[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
CREDIT RATING AGENCIES AND THE FINANCIAL CRISIS
=======================================================================
HEARING
before the
COMMITTEE ON OVERSIGHT
AND GOVERNMENT REFORM
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
OCTOBER 22, 2008
__________
Serial No. 110-155
__________
Printed for the use of the Committee on Oversight and Government Reform
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
http://www.house.gov/reform
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COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM
HENRY A. WAXMAN, California, Chairman
PEDOLPHUS TOWNS, New York TOM DAVIS, Virginia
PAUL E. KANJORSKI, Pennsylvania DAN BURTON, Indiana
CAROLYN B. MALONEY, New York CHRISTOPHER SHAYS, Connecticut
ELIJAH E. CUMMINGS, Maryland JOHN M. McHUGH, New York
DENNIS J. KUCINICH, Ohio JOHN L. MICA, Florida
DANNY K. DAVIS, Illinois MARK E. SOUDER, Indiana
JOHN F. TIERNEY, Massachusetts TODD RUSSELL PLATTS, Pennsylvania
WM. LACY CLAY, Missouri CHRIS CANNON, Utah
DIANE E. WATSON, California JOHN J. DUNCAN, Jr., Tennessee
STEPHEN F. LYNCH, Massachusetts MICHAEL R. TURNER, Ohio
BRIAN HIGGINS, New York DARRELL E. ISSA, California
JOHN A. YARMUTH, Kentucky KENNY MARCHANT, Texas
BRUCE L. BRALEY, Iowa LYNN A. WESTMORELAND, Georgia
ELEANOR HOLMES NORTON, District of PATRICK T. McHENRY, North Carolina
Columbia VIRGINIA FOXX, North Carolina
BETTY McCOLLUM, Minnesota BRIAN P. BILBRAY, California
JIM COOPER, Tennessee BILL SALI, Idaho
CHRIS VAN HOLLEN, Maryland JIM JORDAN, Ohio
PAUL W. HODES, New Hampshire
CHRISTOPHER S. MURPHY, Connecticut
JOHN P. SARBANES, Maryland
PETER WELCH, Vermont
JACKIE SPEIER, California
Phil Barnett, Staff Director
Earley Green, Chief Clerk
Lawrence Halloran, Minority Staff Director
C O N T E N T S
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Page
Hearing held on October 22, 2008................................. 1
Statement of:
Fons, Jerome S., former executive, Moody's Corp.; Frank L.
Raiter, former executive, Standard & Poor's; and Sean J.
Egan, managing director, Egan-Jones Ratings................ 20
Egan, Sean J............................................. 42
Fons, Jerome S........................................... 20
Raiter, Frank L.......................................... 31
Joynt, Stephen W., president and chief executive officer,
Fitch, Inc.; Raymond W. McDaniel, chairman and chief
executive officer, Moody's Corp.; and Deven Sharma,
president, Standard & Poor's............................... 107
Joynt, Stephen W......................................... 107
McDaniel, Raymond W...................................... 116
Sharma, Deven............................................ 142
Letters, statements, etc., submitted for the record by:
Davis, Hon. Tom, a Representative in Congress from the State
of Virginia, letter dated October 22, 2008................. 17
Egan, Sean J., managing director, Egan-Jones Ratings,
prepared statement of...................................... 45
Fons, Jerome S., former executive, Moody's Corp., prepared
statement of............................................... 23
Joynt, Stephen W., president and chief executive officer,
Fitch, Inc., prepared statement of......................... 111
Kucinich, Hon. Dennis J., a Representative in Congress from
the State of Ohio, White Paper on Rating Competition and
Structured Finance......................................... 74
Maloney, Hon. Carolyn B., a Representative in Congress from
the State of New York, credit policy issues at Moody's..... 61
McDaniel, Raymond W., chairman and chief executive officer,
Moody's Corp., prepared statement of....................... 118
Raiter, Frank L., former executive, Standard & Poor's,
prepared statement of...................................... 33
Sali, Hon. Bill, a Representative in Congress from the State
of Idaho, prepared statement of............................ 196
Sharma, Deven, president, Standard & Poor's, prepared
statement of............................................... 144
Towns, Hon. Edolphus, a Representative in Congress from the
State of New York, prepared statement of................... 193
Waxman, Chairman Henry A., a Representative in Congress from
the State of California, prepared statement of............. 5
CREDIT RATING AGENCIES AND THE FINANCIAL CRISIS
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WEDNESDAY, OCTOBER 22, 2008
House of Representatives,
Committee on Oversight and Government Reform,
Washington, DC.
The committee met, pursuant to notice, at 10 a.m., in room
2154, Rayburn House Office Building, Hon. Henry A. Waxman
(chairman of the committee) presiding.
Present: Representatives Waxman, Maloney, Cummings,
Kucinich, Tierney, Watson, Lynch, Yarmuth, Norton, McCollum,
Sarbanes, Speier, Davis of Virginia, Shays, Souder, Issa and
Bilbray.
Staff present: Kristin Amerling, chief counsel; Russell
Anello, Counsel; caren Auchman, communications associate; Phil
Barnett, staff director; Jennifer Berenholz, assistant clerk;
Brian Cohen, senior investigator and policy advisor;
Christopher Davis, professional staff member; Zhongrui ``JR''
Deng, chief information officer; Miriam Edelman, special
assistant; Alexandra Golden, investigator; Michael Gordon,
senior investigative counsel; Earley Green, chief clerk; Karen
Lightfoot, communications director and senior policy advisor;
Jennifer Owens, special assistant; David Rapallo, chief
investigative counsel; Leneal Scott, information officer; Mitch
Smiley and Matt Weiner, staff assistants; John Williams, deputy
chief investigative counsel; Lawrence Halloran, minority staff
director; Jennifer Safavian; minority chief counsel for
oversight and investigations; Brien Beattie, Molly Boyl, Alex
Cooper, Adam Fromm, and Todd Greenwood, minority professional
staff members; Larry Brady and Nick Palarino, minority senior
investigators and policy advisors; Christopher Bright and John
Cuaderes, minority senior professional staff members; Patrick
Lyden, minority parliamentarian and Member services
coordinator; and Brian McNicoll, minority communications
director.
Chairman Waxman. Today the committee is holding its third
hearing on the financial crisis on Wall Street. Our subject
today is the role of the credit rating agencies.
The leading credit rating agencies, Standard & Poor's,
Moody's and Fitch, are essential financial gatekeepers. They
rate debt obligations based on the ability of the issuers to
make timely payments. A triple-A rating has been regarded as
the gold standard for safety and security of these investments
for nearly a century.
As our financial markets have grown more complex, the role
of the credit rating agencies has grown in importance. Between
2002 and 2007, Wall Street issued a flood of securities and
collateralized debt obligations called CDOs backed by risky
subprime loans.
