[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
U.S. GOVERNMENT PRINTING OFFICE
39-541 WASHINGTON : 2008
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092104 Mail: Stop IDCC, Washington, DC 20402�090001
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
[GRAPHIC] [TIFF OMITTED] T9541.001
[GRAPHIC] [TIFF OMITTED] T9541.002
[GRAPHIC] [TIFF OMITTED] T9541.003
[GRAPHIC] [TIFF OMITTED] T9541.004
[GRAPHIC] [TIFF OMITTED] T9541.005
[GRAPHIC] [TIFF OMITTED] T9541.006
[GRAPHIC] [TIFF OMITTED] T9541.007
[GRAPHIC] [TIFF OMITTED] T9541.008
[GRAPHIC] [TIFF OMITTED] T9541.009
[GRAPHIC] [TIFF OMITTED] T9541.010
[GRAPHIC] [TIFF OMITTED] T9541.011
[GRAPHIC] [TIFF OMITTED] T9541.012
[GRAPHIC] [TIFF OMITTED] T9541.013
[GRAPHIC] [TIFF OMITTED] T9541.014
[GRAPHIC] [TIFF OMITTED] T9541.015
[GRAPHIC] [TIFF OMITTED] T9541.016
[GRAPHIC] [TIFF OMITTED] T9541.017
[GRAPHIC] [TIFF OMITTED] T9541.018
[GRAPHIC] [TIFF OMITTED] T9541.019
[GRAPHIC] [TIFF OMITTED] T9541.020
[GRAPHIC] [TIFF OMITTED] T9541.021
[GRAPHIC] [TIFF OMITTED] T9541.022
[GRAPHIC] [TIFF OMITTED] T9541.023
[GRAPHIC] [TIFF OMITTED] T9541.024
[GRAPHIC] [TIFF OMITTED] T9541.025
[GRAPHIC] [TIFF OMITTED] T9541.026
[GRAPHIC] [TIFF OMITTED] T9541.027
[GRAPHIC] [TIFF OMITTED] T9541.028
[GRAPHIC] [TIFF OMITTED] T9541.029
[GRAPHIC] [TIFF OMITTED] T9541.030
[GRAPHIC] [TIFF OMITTED] T9541.031
[GRAPHIC] [TIFF OMITTED] T9541.032
[GRAPHIC] [TIFF OMITTED] T9541.033
[GRAPHIC] [TIFF OMITTED] T9541.034
[GRAPHIC] [TIFF OMITTED] T9541.035
[GRAPHIC] [TIFF OMITTED] T9541.036
[GRAPHIC] [TIFF OMITTED] T9541.037
[GRAPHIC] [TIFF OMITTED] T9541.038
[GRAPHIC] [TIFF OMITTED] T9541.039
[GRAPHIC] [TIFF OMITTED] T9541.040
[GRAPHIC] [TIFF OMITTED] T9541.041
[GRAPHIC] [TIFF OMITTED] T9541.042
[GRAPHIC] [TIFF OMITTED] T9541.043
[GRAPHIC] [TIFF OMITTED] T9541.044
[GRAPHIC] [TIFF OMITTED] T9541.045
[GRAPHIC] [TIFF OMITTED] T9541.046
[GRAPHIC] [TIFF OMITTED] T9541.047
[GRAPHIC] [TIFF OMITTED] T9541.048
[GRAPHIC] [TIFF OMITTED] T9541.049
[GRAPHIC] [TIFF OMITTED] T9541.050
[GRAPHIC] [TIFF OMITTED] T9541.051
[GRAPHIC] [TIFF OMITTED] T9541.052
[GRAPHIC] [TIFF OMITTED] T9541.053
[GRAPHIC] [TIFF OMITTED] T9541.054
[GRAPHIC] [TIFF OMITTED] T9541.055
[GRAPHIC] [TIFF OMITTED] T9541.056
