honest 
answer you were giving, but your gut answer. If you had an 
opportunity to do something different than you did, would you? 
And what would that be?
    Ms. Tillman. Well, I think that we would look for more 
quality information than potentially that we are getting right 
now. Because it has just proven not necessarily to be as 
reliable as it has in the past. And just really push for--
    Chairman Kanjorski. Why would you suggest--when I take the 
string of 8 or 12 people who are involved in this transaction, 
even down to the last guy recommending to the pension fund that 
they buy this particular security, they are all making money on 
the deal and they have no skin in the game and they are out of 
the deal in a moment. Why wouldn't you question the motives and 
the activities and the judgments of every person in that line, 
and how could you do that?
    Ms. Tillman. Well, one of the things that we are doing, and 
it probably didn't get out here, is that we do look at the 
originators and the servicers in the mortgage market. And what 
we have started to do is really look very heavily on what fraud 
protection-types of policies that these originators have in 
place. Because I think I said earlier the--
    Chairman Kanjorski. Okay. Let us stop right there. I have 
been involved in this subprime problem for about 5 or 6 years 
now. It is a big, big huge problem. You practically never find 
a fraud situation unless you find a fraudulent appraiser. You 
have to have a bad appraiser to go along with the deal. Didn't 
you all know that?
    Ms. Tillman. Well, we do take into consideration--we work 
into every deal that we do on RMBS a certain amount of fraud, 
because it is known in the mortgage field that it takes place.
    Chairman Kanjorski. Well, but I do not mean prosecutable 
fraud or prosecuted fraud.
    Ms. Tillman. Fraud in the sense that the information that 
we are getting may not be the type of information or 
characteristics that you would assume. And that is what I said. 
Like the FICO scores that we looked at, the high FICO scores in 
2006 are actually behaving like very low FICO scores in 2004 
and 2005.
    Chairman Kanjorski. Yes, because they have been 
restructured and fixed.
    Ms. Tillman. Well, exactly.
    Chairman Kanjorski. But you all watch television, you see 
who you can call to fix your FICO score. I mean, that does not 
take a penetrating mind, does it?
    Ms. Tillman. Well, it is one of the things we are currently 
really looking into now. But that occurrence just didn't happen 
in the past.
    Mr. Mason. Mr. Chairman?
    Chairman Kanjorski. Let us get Dr. Mason in there.
    Mr. Mason. I just want to say that I am sympathetic to what 
the ratings agencies' representatives are saying at this point. 
That, at a certain point, yes, there are things that can be 
fixed in the ratings end of the industry. But the problems that 
we face today had fraudulent borrowers, in some cases, 
fraudulent brokers, fraudulent appraisers, fraudulent 
underwriters, all the way up through the chain.
    And from my days with the bank supervisors, if somebody is 
going to commit fraud, they are going to try to cover it up as 
much as possible. And, yes, it will eventually spill out, and 
it is really going to mess up your model if you have a 
statistical model that you are running. And that is part of 
what we have seen.
    For these data feeds that the agencies rely upon for the 
review in the monthly performance, those are coming from 
servicers. And the servicers are sometimes related to the same 
firm that originated the loan, sometimes not. They are a whole 
other source of the problem here. One of the incentives they 
often hold is a residual, a bottom first loss stake in the 
securitized pool. They want to maximize the value of that 
residual.
    And one way of doing that is keeping as many of the 
borrowers paying as possible. Because, in fact, if the 
borrowers don't pay, the servicer has to act as if they are 
paying and pass the money on to the note holder. So there are 
dire implications for the servicer in the amount of default and 
every reason to try to keep loans out of default by hook or by 
crook.
    And one of the key elements that needs to be looked at here 
is the process of modification and what is called re-aging, the 
process by which you determine that a loan, after it has been 
defaulted for a while, is good again. Some servicing firms are 
very aggressive at re-aging. They will even lower your payment 
to get you to make one on-time payment so that we can call you 
good again and we can take you out of the default category and 
call you a good, on-time loan. But the loan is not going to 
stay there; it is going to redefault. But the servicer reports 
back to the ratings agency that this loan is good, this is 
performing, we received the payments on time, everybody is 
happy. And then you see the deal go along beautifully for a 
while and then drop off a cliff.
    And we have seen a lot of--
    Mr. Marshall. Mr. Chairman?
    Mr. Mason. --inappropriate behavior in the industry.