These new financial inventions were so complex that
virtually no one really understood them. For investors, a
triple-A rating became the stamp of approval that this
investment is safe. And for Wall Street's investment banks, a
triple-A rating became the independent validation that turned a
pool of risky home loans into a financial gold mine. The
leading credit rating agencies grew rich rating mortgage-backed
securities and CDOs. And we have a chart. I hope we can display
it. That chart will show the total revenues for the three
firms, double from $3 billion in 2002 to over $6 billion in
2007.
At Moody's, profits quadrupled between 2000 and 2007. In
fact, Moody's had the highest profit margin of any company in
the S&P 500 for 5 years in a row. Unfortunately for investors,
the triple-A ratings that proved so lucrative for the rating
agencies soon evaporated. S&P has downgraded more than two-
thirds of its investment-grade ratings. Moody's had to
downgrade over 5,000 mortgage-backed securities.
In their testimony today the CEOs of Standard & Poor's,
Moody's and Fitch will tell us that, ``virtually no one
anticipated what is occurring.'' But the documents that the
committee obtained tell a different story.
Raymond McDaniel, the CEO of Moody's, will testify today
that, ``we have witnessed events that many, including myself,
would have thought unimaginable just 2 months ago.'' But that
is not what he said in a confidential presentation he made to
the board of directors in October 2007.
The title of the presentation is ``Credit Policy Issues at
Moody's Suggested by the Subprime Liquidity Crisis.'' In this
presentation, Mr. McDaniel describes what he calls a dilemma
and a very tough problem facing Moody's.
According to Mr. McDaniel, ``the real problem is not that
the market underweights rating quality but rather that in some
sectors it actually penalizes quality. It turns out that
ratings quality has surprisingly few friends: Issuers want high
ratings; investors don't want ratings downgrades; short-sighted
bankers labor short-sightedly to game the rating agencies.''
Mr. McDaniel then tells his board, ``unchecked competition
on this basis can place the entire financial system at risk.''
Mr. McDaniel describes to his board how Moody's has, ``erected
safeguards to keep teams from too easily solving the market
share problem by lowering standards.''
But then he says, ``this does not solve the problem.'' In
his presentation, the ``not'' is written in all capitals.
He then turns to a topic that he calls, ``Rating Erosion by
Persuasion.'' According to Mr. McDaniel, ``analysts and MDs,
managing directors, are continually pitched by bankers,
issuers, investors and sometimes we drink the Kool-Aid.''
A month earlier in September 2007, Mr. McDaniel
participated in a managing director's town hall, and we
obtained a copy of the transcript of the proceeding.
And let me read to you what Mr. McDaniel said: The purpose
of this town hall is so that we can speak as candidly as
possible about what is going on in the subprime market. What
happened was it was a slippery slope. What happened in 2004 and
2005 with respect to subordinated tranches is that our
competition, Fitch and S&P, went nuts. Everything was
investment grade. It didn't really matter. We tried to alert
the market. We said we're not rating it. This stuff isn't
investment grade. No one cared, because the machine just kept
going.
The following day, a member of the Moody's management team
commented, ``we heard two answers yesterday. One, people lied;
and two, there was an unprecedented sequence of events in the
mortgage markets. As for one, it seems to me that we had
blinders on and never questioned the information we were given.
As for two, it's our job to think of the worst-case scenarios
and model them. Combined, these two errors make us look either
incompetent at credit analysis or like we sold our soul to the
devil for revenue.''
The documents from Standard & Poor's paints a similar
picture. In one document, an S&P employee in the structured
finance division writes, ``it could be structured by cows, and
we would rate it.''
In another, an employee asserts, ``rating agencies continue
to create an ever bigger monster, the CDO market. Let's hope we
are all wealthy and retired by the time this house of cards
falters.''
There are voices in the credit rating agencies that called
for a change, and we are going to hear from two of them on our
first panel: Frank Raiter from Standard & Poor's and Jerome
Fons from Moody's. In 2001, Mr. Raiter was asked to rate an
early collateralized debt obligation called Pinstripe. He asked
for the collateral tapes so that he could assess the
creditworthiness of the home loans backing the CDO.
This is the response he got from Richard Gugliada, the
managing director: Any requests for loan level tapes is totally
unreasonable. Most investors don't have it and can't provide
it. Nevertheless we must produce a credit estimate. It's your
responsibility to provide those credit estimates and your
responsibility to devise some method for doing so.
Mr. Raiter was stunned. He was being directed to rate
Pinstripe without access to essential credit data. He e-mailed
back, ``this is the most amazing memo I have ever received in
my business career.''
Last November, Christopher Mahoney, Moody's vice chairman,
wrote Mr. McDaniel, the CEO, that Moody's has made mistakes and
urged that a manager in charge of the securitization area
should be held to account. Mr. Mahoney's employment was
terminated by the end of the year.
Investors, too, were stunned by the lax practices of the
credit rating agencies. The documents we reviewed showed that a
portfolio manager with Vanguard, the large mutual fund company,
told Moody's over a year ago that the rating agencies, ``allow
issuers to get away with murder.''
A senior official at Fortis Investments was equally blunt
saying, ``if you can't figure out the loss ahead of the fact,
what is the use of your ratings? If the ratings are BS, the
only use in ratings is comparing BS to more BS.''
Some large investors like PIMCO tried to warn Moody's about
the mistakes it was making. But according to the documents,
they eventually gave up because they, ``found the Moody's
analysts to be arrogant and gave the indication we're smarter
than you.''
Six years ago, Congress pressed the SEC to assert more
control over the credit rating agencies. In 2002, the Senate
Governmental Affairs Committee investigated the rating agencies
and found serious problems. The committee concluded that
meaningful SEC oversight was urgently needed. The next year,
the SEC published its own report, which also found serious
problems with credit rating agencies.
Initially, it looked like the SEC might take action. In
June 2003, the SEC issued a concept release seeking comments on
possible new regulations. Two years later, in April 2005, SEC
issued a proposed rule.
Yet despite the Senate recommendation and SEC's own study,
the SEC failed to issue any final rule to oversee credit rating
agencies. The SEC failed to act and left the credit rating
agencies completely unregulated until Congress finally passed a
law in 2006.
At tomorrow's hearing with Federal regulators, Members will
have a chance to ask the SEC chairman, Christopher Cox, about
his agency's record. Today, our focus is on the credit rating
agencies themselves, and Members can question the CEOs of
Standard & Poor's, Moody's and Fitch about their performance.
Running the credit rating agencies has been a lucrative
occupation. Collectively, the three CEOs have made over $80
million. We appreciate that they have cooperated with the
committee and look forward to their testimony.
The story of the credit rating agencies is a story of a
colossal failure. The credit rating agencies occupy a special
place in our financial markets. Millions of investors rely on
them for independent objective assessments. The rating agencies
broke this bond of trust, and Federal regulators ignored the
warning signs and did nothing to protect the public.