[GRAPHIC] [TIFF OMITTED] T9541.057
[GRAPHIC] [TIFF OMITTED] T9541.058
[GRAPHIC] [TIFF OMITTED] T9541.059
[GRAPHIC] [TIFF OMITTED] T9541.060
[GRAPHIC] [TIFF OMITTED] T9541.061
[GRAPHIC] [TIFF OMITTED] T9541.062
[GRAPHIC] [TIFF OMITTED] T9541.063
[GRAPHIC] [TIFF OMITTED] T9541.064
[GRAPHIC] [TIFF OMITTED] T9541.065
[GRAPHIC] [TIFF OMITTED] T9541.066
[GRAPHIC] [TIFF OMITTED] T9541.067
[GRAPHIC] [TIFF OMITTED] T9541.068
[GRAPHIC] [TIFF OMITTED] T9541.069
[GRAPHIC] [TIFF OMITTED] T9541.070
[GRAPHIC] [TIFF OMITTED] T9541.071
[GRAPHIC] [TIFF OMITTED] T9541.072
[GRAPHIC] [TIFF OMITTED] T9541.073
[GRAPHIC] [TIFF OMITTED] T9541.074
[GRAPHIC] [TIFF OMITTED] T9541.075
[GRAPHIC] [TIFF OMITTED] T9541.076
[GRAPHIC] [TIFF OMITTED] T9541.077
[GRAPHIC] [TIFF OMITTED] T9541.078
[GRAPHIC] [TIFF OMITTED] T9541.079
[GRAPHIC] [TIFF OMITTED] T9541.080
[GRAPHIC] [TIFF OMITTED] T9541.081
[GRAPHIC] [TIFF OMITTED] T9541.082
[GRAPHIC] [TIFF OMITTED] T9541.083
[GRAPHIC] [TIFF OMITTED] T9541.084
[GRAPHIC] [TIFF OMITTED] T9541.085
[GRAPHIC] [TIFF OMITTED] T9541.086
[GRAPHIC] [TIFF OMITTED] T9541.087
[GRAPHIC] [TIFF OMITTED] T9541.088
[GRAPHIC] [TIFF OMITTED] T9541.089
[GRAPHIC] [TIFF OMITTED] T9541.090
[GRAPHIC] [TIFF OMITTED] T9541.091
[GRAPHIC] [TIFF OMITTED] T9541.092
[GRAPHIC] [TIFF OMITTED] T9541.093
[GRAPHIC] [TIFF OMITTED] T9541.094
[GRAPHIC] [TIFF OMITTED] T9541.095
[GRAPHIC] [TIFF OMITTED] T9541.096
[GRAPHIC] [TIFF OMITTED] T9541.097
[GRAPHIC] [TIFF OMITTED] T9541.098
[GRAPHIC] [TIFF OMITTED] T9541.099
[GRAPHIC] [TIFF OMITTED] T9541.100
[GRAPHIC] [TIFF OMITTED] T9541.101
[GRAPHIC] [TIFF OMITTED] T9541.102
[GRAPHIC] [TIFF OMITTED] T9541.103
[GRAPHIC] [TIFF OMITTED] T9541.104
[GRAPHIC] [TIFF OMITTED] T9541.105
[GRAPHIC] [TIFF OMITTED] T9541.106
[GRAPHIC] [TIFF OMITTED] T9541.107
[GRAPHIC] [TIFF OMITTED] T9541.108
[GRAPHIC] [TIFF OMITTED] T9541.109
[GRAPHIC] [TIFF OMITTED] T9541.110
[GRAPHIC] [TIFF OMITTED] T9541.111
[GRAPHIC] [TIFF OMITTED] T9541.112
[GRAPHIC] [TIFF OMITTED] T9541.113
[GRAPHIC] [TIFF OMITTED] T9541.114
[GRAPHIC] [TIFF OMITTED] T9541.115
[GRAPHIC] [TIFF OMITTED] T9541.116
[GRAPHIC] [TIFF OMITTED] T9541.117
[GRAPHIC] [TIFF OMITTED] T9541.118
[GRAPHIC] [TIFF OMITTED] T9541.119
[GRAPHIC] [TIFF OMITTED] T9541.120