    Mr. Marshall. Mr. Chairman, may I?
    Chairman Kanjorski. Yes.
    Mr. Marshall. Mr. Kanef--and I kind of did this to you, and 
I almost feel badly about it. Okay, so your reason for not 
going back and rerating in light of this new information is 
that it would be misleading, potentially, because of the fact 
that there has been a history, an 18-month history, a 2-year 
history, something like that, depending upon the issue 
obviously, and that is probably better evidence of what the 
lack of future performance is going to be than going back and 
trying to refigure out what we should have said back in 2006.
    And so, I guess that prompts a question. Do you randomly 
check--you know, you do do some revisiting of the expected 
performance, with regard to certain issues. You sort of track 
them, and that is that rear-view mirror stuff that Mr. Bass was 
talking about, correct?
    Mr. Kanef. Yes. If--
    Mr. Marshall. Is that done randomly?
    Mr. Kanef. If I could be clear--because this is something 
that I perhaps didn't answer as clearly as I should have--what 
we really have between Mr. Bass and myself is a difference of 
opinion of the way in which the ratings should be surveilled or 
reviewed.
    We review every single rating that we have on an RMBS 
transaction every month. So every single transaction, the past 
performance of that transaction is reviewed every month. And, 
in addition, we do also consider the changes that have been 
made to deals that need to be rated on a going-forward.
    But we don't rely 100 percent on the new information, 
because the performance information of the pool is also an 
important component of the way in which we continue to rate the 
outstanding transactions.
    Mr. Marshall. So you are saying you are looking at, you are 
thinking about the necessity to rerate across your entire 
portfolio every month?
    Mr. Kanef. On a monthly basis, when we get the new data on 
the performance of that transaction. We receive data once a 
month on each transaction. And, again, we do review it, each 
transaction, in our rating universe once a month when that data 
comes in.
    Mr. Marshall. It seems to me that for these mez deals that 
were batched, they are the ones, just offhand, just 
mathematically, they are the ones that are disasters as soon as 
the entire industry moves, because they, by definition, are 
that portion of the industry.
    Have you gone back and looked at all of them? Have you 
rerated all of them?
    Mr. Kanef. Yes. And we, in fact, have moved, changed the 
ratings, the initial ratings, on a number of BAA tranches 
issued out of the subprime RMBS sector in 2006. And, in fact, 
on the CDO side is the mez CDOs that Mr. Bass has referred to. 
Those are also rerated on a monthly basis.
    Mr. Marshall. Thank you.
    Mr. Sherman. Mr. Chairman?
    Chairman Kanjorski. Yes?
    Mr. Sherman. I would like to get back to the issue of what 
the economic incentives are for those in the rating industry.
    I am an old CPA auditor, and we used to say we were the 
only umpires that were paid by one of the teams. Now I realize 
we weren't alone; you folks are also paid umpires, paid by one 
of the teams.
    One thing that is obvious is, if you are in a league in 
which the pitchers pay the umpires, you don't want to get a 
reputation as the guy with the narrowest strike zone. The 
economic incentive with regard to this deal is to make sure you 
have a good reputation as a pitcher's umpire in order to get 
the next assignment. And so, you are in a situation where you 
need some reputation with investors. And, obviously, this 
recent problem has not helped any of your agencies with that.
    But up until the last few months, what you needed was at 
least an investment grade image with investors. And then with 
the issuers, if you were thought to be slightly more liberal 
but still credible with investors, you got the assignment.
    What do we need to do, or should we do anything, to change 
the economic incentives in the rating business? Should we 
require rotation? Should we have the SEC do the assigning, so 
that the pitchers don't get to pick the umpire? Or is the 
present system, combined with the reputational risk that you 
have experienced and the lawsuits risk that you have 
experienced, sufficient enough to make sure that the strike 
zone doesn't get too wide?
    Mr. Mathis?
    Mr. Mathis. On the issue of the strike zone and whatever, 
accountability comes into that play. If you are doing something 
and you have to pay--you mentioned earlier, Congressman, that 
they could be sued. Well, this is America and anybody can be 
sued. The question is, can you win a judgment? And, as you 
know, the 1975 Act basically exempted all of the NSROs.
    Mr. Sherman. ``NSRO'' standing for?
    Mr. Mathis. I am sorry, NRSROs--exempted all of them 
basically from any underwriters liability.