The result is that our entire financial system is now at
risk, just as the CEO of Moody's predicted a year ago. And now
I want to recognize the Republican side for their opening
statements.
[The prepared statement of Chairman Henry A. Waxman
follows:]
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Mr. Davis of Virginia. Thank you, Mr. Chairman.
I'm going to have Mr. Shays give it.
Let me just make two comments. No. 1, I associate myself
with your remarks today. And second, we have a letter signed by
all of our Members on our side invoking our right to a day of
testimony by witnesses selected by the minority on matters we
think should be included. And we look forward to working with
you.
Chairman Waxman. The letter will be part of the record.
[The information referred to follows:]
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Mr. Shays. Mr. Chairman, when the referee is being paid by
the players, no one should be surprised when the game spins out
of control. That is what happened on Wall Street when credit
rating agencies followed the delirious mob making millions on
mortgage-backed securities and sold their independence to the
highest bidder.
As a result, investments once thought safe are being
downgraded, some to no more than junk status. Trillions of
dollars could vanish as asset redemptions calls for additional
collateral, payments on derivative contracts, and outright
defaults unwind, sending unpredictable after-shocks into an
already traumatized economy.
It has been known for years that quantitative analysis
armed with cutting-edge software, realtime data and ultra
sophisticated algorithms were operating light years beyond
regulators and credit evaluators using static econometric
models. Esoteric investment products were structured to garner
a triple-A grade by slicing and dicing risks into bits too
small to register. Investors did not have enough information
about the real value of the underlying assets or about how
credit analysts reached their conclusions on the safety of
their products being sold.
Despite significant warning signs of a system under strain
dating back to the failure of the large hedge fund, Long Term
Capital Management, in the late 1990's, Congress and the
Securities Exchange Commission [SEC], were slow to recognize
the peril posed by insensitive or financially compromised
creditworthiness rating systems.
Proposals to deconflict the interests of rating companies
and their pay masters and to exact greater transparency and
autonomy from the rating process came too little, too late. So
the con game continued: A scheme to engender and sustain a
false sense of confidence in the improbable proposition that
housing prices would never fall. Like the Titanic, the Good
Ship Subprime was universally hailed as unsinkable. Succumbing
to and profiting from the mass hysteria, rating agencies
stopped looking for the icebergs always waiting in the world's
financial sea lanes.
Subjective judgments, perceptions of risk and opinions on
value, obviously, can't be regulated. But the rigor and
consistency of the methodologies used and the validity of the
data inputs relied upon can and should be far more transparent
to investors and the SEC. Only that will rebuild genuine
confidence in credit rating.
Finally, Mr. Chairman, I'm glad you agree to hold a hearing
on the role of Fannie Mae and Freddie Mac. While I understand
your reluctance to probe politically volatile topics for both
parties before the election, the planned November 20th hearing
date should give the committee time to request documents and
shine some much needed sunlight on to the failed operations of
the toxic twins of mortgage finance. The document requests have
to include all records of lobbying contracts, lobbying
expenditures, political action committee strategy and
contributions to various organizations, particularly those
favored by Members of Congress. It is past time for Fannie and
Freddie to come clean about their reform avoidance activities
and just as overdue that Congress confront its own role in
coddling the arrogant authors of the housing finance crisis.
Chairman Waxman. Thank you very much, Mr. Shays. I look
forward to working with you on that issue.
Before we recognize panel one, I have a unanimous consent.
Without objection, questioning for panel one will proceed as
follows: The majority and minority will each begin with a 10-
minute block of time with the chairman and ranking member, each
having the right to reserve time from this block for later use.
And without objection, that will be the order.
On panel one, we have Jerome Fons, who is an economist who
worked at Moody's Investor Service as a managing director until
2007. Frank Raiter worked as a managing director for
residential mortgage-backed securities at Standard & Poor's
until 2005, and Sean Egan is the managing director of Egan-
Jones Ratings in Haverford, PA.
We're pleased to welcome you to our committee. We
appreciate your being here. It's the practice of this committee
that all witnesses that testify before us do so under oath, so
I would like to ask you if would please stand and raise your
right hands.
[Witnesses sworn.]
Chairman Waxman. The record will show that each of the
witnesses answered in the affirmative.
Your prepared statements will be in the record in its
entirety. We would like to ask you to try to limit your oral
presentations to around 5 minutes. We will have a clock that
will have green for 4 minutes, orange for 1 minute, and then
after 5 minutes, it will turn red. When you see that it's red,
we would like that to be a reminder that we would like you to
sum up the oral presentation to us.
There is a button on the base of each mic, so be sure it's
pressed in and close enough to you so that we can hear
everything that you have to say.
Mr. Fons, why don't we start with you.
STATEMENTS OF JEROME S. FONS, FORMER EXECUTIVE, MOODY'S CORP.;
FRANK L. RAITER, FORMER EXECUTIVE, STANDARD & POOR'S; AND SEAN
J. EGAN, MANAGING DIRECTOR, EGAN-JONES RATINGS
STATEMENT OF JEROME S. FONS
Mr. Fons. Thank you, Mr. Chairman.
Chairman Waxman and Ranking Member Davis and members of the
committee, good morning.
I am pleased to be invited to offer testimony on the state
of the credit rating industry. Until August 2007, I worked at
Moody's Investors Service where I had exposure to nearly every
aspect of the ratings business. My last position at Moody's was
managing director, credit policy. I was a member of Moody's
Credit Policy Committee, and I chaired the firm's Fundamental
Credit Committee. Prior to my 17 years at Moody's, I was an
economist with the U.S. Federal Reserve and with Chemical Bank
New York. Since leaving Moody's, I have been an independent
consultant advising firms on rating agency issues.
As this committee has heard before, the major rating
agencies badly missed the impact of falling house prices and
declining underwriting standards on subprime mortgages.
Subprime residential mortgage-backed securities with initially
high ratings found their way into nearly every corner of the
financial system. Although evidence of falling home values
began to emerge in late 2006, ratings did not reflect this
development for some time. The first downgrades of subprime-
linked securities occurred in June 2007. In short order, faith
in credit ratings diminished to the point where financial
institutions were unwilling to lend to one another. And so we
had and are still having a credit crisis.
Why did it take so long for the rating agencies to
recognize the problem? Why were standards so low in the first
place? And what should be done to see that this does not happen
again?
My view is that a large part of the blame can be placed on
the inherent conflicts of interest found in the issuer-pays
business model and on rating shopping by issuers of structured
securities. A drive to maintain or expand market share made the
rating agencies willing participants in this shopping spree.
Let me speak from my experience at Moody's. Moody's
reputation for independent and accurate ratings sprang from a
hard-headed culture of putting investors' interests first. Up
until the late 1960's, the firm often refused to meet with
rated companies. Even through the mid-1990's, long after the
firm and its competitors began to charge issuers for ratings,
Moody's was considered the most difficult firm on Wall Street
to deal with.
A 1994 article in Treasury & Risk Management Magazine
pointed to surveys that highlighted issuers' frustrations with
Moody's. This had a profound impact on the firm's thinking. It
raised questions about who our clients were and how best to
deal with them. Management undertook a concerted effort to make
the firm more issuer-friendly.
In my view, the focus of Moody's shifted from protecting
investors to marketing ratings. The company began to emphasize
customer service and commissioned detailed surveys of client
attitudes. I believe the first evidence of this shift
manifested itself in flawed ratings on large telecom firms
during that industry's crisis in 2001.
Following Moody's 2000 spin from Dunn & Bradstreet,
management's focus increasingly turned to maximizing revenues.
Stock options and other incentives raised the possibility of
large payoffs. Managers who were considered good businessmen
and women, not necessarily the best analysts, rose through the
ranks. Ultimately, this focus on the bottom line contributed to
an atmosphere in which the aforementioned ratings shopping
could take hold.
The so-called reforms announced to date are inadequate.
While there are no easy fixes to the problems facing the rating
industry, I will offer some suggestions. First, we need to see
wholesale change at the governance and senior management levels
of the large rating agencies. Managers associated with faulty
structured finance ratings must also depart. New leadership
must acknowledge the mistakes of the past and end the defensive
posture of denial brought on by litigation fears.
Second, bond ratings must serve the potential buyer of the
bond and no one else; that is, ratings must be correct today in
the sense that--that a rating must be correct today in the
sense that it fully reflects the views of the analyst or rating
committee with no attempts to stabilize ratings. A byproduct of
this behavior will be that rating changes eventually lose their
influence. Such a situation might arise sooner if regulators
and legislators cease reliance on ratings. Elimination of the
SEC's NRSRO designation will be a step in this direction. Also,
regulators must drop restrictions on unsolicited ratings. This
would help to minimize rating shopping and allow competition to
yield positive benefits, such as lower costs and higher quality
ratings.
Going forward, structured finance rating practices must
emphasize transparency and simplicity. Statistical backward-
looking rating methods need to be augmented with a strong dose
of common sense. All rated structured transactions should be
fully registered and subject to minimum disclosure
requirements.
The rating agencies need to implement concrete measures for
taming the conflicts posed by the issuer-pays business model. I
do not believe that investor-pays model is the correct answer.
There is a free rider problem with subscriber-funded ratings,
and most would agree that ratings should be freely available
particularly if they are referenced in regulations.
It is not my intention to indict everyone working in the
rating industry. Indeed, the analysts that I interacted with
took their responsibility seriously and demonstrated high moral
character. I was proud to be associated with Moody's, a feeling
shared by many others at the firm. And I fervently believe that
substantive reforms can restore the integrity and stature of
the bond rating industry.
Thank you.
[The prepared statement of Mr. Fons follows:]
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Chairman Waxman. Thank you very much, Mr. Fons.
Mr. Raiter.
STATEMENT OF FRANK L. RAITER
Mr. Raiter. Chairman Waxman and Ranking Member Davis, I
would like to thank you for inviting me to this hearing today.
My name is Frank Raiter, and from March 1995 to April 2005,
I was the managing director and head of the Residential
mortgage-backed securities Ratings Group at Standard & Poor's.
I was responsible for directing ratings criteria development,
ratings production, marketing and business development for
single-family mortgage and home equity loan bond ratings and
related products. My tenure at S&P coincided with the rapid
growth in mortgage securitization and development of new
mortgage products, including subprime and expanded Alt-A
products. During this period, total residential mortgage
production in the United States grew from $639 billion in 1995
to $3.3 trillion in 2005. Subprime production grew from $35
billion to $807 billion over the same period.
By regulation, institutional investment policy and
tradition, the sale of associated mortgage-backed securities
generally required ratings from two of the nationally
recognized statistical rating organizations [NRSROs]. While a
necessary player in the exploding market, the rating agencies
were not the drivers of the train. The engine was powered by
the low interest rates that prevailed after the turn of the
century. The conductors were the lenders and the investment
bankers who made the loans and packaged them into securities,
and the rating agencies were the oilers who kept the wheels
greased. And I might add, the passengers on the train were the
investors, and it was standing room only. There is a lot of
blame to go around.
To appreciate the unique role that the rating agencies
performed in the residential mortgage market, it is necessary
to understand the ratings process. The mortgage-backed security
consists of a pool of individual mortgage loans, and depending
on the type of mortgage product, whether it's prime, subprime,
Alt-A, whatever, an underlying given security could have as
many as 1,000 to 25,000 loans in it. The ratings process
consisted of two distinct operations, the credit analysis of
the individual mortgages and a review of the documents
governing the servicing of the loans and the payments to
investors in the securities.
The credit analysis is focused on determining the expected
default probabilities on each loan and the loss that would
occur in the event of default. And these in turn established
the expected loss that support triple-A bonds. In short, what
the ratings process attempts to do is to find out what that
equity piece is that needs to support the triple-A bonds so
that investor won't take any losses. It's very similar to the
home equity you have in a home loan. That equity is intended to
protect the lender from taking a loss in the event of a change
in circumstance.
In 1995, S&P used a rules-based model for determining the
loss expected on a given bond. Late that year, it was
determined and decided to move to a statistical-based approach,
and we began gathering data to come out with a first model that
was based on approximately 500,000 loans with performance data
going back 5 years.
That version of the LEVELs model was implemented in 1996
and made available for purchase by originators, investment
bankers, investors and mortgage insurance companies. By making
the model commercially available, S&P was committed to maintain
parity between the model that they ran and the answers that
they were giving to the investors and the issuers that
purchased the model.
In other words, S&P promised model clients that they would
always get the same answers from the LEVELs model that the
rating agency got. Implicit in this promise was S&P's
commitment to keep the model current. In fact, the original
contract with the model consultant called for annual updates to
the model based on a growing data base. An update was
accomplished in late 1998, 1999, and that model was ultimately
released.
The version was built on 900,000 loans. And I'm going to
speed this up a little bit. We developed two more iterations of
the model, one with 2.5 million loans and one with 10 million
loans. In a nutshell, those versions of the model were never
released. While we had enjoyed substantial management support
up to this time, by 2001, the stress for profits and the desire
to keep expenses low prevented us from in fact developing and
implementing the appropriate methodology to keep track of the
new products.
As a result, we didn't have the data going forward in 2004
and 2005 to really track what was happening with the subprime
products and some of the new alternative-payment type products.
And we did not, therefore, have the ability to forecast when
they started to go awry. As a result, we did not, by that time,
have the support of management in order to implement the
analytics that, in my opinion, might have forestalled some of
the problems that we're experiencing today.