    In addition, the agencies have been able to win decisions 
in court saying that their opinions are free speech, and 
therefore they are not liable for any of their opinions if they 
are, in fact, wrong. And then--
    Mr. Sherman. Wait a minute. I used to be a lawyer too. If I 
told the guy that the will was valid and it turns out, from his 
heirs' standpoint, that it wasn't, I could say it was free 
speech. I mean, isn't there malpractice liability?
    Mr. Mathis. For the most part, the courts have held that 
the actions of the rating agencies are free speech and that, if 
they are later proved to be wrong, they don't have the same 
kind of liability that you do as a lawyer, as a professional.
    Mr. Sherman. Why does the First Amendment apply to the 
speech of rating agencies but not the speech of lawyers and 
doctors or accountants, for that matter, who, by the way, do 
the exact same thing? They rate the financial statements 
instead of rating the securities.
    Mr. Mathis. Well, here you have a basically government-
sponsored program, through legislation, where the people have 
been essentially exempted from accountability on a legal basis. 
And in addition--
    Chairman Kanjorski. I was going to suggest to you, we have 
Dan's father in the audience. Maybe we can get an expert 
opinion here. I could not resist saying that.
    Mr. Mathis. Can I just say one more thing? Recently, one of 
the rating agencies, in a lawsuit, cited the 2006 Act as 
something that really exempted them from liability along these 
lines.
    Mr. Sherman. So their argument is somehow they are in a 
different position than the accountants? Although the 
accountants issue an opinion, an opinion on financial 
statements, the rating agencies issue an opinion on the 
creditworthiness of the security. What legal doctrine--and, 
boy, you guys have some great lawyers.
    Mr. Kanef?
    Mr. Kanef. If I could just state that there is one 
significant difference between the opinion that is provided by 
a rating--well, there may be many, but one that I would like to 
point out is the difference between the opinion of a rating 
agency and the opinion of an accountant or perhaps a lawyer. 
And that is the opinion provided by a rating agency is a 
subject of forward-looking opinion about the likelihood that a 
default will or will not occur at some point in the future. An 
accountant is reviewing a set of financial statements that are 
factually present and that reflect a situation that has already 
occurred.
    And so, one of the large differences is simply the fact 
that--
    Mr. Sherman. I would say, if you know more about 
accounting, you realize that you have to, for example, write 
off an asset that won't be valuable in the future. When a 
company buys research results, you have to determine, are they 
going to be valuable in the future? And so, it is odd to say 
that accountants, in determining whether the financial 
statement is accurate now, don't have to have a crystal ball 
about the future.
    I realize that accountants like to give the impression that 
they are in a science and not an art, but anybody who looks at 
the individual decisions realizes the opposite. Likewise, 
lawyers give opinions all the time; I used to write tax 
opinions, saying, if you get challenged by the IRS, you are 
going to win this thing and get your tax deductions. Thank God 
the statute of limitations has expired on those.
    I mean, it is hard for me to say that everyone else--
medicine, law, accounting--is a science to which we can hold 
the practitioners accountable to a standard of due care, but 
that rating agencies are an art which is only in the eye of the 
beholder.
    Let me hear from the doctor.
    Mr. Mason. I just want to point out that I think Congress 
has acted on this part. And I am in line with the views 
espoused by the IMF in the recent Global Financial Stability 
Report, that we have a lot of regulations that have not been 
enforced by the SEC, by bank regulators, by accountants 
sometimes. One of them is the 2006 Act, which, as I understand 
it, tried to bring the industry into adherence with--and this 
is from my written testimony--the International Organization of 
Securities Commissions, or IOSCO, code of conduct, which reads 
that, ``The credit rating agency should adopt, implement and 
enforce written procedures to ensure that the opinions it 
disseminates are based on a thorough analysis of all 
information known to the CRA that is relevant to its analysis, 
according to the credit rating agency's published rating 
methodology.''
    And yet, we still have--and this is from--now, I will 
admit, my particular quote here predates--
    Mr. Sherman. Doctor, if I can interrupt you with perhaps a 
more narrowly drafted question. Is it your understanding that, 
even if a plaintiff could show negligence or even gross 
negligence, they might be unable to recover from a rating 
agency?
    Mr. Mason. Well, let me read the disclaimer that Moody's 
uses, that Moody's has no obligation to perform--it does not 
perform due diligence with respect to the accuracy of 
information it receives or obtains--
    Mr. Sherman. Well, Doctor, if I can interrupt you. We only 
hold a professional responsible for doing their own job well. 