And with that, I will end my remarks and be happy to answer
any questions you might have.
[The prepared statement of Mr. Raiter follows:]
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Chairman Waxman. Thank you very much, Mr. Raiter.
We will have questions after Mr. Egan for the three of you.
Mr. Egan.
STATEMENT OF SEAN J. EGAN
Mr. Egan. Thank you.
The current credit rating system is designed for failure,
and that is exactly what we are experiencing.
AIG, Fannie Mae, Freddie Mac, Bear Stearns, Lehman
Brothers, Countrywide, IndyMac, MBIA, Ambac, the other model
lines, Merrill Lynch, WaMu, Wachovia, and a string of
structured finance securities all have failed or nearly failed
to a great extent because of inaccurate, unsound ratings.
The ratings of the three companies appearing before this
committee today, Moody's, S&P and Fitch, were a major factor in
the most extensive and possibly expensive financial calamity in
recent American history. The IMF has estimated financial loss
from the current credit crisis at $1 trillion, but other
estimates from knowledgeable sources have pegged it at twice
that amount. Of course, there have been other contributing
parties to this debacle, including some of the mortgage
brokers, depository institutions, and investment banks, but
there should be no doubt that none of this would have been
possible were it not for the grossly inflated, unsound and
possibly fraudulent ratings provided to both the asset-backed
securities directly issued as well as companies which dealt in
these securities, whether it be originating, aggregating,
financing, securitizing, insuring, credit enhancing or
ultimately purchasing them.
Issuers paid huge amounts to these rating companies for not
just significant rating fees but, in many cases, very
significant consulting fees for advising the issuers on how to
structure the bonds to achieve maximum triple-A ratings. This
egregious conflict of interest may be the single greatest cause
of the present global economic crisis. This is an important
point which is often overlooked in the effort to delimit the
scope of the across-the-board failures of the major credit
rating firms. This is not just a securitization problem.
The credit rating industry is a $5 to $6 billion market
with these three companies, S&P, Moody's and Fitch, controlling
more than 90 percent of the market. With enormous fees at
stake, it is not hard to see how these companies may have been
induced, at the very least, to gloss over the possibilities of
default or, at the worst, knowingly provide inflated ratings.
Again, the problems were not just in structured finance but
also the unsecured bonds and other plain vanilla debt offerings
of many of the corporate entities participating in the mortgage
market.
These shortcomings moreover are nothing new. We have been
here before, specifically in 2002, after Enron failed, despite
the fact that the major rating agencies had its debt at
investment grade up through and including just before the
company filed for bankruptcy protection. At Egan-Jones, we
downgraded Enron months before our competitors. In the case of
WorldCom, it was about 9 months before our competitors.
In testimony at the time, it was before the Congress we
pointed out the inherent conflict of interest in the business
model of the credit rating agencies, which purport to issue
ratings for the benefit of investors but in fact are paid by
the issuers of those securities. At a congressional hearing in
2003, I stated that Fannie Mae and Freddie Mac did not merit a
triple-A rating which Moody's, S&P, and Fitch accorded to them.
At about that time, we issued a rating call to the same effect
with respect to MBIA which our competitors rated triple-A until
just a few months ago.
Currently, we rate MBIA and Ambac significantly in the spec
grade category; I think we are at about single-B or below.
How is it that the major rating agencies, which have
approximately 400 employees for every analyst at Egan-Jones
have been consistently wrong over such an extended period of
time? I would like to say that we have more sophisticated
computer models or that our people are just plain better at
what they do. I hope that some of that is true, but the real
answer is that Egan-Jones is in the business of issuing timely,
accurate credit ratings; whereas Moody's, S&P, and Fitch have
gravitated to the much more lucrative business of expediting
the issuance of securities.
Investors want credible ratings. Issuers on the other hand
want the highest rating possible, since that reduces funding
costs. Under the issuer-pay business model, a rating agency
which does not come in with a highest rating will before long
be an unemployed rating firm. It's that simple. And all the
explanations and excuses cannot refute this elementary truth.
Let's go back to the Enron example. At the time, the major
rating agencies rationalized this on the basis that there was
fraud involved. We've heard that same thing to reflect the
mortgage assets underlying the current crisis. Guess what?
There may always be an element of fraud involved in the
financial markets, and contrary to what you may hear from the
other rating agencies, it is expressly the job of the rating
agency to ferret out that fraud before providing an imprimatur
upon which thousands of institutional investors and tens of
thousands of individual investors have every reasonable
expectation to rely on.
It was not always this way. When John Moody founded the
company which still bears his name almost 100 years later, many
of his colleagues on Wall Street urged him to keep the
information to himself. He declined to do so and instead opted
for public dissemination used by and paid for by investors. The
same history was true for S&P and Fitch until all three
companies reversed their business model in the late 1970's and
sought compensation from the issuers of the securities. The
fact that this shift occurred contemporaneously with the rise
of asset-backed financing is by no means a coincidence. Profits
soared at these companies, but quality and independence moved
increasingly inversely. And advocating the principle of
returning the ratings industry to its roots, we've been told by
the public policymakers that they in the Congress or the
administrative agencies should not be expected to choose among
competing business models. We are at a loss to comprehend this
hands-off approach.
If the business model currently utilized by Egan-Jones and
previously used with great success by our competitors
demonstrates a track record of serial failures with at least $1
trillion of adverse financial consequences, why is it not
sufficient cause for the government to intervene? When the
Congress was confronted with the safety record of the Corvair
versus, for example, a Subaru or Volvo, the response was not
laissez-faire. The Congress and the regulators, indeed even the
auto industry itself, responded with corrective actions. For
the rating industry the only real reform is to realign the
incentives and get the industry back in the business of
representing those who invest in securities, not those who
issue them.
Our written testimony includes a number of recommendations
that would restore checks and balances to the rating system.
But my main purpose in being here today is to highlight the
nature of the problem and the need to address the root cause
not merely symptoms. Thank you for having me at this hearing
and inviting Egan-Jones to present testimony. I would be
pleased to address any questions.
[The prepared statement of Mr. Egan follows:]
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Chairman Waxman. Thank you very much, Mr. Egan.
Now, pursuant to the unanimous consent agreement, we will
start the questioning 10 minutes on each side, and the Chair
yields 5 of his minutes, of his time, to Mr. Yarmuth.
Mr. Yarmuth. Thank you, Mr. Chairman.
I want to thank the witnesses for their testimony.
Mr. Raiter, you explained that mortgage-backed securities
are very complicated. We're all beginning to find that out,
that each one could contain literally thousands of mortgages
and the way you explained in your testimony you need a very
sophisticated statistical modeling system to analyze all these
mortgages to see how likely it is that each one or any one
might default, and things get even more complicated when we
start talking about collateralized debt obligations, the
securities that are constructed out of numerous asset-backed
securities, is that right?