If the X-ray is bad and the radiologist reads it correctly, you 
can't sue him for malpractice.
    Mr. Mason. Right. But--
    Mr. Sherman. The question is not whether Moody's is 
responsible for the quality of work done by others. The 
question is, if they themselves perform their role in a 
negligent manner, are they subject to liability?
    Mr. Mason. But Moody's does not undertake to determine that 
any information that they use is complete.
    Mr. Sherman. What was that again?
    Mr. Mason. They don't even try to see if the information is 
complete. They just--
    Mr. Marshall. Will the gentleman yield?
    Mr. Sherman. I yield to the gentleman.
    Mr. Marshall. Let me, instead of stating it abstractly, 
bring it back to what we are talking about here. And if this 
particular mezzanine tranche is the one that is the problem, I 
suppose the contention would be that the raters, in buying the 
pitch that this should be listed--that any segment of this 
should be listed AAA, were grossly negligent in not taking into 
account what would inevitably, anybody looking at this would 
conclude inevitably, happen if the economy turned south on 
housing, that this was what was going--they were not AAA. 
Nobody in good faith could rate these things AAA.
    So, suppose that is the contention. Suppose reasonable 
people listened to it and conclude, ``You are right; they were 
utterly incompetent in concluding that that 80 percent could be 
listed AAA. It doesn't meet any standard of expertise in the 
industry.'' Let us assume that is the case. Are you saying that 
there is no recovery?
    Mr. Mason. That appears to be the treatment from the 
courts, that there is no recourse to the ratings agency.
    Mr. Marshall. Do you agree--
    Chairman Kanjorski. Based on constitutional law, First 
Amendment rights, or based on some failure to put a regulation 
in effect or pass a statute? I mean, are they barred? Is there 
no way we can make them responsible?
    Mr. Mason. Now, I am an economist, not an attorney, but it 
is my understanding that it is based upon First Amendment 
rights, that this is merely an opinion.
    But my assertion stands that when we begin to base ERISA or 
pension fund legislation on a BBB cutoff, this is more than--
    Mr. Sherman. If I can just interject. All accountants ever 
do is express an opinion on financial statements. I am 
flabbergasted to hear that medical opinions, legal opinions, 
and accounting opinions are all subject to malpractice and 
rating agencies aren't.
    Mr. Marshall. I doubt this happened in this case. I mean, 
it is entirely possible that they were pretty negligent in 
assessing this.
    But let us take it one step further, and let us assume that 
there was intentional fraud here. Let us assume, it is just 
hypothetical, that the rating agency, tempted by fees that were 
going to be earned as a result of being able to pass all these 
things, went ahead and said, it is a lot of give and take, back 
and forth, ``Okay, we will rate this 80 percent of these 
things, we will rate them at AAA; we will do what you want to 
do.'' And some jury concludes that that is just flat-out fraud. 
They knew at the time they were doing it that these weren't 
AAA, and they did it just to get some money. Is there no 
recovery there?
    Mr. Mason. I have seen--I think if you could find printed 
evidence that parties were colluding beyond tacit collusion, 
explicit collusion--of course, again, I am not an attorney--but 
it appears that there have been occasional cases where the 
First Amendment protection has been breached. The one that I 
know of, in particular, is where the agency was found to be 
actively guiding the structure of the securitization, 
recommending that, in particular, 80 percent be AAA and 
actually providing--
    Mr. Marshall. Some of the ratings given earlier, the 
derivatives, were just stunning, how bad they were.
    Mr. Mason. Well, another point of regulatory bite here that 
I think is very important to your original question about CDOs 
is that CDOs are often built with contractual triggers that are 
only enacted upon a ratings decision. So that if the ratings 
decisions on what I would call the primary structured finance 
instruments, the residential mortgage-backed securities are 
delayed, then the terms in the CDOs that would be enacted by 
those downgrades don't get triggered, and we don't get a 
revaluation of the CDO, nor do we get even a clean-up or an 
investor recourse action so the investors can get out of the 
non-performing CDO.
    So, to me, this presents another regulatory responsibility 
of the ratings agencies to act in a timely and complete manner 
and to continue to rerate regularly and completely.
    Now, I am going to say that, the way the industry is 
currently built, they are not paid to do that. And I think that 
is a shortcoming of the way the industry developed.