Mr. Raiter. The premise, as I understand it, and I was not
in the CDO group, but the premise in the CDO arena was, by
bundling a pool of bonds that had already been rated, that what
you were looking at predominately was the diversity index
between the performance of bonds in the residential market in
the pool with bonds from the corporate market.
Mr. Yarmuth. These are obviously very sophisticated models
that are needed to analyze.
Mr. Raiter. They are supposed to be.
Mr. Yarmuth. So I want to show you a document that the
committee obtained from S&P and get your reaction to it. This
is not an e-mail. This is an instant message or series of
instant messages between two S&P officials who were chatting
back and forth over the computer. It took place on the
afternoon of April 5, 2007, and based on the document, we can
identify the two employees as officials who work in a
Structured Finance Division of S&P in New York City. So a
Structured Finance Division would be the one that analyzes
these types, these complicated securities?
Mr. Raiter. That is correct.
Mr. Yarmuth. As I show you these, you will see that what
they're talking about. They're talking about whether they
should rate a certain deal. Here is what they said.
Official No. 1: By the way, that deal is ridiculous.
Official No. 2: I know, right, model definitely does not
capture half the risk.
Official No. 1: We should not be rating it.
Official No. 2: We rate every deal. It could be structured
by cows, and we would rate it.
Official No. 1: But there is a lot of risk associated with
it. I personally don't feel comfy signing off as a committee
member.
This document is not testimony. And it hasn't been prepared
by an attorney and vetted by the company. It's just two S&P
officials sending messages to each other, but what they say is
extremely disturbing. Their attitude seems to be casual
acceptance that they rate deals that they should not be rating,
deals that are too risky, and they rate deals no matter how
they're structured.
So I want to ask you, what does the official mean when she
says, ``the model definitely des not capture half the risk?''
What is she referring to there?
Mr. Raiter. Well, again, I'm not an expert on the CDO model
or the methods that they used. But what I have read about is
it's tremendously driven by this diversity index that is
supposed to tell you whether the bonds that are put in one of
those transactions are correlated, so if one sector of the
market starts to go down, whether that might have an impact on
the performance of other bonds. As they started, in my opinion,
putting more residential mortgage and consumer bonds in these
transactions, they were highly correlated in our intuition. We
weren't working on it, but it was highly correlated. It really
amazed us that they could put so many mortgages in the pool and
still believe that it had diversification risk.
But we were not part and parcel to those conversations. The
only thing that I really got involved in was when I was
requested to put these ratings on transactions we hadn't seen
and to basically guess as to what a rating might be.
Mr. Yarmuth. I guess maybe to be, put it more simply for
lay people like us is, if somebody says that they're not
assessing half the risk, would that mean that somebody who was
relying on the ratings to make an investment in those
securities would not be getting an accurate picture of the risk
that was involved?
Mr. Raiter. I would presume that is an interpretation.
Mr. Yarmuth. Which is the purpose of the ratings, correct?
Mr. Raiter. The purpose of the rating is to clearly and on
a timely basis reflect what that risk is according to the
experts at the rating agencies, and that rating apparently did
not.
Mr. Yarmuth. Now the committee went back to investigate
whether S&P had in fact rated this particular deal, the one the
instant message discusses, and yesterday the SEC informed the
committee that, the committee staff, that it indeed had rated
it.
So I'm going to ask, Mr. Egan, what do you think the
official means when she says it could be structured by cows and
we would rate it?
Mr. Egan. Well, perhaps that cow is particularly talented.
What it means is that it's ridiculous; that, as the--we have
the approach, again we stepped into the shoes of the investor,
that if you don't understand it, if it's unsound, don't put
your rating on it. There is no law that says that you have to
rate everything. In fact, you view the rating agencies as being
similar to the meat inspectors. If the meat is unsound, that
it's tainted, the inspector has the obligation to stop the line
and get rid of it or it threatens the whole system, because
what happens on the other end of the line that is with
investors is they can't tell the difference between good meat
and tainted meat. The investors don't have access to all the
information. They don't have the expertise. They're relying on,
hopefully, an independent agent--and that is the crux of the
problem, the independence--to stop things from coming down the
line.
In fact, I would argue that the Fed's and Treasury's
actions are going to have less and less impact because it's not
solving the underlying problem. The underlying problem is that
ratings link up providers of capital and users of capital. And
if that linkage is broken, which is what has happened right
now, you're not going to have people coming into the market.
They don't trust it. They won't eat the meat if it is tainted,
and we have a breakdown in the system, despite probably about
$3 trillion worth of support for the financial system.
Mr. Yarmuth. Thank you for using the beef metaphor for the
cow question.
Chairman Waxman. Thank you, Mr. Yarmuth.
The Chair reserves the balance of his time, and now turns
to Mr. Davis for 10 minutes.
Mr. Davis of Virginia. I think you milked that one.
I have a couple of questions. First of all, thank you very
much for your testimony. I think it has been very helpful to
both sides.
On the next panel, we're going to hear from senior
executives that acknowledge that the assumptions that S&P used
to estimate the risk of subprime mortgage default in order to
produce ratings of mortgage-backed securities between 2005 and
2007 were wrong. Is it simply, my question is to each of you,
is it simply the case that they got the assumptions wrong, or
do you think there is more to the story that maybe they aren't
willing to share with us? So I throw out a couple. Their
clients, when you say, who are their clients, it really wasn't
the general public, was it? It was the securities they were
rating, and it was their shareholders. And they were real happy
with these, isn't that the underlying problem?
I will start you with, Mr. Egan.
Mr. Egan. Absolutely. If you're a manager of a public
company, your job is to enhance value of that company as much
as possible. And the providers of 95 percent, between 90 and 95
percent of the revenues of S&P and Moody's and Fitch happen to
be the issuers. And the other oddity, and we look at industries
all the time you never find an industry like the credit rating
industry. The Justice Department used the term ``partner
monopoly,'' and that is a fair term. The problem is that there
is no downside for being wrong. In our case, we're paid solely
by the institutional investor. If we're wrong, we lose clients.
So our job is to get to the truth quickly. We're sort of like a
bank. In the old business model, if you went to a bank, let's
say 15 years ago, you wanted a mortgage, you go to a bank, the
bank would assess, the banking officer along with the credit
officer would assess your ability to repay the loan. And then
it would go to the head of the credit committee, and then it
would go to the State or Federal bank examiner. So you had
three checks. The goal is to make sure that the credit was
assessed properly. You don't want to be too tight or you won't
do any business, and you don't want to be so loose so you have
garbage in the portfolio.
That system has been thrown out the door to one whereby
everybody involved in the process has an incentive for letting
things go by basically, from the mortgage broker, the mortgage
banker, the investment bank, the issuer-paid rating firm; they
all get paid if a deal happens, and they don't get paid if a
deal doesn't happen. In the case of the rating firms, if S&P
decides or Moody's decides to tighten up their standards, S&P
and Moody's will take the transaction. And so it's very easy to
just go along with the flow because the downside is very
limited. You can't be sued, effectively.
Mr. Davis of Virginia. It's a great point. The real
question is, I understand where the incentives are. What is
your ethical obligation? Is it to your clients and your
shareholders that are putting you, up or is it to the public?
Mr. Egan. They serve two masters. And the most important
master is the one who pays the freight which happens to be the
issuers. In our case, it's the institutional investors. Our
business has grown over the past year because we have warned
people about the disasters coming down the pike. We got a lot
of grief for it because people thought we were wrong. But we
were worried about the bond alliance and the broker dealers and
a series of others. So our interests are aligned with the
ultimate holders of these securities.
Mr. Davis of Virginia. Mr. Raiter, Mr. Fons, do you want to
make any comment? You sat there trying to make the right
decisions. You didn't have the pressures that they felt above
to make profits and to----
Mr. Raiter. I believe that Standard & Poor's at this time,
there was a raging debate between the business managers and the
analysts. The analysts were in the trenches. We saw the
transactions coming in. We could see the shifts that were
taking place in the collateral. And we were asking for more
staff and more investment in being able to build the data bases
and the models that would allow us to track what was going on.
The corporation, on the other hand, was interested in trying to
maximize the money that was being sent up to McGraw-Hill, and
the requests were routinely denied. So, by 2005, when I
retired, we did have two very excellent models that were
developed but not implemented. And it's my opinion that had we
built the data bases and been allowed to run those models and
continually populated that base and do the analysis on a
monthly quarterly basis, we would have identified the problems
as they occurred.
Another big area that Mr. Egan has discussed is there are
two sides to the rating. You have an initial rating when the
bonds are sold, and then you have the surveillance. And at some
point in the mid-1990's, the management in Standard & Poor's
decided to make surveillance a profit center instead of an
adjunct critical key part of keeping investors informed as to
how their investments were performing after they bought the
bonds. And as a result, they didn't have the staff or the
information. They didn't even run the ratings model in the
surveillance area which would have allowed them to have
basically re-rated every deal S&P had rated to that time and
see exactly what was going on and whether the support was there
for those triple-A bonds.
The reason they gave for not doing it was because they were
concerned that the ratings would get volatile and people would
start to feel like all triple-As aren't the same. And it was a
much more pragmatic business decision than really focusing on
how to protect the franchise and the reputation by doing the
right thing for the investors. Mr. Jones and Mr. Egan pointed
out, we weren't paid by the investors, but we certainly, at the
ratings level, pitched them because we would say in our
presentations, if S&P isn't on a transaction, you ought to ask,
why? And we would do the same thing in presentations that we
shared jointly with Moody's analysts. We would always tell the
investors, you guys are driving this big market, and you're not
doing your homework. You're buying everything that is coming
out the chute, and you need to spend a little more time on your
own analysis and review.
Mr. Davis of Virginia. Nobody looked under the hood.
Mr. Fons. The large ratings agencies do take some fees from
investors. They have so-called investor clients. They market
their services in terms of their research service and other
things, so there is some focus there. But as I said in my
testimony, as Mr. Raiter just mentioned, the franchise derives
from the reputation that the firms have. And that comes from
serving the ultimate clients, and that is the investor,
particularly an investor who hasn't bought a bond yet who is
considering a purchase of a security.
Mr. Davis of Virginia. And that was really what was
betrayed here, isn't it?
Mr. Fons. That focus led to the rise in the reputation that
helped build the franchise that they eventually saw as a cash
cow, and they wanted to milk and start serving many masters. As
you said, you can't do that.
Mr. Davis of Virginia. I will reserve the balance of my
time.
Chairman Waxman. The gentleman reserves the balance of his
time.
Mrs. Maloney.
Mrs. Maloney. Thank you Mr. Chairman.
And I thank the panelists today.
Mr. Egan, in your testimony, you basically said that these
credit rating agencies were the gatekeepers. They rated these
very complex products, the derivatives, the mortgage-backed
securities on which investors and, I would say, the entire
economy relied. I have to say that it is important to note that
the President's working group has said that the credit rating
agencies contributed substantially to the present financial
crisis by their failure to warn investors of the recent wave of
credit defaults and institutional failures.
I would like to begin with you, Mr. Fons, and look at how
aware these credit rating agencies were of the risk that was
out there. And I want to ask you about a presentation prepared
by Moody's CEO Raymond McDaniel. This presentation was prepared
for a meeting of Moody's board of directors on October 25,
2007, when the company was coming to grips with its role in the
subprime debacle. The document, in my opinion, is an
exceptionally candid internal assessment of what went wrong at
Moody's. Its title is, ``Credit Policy Issues at Moody's
Suggested by the Subprime Liquidity Crisis,'' and it is marked
``confidential and proprietary.''
Under the heading, ``Conflicts of Interest: Market Share,''
the documents says, ``the real problem is not that the market
underweights ratings quality but rather that in some sectors it
actually penalizes quality. It turns out that ratings quality
has surprisingly few friends. Issuers want high ratings.
Investors don't want ratings downgrade. Shortsighted bankers
labor shortsightedly to game the ratings agencies.''
Mr. Fons, you used to work at Moody's. This document
appears to contradict years of public statements by Mr.
McDaniel and other Moody's officials that they are not
pressured by the issuers. And I'd like to ask you, Mr. Fons,
are you surprised by this kind of assessment that Mr. McDaniel
would be making to his board of directors?
Mr. Fons. No, I'm not surprised at all. I mean, this
totally reflected my views and the views of many others at the
firm. Many, of course, didn't want to hear this.
One problem with this whole statement is that the emphasis
is on rating quality, and in my view that is something that has
never really been clearly articulated by the agencies or by the
regulators or by anybody else. We talk about ratings quality,
but there is no clear definition of what that means, and
without a firm target there, we don't have much to go on.
But clearly what he is referring to is accurate ratings
here. And we definitely knew that the investors were conflicted
in what they wanted in terms of having stable ratings on bonds
once they held them, that issuers are conflicted and they
wanted high ratings on their securities, whether or not they
deserved them, and that bankers were taking advantage of the
competition in the industry to game the system.
Mrs. Maloney. Let me read another quote from this document.
Mr. McDaniel further writes, ``Unchecked competition on this
basis can place the entire financial system at risk.''
It appears he was correct, knowing back in 2007 their
failure to act put our entire financial system at risk. And are
you surprised by this statement? What is your comment on this
statement?