    Mr. Marshall. Before they get paid to do that, what does 
the industry have to say in response to the doctor's 
observation, Dr. Mason's observation about responsibility here, 
rerating responsibility? Ms. Tillman? Mr. Kanef?
    Mr. Kanef. I think, as a representative of Moody's, I will 
tell you that Moody's believes it has a responsibility to 
review the data that we receive every month. Calling it rerate 
or review is, I think, beside the point. What we do--and we 
have a separate team that is made up of analysts and chaired by 
a chief credit officer, and that team reviews the updated 
information we have that relates to each of the outstanding 
securitizations that we rate each month. And it is a 
responsibility that we take very seriously.
    Mr. Marshall. Suppose you just decided to take Mr. Bass's 
advice, and you got very aggressive, and then you are reviewing 
this month, you had been thinking about it for a while, and you 
said, ``Okay, we are going to rerate, I am going to rerate just 
about everything here, and I am going to drop it all.'' What 
effects on Moody's--
    Mr. Kanef. I think that we have a responsibility to, based 
upon the approach that we are using, to make certain that we 
are providing our best possible opinion to the market. And I 
believe that we take that responsibility seriously. If the 
approach that we use in rating suggested that we needed to take 
significant additional downgrades beyond the downgrades that we 
have already taken during the past 18 months, we would do so.
    Mr. Marshall. But you do that reluctantly.
    Mr. Kanef. I would not do that reluctantly, sir. We would 
try to make certain that we had our best possible opinion on 
the future.
    Mr. Marshall. Okay, so I accept that is what drives you, 
for purposes of this question. I accept that is what drives 
you. What consequences?
    Ms. Tillman. Our reputation and what you have all been 
talking about here has been a big part of the consequence of 
what has been going on here. I mean, our reputation is 
everything. The market evaluates us every day.
    And I think that one of the things we have to recognize 
here, and you all have talked about it, you know, that somehow 
our reputation has been tarnished. And we have to be able to go 
out and explain what it is we do better to a broader audience 
to be involved with other industry associations. Because the 
bottom line is a couple of things: We only are talking about 
probability of default. We are not talking about whether this 
is a suitable investment. We are talking about a highly 
sophisticated institutional investor--
    Mr. Marshall. The problem with that observation is that, in 
fact, the probability of default goes way up if, indeed, the 
entire industry can't get any money. It is the nature of how 
all of this is structured. So the suitability--
    Ms. Tillman. But that is not around--
    Mr. Marshall. Pardon me? The suitability of the investment 
is directly related to the stability of the industry. You can't 
separate the two, in this instance.
    Ms. Tillman. We are not setting market values or market 
prices. The market does that. And there is a lot more that goes 
into--
    Mr. Marshall. But when the market price goes way down on 
these things, money drives up, refinancings don't occur, 
defaults go up. So there is a direct relationship between 
performance of the instrument that you are judging and the 
market, in this instance. Am I mistaken about that?
    Ms. Tillman. Well, I think what has happened in the 
markets, and I think one of the panel members said it, there is 
a fear factor in the markets right now. And, certainly, a more 
open, transparent marketplace is something that we absolutely 
agree with, because the fear is that people don't necessarily 
know what exactly it is that they are holding.
    And what we do is do our best to explain what is in the 
portfolios, what we are looking at. When circumstances change, 
we talk to investors, we talk to issuers. We talk about ideas 
that we have on an ongoing basis. We talk to the market. We 
have teleconferences. We go on and on and on about what our 
views are.
    And we do change. Ratings aren't static. It is supposed to 
be stable, but it can't be static when you have changing 
circumstances occurring, which is why you have a surveillance 
process. And as you, in the surveillance process, see that 
behavior is changing, sir, we change our models, we review 
everything that may be impacted by that, and we go out and we 
do what we need to do.
    And that is all I can say. I don't know how to seriously 
explain it any further than that.
    Mr. Marshall. I got you. Right. So, as you are looking, as 
you are reviewing, monthly, across the board, is there this 
feeling that, to the extent that have you to rerate, somehow 
you lose a little bit of credibility with regard to your 
original rating?
    Ms. Tillman. Actually, since our responsibility is to speak 
to the creditworthiness and probability of default, it 
absolutely is our responsibility that, if it is a weaker credit 
than we had first anticipated, that we will downgrade it. That 
is our responsibility.
    Mr. Marshall. Mr. Bass?
    Mr. Bass. I know I keep going back to this, but I think it 
is very important. When they talk about their credibility and 
the probability of default, the probability of default of a 
mezzanine CDO AAA piece is exponentially higher, you probably 
can't even calculate how much higher it is, in this structure 
than it is in a corporate structure.
    And they haven't even told us yet that they have blown it. 
The fact that they allowed that structure to be rated the way 
it was rated, it doesn't matter what their surveillance teams 
are doing. The fact that they allowed a mezzanine CDO structure 
to be launched is where they blew it, and they lost their 
credibility. Because those AAAs, some of them will be fully 
impaired, and anything below AAA will be wiped out. And that is 
the loss of credibility from the beginning, not as we rerate 
things. That is the structural problem.
    Mr. Marshall. Mr. Adelson?
    Mr. Adelson. Yes, I have to respond a second to what Mr. 
Bass is saying.
    You know, the issue of the mezzanine CDOs is a great 
illustration, and it is interesting that he is saying it now, 
you know, after the fact. You know, there were researchers, a 
number of us, myself included, but others in the research 
community, who basically took that view a long, long time ago, 
right? So it is not a surprise.
    But the rating agencies' view--where I differ with Mr. Bass 
is the rating agencies' view was not unreasonable. We had a 
different point of view. We differed from their point of view. 
Their point of view was not unreasonable. Ours was not 
unreasonable. It is a complicated problem as to which 
reasonable people can differ in making assumptions and in 
tackling the analysis.
    Mr. Marshall. Mr. Adelson, I am getting the impression that 
no reasonable person could conclude that these particular 
issues--
    Mr. Adelson. No.
    Mr. Marshall. Let me finish--that these particular issues 
would survive a substantial turndown in the housing market.
    Mr. Adelson. What they had was actually historical 
evidence--
    Mr. Marshall. Well, that was--
    Mr. Adelson. --about the correlated performance of BBBs, 
okay? Now, I would have said you look beyond the historical 
performance and you place more emphasis on what might happen, 
what you could imagine to happen--okay?--as opposed to relying 
more on the actual data, what you had observed. And you did 
have data for a pretty long time series about the performance 
of BBBs. The correlation factors that the rating agencies came 
up with, as much as I disagreed with them--right?--were not 
coming out of thin air, all right?
    I have probably criticized the rating agency correlation--
    Mr. Marshall. Mr. Adelson--
    Mr. Adelson. --more than anyone.
    Mr. Marshall. Mr. Adelson, can you rate something or should 
you rate something AAA if there is a 5 percent chance you will 
lose the entire investment?
    Mr. Adelson. I think the question--
    Mr. Marshall. Just answer that question. Can you answer 
that question?
    Mr. Adelson. I don't think I can. I think the best answer I 
could give you would be it depends on what you mean with your 
ratings.
    Mr. Marshall. Well, you were at Moody's for a long time. 
You said so yourself; you have given ratings before. So how 
would you rate that? If you thought there was a 5 percent 
chance that the entire investment would be lost entirely, gone, 
and you say--
    Mr. Adelson. Well, I would give that a very low rating.
    Mr. Marshall. Pardon me?
    Mr. Adelson. There is a 5 percent chance that you are going 
to have a 100 percent loss, so a 5 percent expected loss is 
going to be a low rating.
    Mr. Marshall. It would not be investment grade?
    Mr. Adelson. That would be below investment grade on the 
short-term horizon.
    Chairman Kanjorski. I am sorry. Thank you.
    Mr. Marshall. You guys have been very patient--we 
appreciate it--and very informative.
    Chairman Kanjorski. Panel, I want to thank you very much. I 
wish we could stay here for another hour and ask you questions. 
As a matter of fact, I hope that you will all be available if 
we want to have a future hearing. I think it would be helpful 
for the whole committee. And you can see how well-attended the 
committee hearing was today, so we know that so many people 
will miss you in the future.
    But because we have about 3 minutes to vote, and because 
you have been so kind, we are going to wrap this up.
    The Chair notes that some members may have additional 
questions for this panel which they may wish to submit in 
writing. Without objection, the hearing record will remain open 
for 30 days for members to submit written questions to these 
witnesses and to place their responses in the record.
    And, with that, this hearing is adjourned. Thank you.
    [Whereupon, at 5:55 p.m., the hearing was adjourned.]

                            A P P E N D I X



                           September 27, 2007


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