Mr. Fons. Well, at that point it was too late to do
anything. It was clear the ratings were wrong. It was clear at
that point that the securities that had faulty ratings had
already permeated the entire financial system. And many of
these other institutions were unwitting victims, including the
monoline insurers, including the banks and insurance companies
and others. And so I think this is not surprising, and I
believe it was prescient.
Mrs. Maloney. In this statement, Mr. McDaniel described how
Moody's has addressed the tension between satisfying the
investment banks and providing honest ratings; ``Moody's for
years has struggled with this dilemma. On the one hand, we need
to win the business and maintain market share or we cease to be
relevant. On the other hand, our reputation depends on
maintaining ratings quality.''
He describes some of the steps that Moody's has taken to,
``square the circle.'' But he then says, ``this does not solve
the problem.''
I would like permission, sir, to put this in the record.
Chairman Waxman. Without objection.
[The information referred to follows:]
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Mrs. Maloney. And what is your view on this statement, Mr.
Fons? And I welcome Mr. Egan and Mr. Raiter to make comments
likewise.
Chairman Waxman. The gentlewoman's time has expired, but we
will allow you the time to answer.
Mr. Fons. I believe you hit the nail on the head. It is a
difficult problem, and we don't see an easy answer.
Mr. Egan. In our view, it is not a difficult problem. In
fact, it is very simple. This is a--go back to a model that has
worked, actually, from biblical times. And that is you want an
alignment between the ultimate holder of these assets and
whoever is assessing them. If you have that, a lot of problems
will fall away. You won't have people, you know, taking out
mortgages that they had little chance of paying back.
But you want to focus on the right thing. Some people say
it is a subprime crisis or Alt-A or whatever. No, our view is
is that it is really an industry problem. It is a regulatory
problem. We use the analogy of a 90-year-old man that had a
triple bypass operation. There is no reason that person
shouldn't be allowed to get insurance. Just like subprime
mortgages have a legitimate purpose, Alt-A mortgages have a
legitimate purpose. But back to the 90-year-old man who wants
to get insurance, just make sure that the risk is properly
assessed. OK? That he is charged appropriately for that.
Chairman Waxman. Thank you, Mr. Egan. Thank you, Mrs.
Maloney.
Mr. Issa.
Mr. Issa. Thank you, Mr. Chairman.
I would hope we are not talking about dental insurance here
for that 90-year-old gentleman. But I understand the risk
assessment.
Let's go through a couple of things. I think up here on the
dais we realize that there has been an aircraft crash. And, you
know, there is probably a pilot that didn't do the right thing,
a mechanic that didn't do the right thing, maybe Boeing didn't
do the right thing; and you go back and you say the plane fell
out of the sky because everyone messed up.
What we're trying to did here and what we're hoping you
will help us with is assess how to keep Congress from doing the
two things we do so well, which is nothing at all and
overreact. And it is the latter that I am concerned about.
Mr. Egan, I want to followup on something that is the
premise of your testimony, I believe; and that is that ``whose
bread I eat, whose praise I sing.'' And that is what I think I
heard. That inherently you give an honest answer to your
client, but you are also skewed that way. That the rating
agencies taking money from the people selling the instruments
was a conflict. Is that roughly, loose-sense correct?
Mr. Egan. It is a conflict, yes. An unmanageable conflict,
too.
Mr. Issa. OK, let's go through a couple of things. I want
to judge how much of a conflict. PricewaterhouseCoopers rates a
public company in their audit; right?
Mr. Egan. Yes.
Mr. Issa. They are paid by the company that they are
auditing to give an honest and independent audit.
Mr. Egan. Right.
Mr. Issa. There is an assumption that they do. If they
don't, the entire audit system falls apart.
A CEO of a public company under Sarbanes-Oxley signs saying
I'm telling the truth about the condition of my company on that
report that is prepared by the public accounting firm but has
his signature. Generally truthful; right?
Mr. Egan. Right.
Mr. Issa. Held to be truthful. We rely on it.
If you are an ISO 9001 manufacturer, you pay people to say
whether your quality manufacturing system is in fact credible;
and they rate you for whether you meet that; right?
Mr. Egan. Yes.
Mr. Issa. OK. Goldman Sachs takes a company public, takes
their stock and sells it. Ultimately, Goldman Sachs makes a
fortune on it. But isn't there an essential belief that they
are bringing it to market--they are making a lot of money, but
they are bringing it to market at a relatively par level; and,
historically, isn't that relatively true?
Mr. Egan. Yes.
Mr. Issa. My premise to you is, since we rely on all of
these in the system and all of these are paid for by the person
who in a sense gets rated, might I not ask the question this
way? The subprime loans were essentially the equivalent of
taking the Dow Jones industrial average, having no equity in
it, and then having no margin call, but saying it is triple-A
rated. If I put a package together of the S&P 500 today and I
took one of each of those stocks and put it in there and I sold
it as a package and Moody's underwrote it as triple-A but it
had no equity in it and it had no statement of my income and it
had no recourse, wouldn't in a sense that be closer to what
these packages were? Where you had a liar's loan, no down
payment, and the only way that the loans are going to be paid
back was, A, they had to stay the same or go up; and in some
cases if they didn't go up the people couldn't have made the
payments anyway and yet they got a high rating.
Isn't it the fundamental, actual underpinning of these
documents that should never have gotten a triple-A rating
separate from the question of conflict?
Mr. Egan. No. Let me explain.
Mr. Issa. OK. Let's go through that. Now I have very
limited time. So I want you to answer, but I want to pose it in
a way that you can answer it I think consistent. And I think
Mr. Fons also wants to.
Were there subprime loans in which the substantial portion
of the package had little or no down payment?
Mr. Egan. Yes.
Mr. Issa. OK. Were these in most cases people who in
retrospect were unlikely to be able to make those payments with
their current income if it stayed the same?
Mr. Egan. Yes.
Mr. Issa. And, by definition, the economy has rises and
falls and real estate goes both directions up or down; isn't
that true?
Mr. Egan. Sure, yes.
Mr. Issa. So how do you put a triple-A rating, knowing that
if that happens these cannot in fact be repaid in full or even
close to it?
Mr. Egan. The core problem in the case of the mortgage-
backed securities was that the assumption was that housing
prices would increase. In fact, they embedded an acronym--what
is it--the House appreciation rate, which is somewhat ironic
because it doesn't account for the fact that sometimes houses
deflate, decline.
You brought up a lot of very good examples, but there is a
distinction between the examples you gave and the rating
industry. In the case of PriceWaterhouse, OK, accounting firms
are sued--and successfully sued--if they're substantially
wrong. In the case of the rating industry, what the current
practice is is that ratings are opinions. And we agree with
that. Because, ultimately, we are not guaranteeing all the
securities. There is too much out there. The industry would go
away. It is a force that--if you did away with the freedom of
speech defense.
In the case of the accounting industry, Arthur Andersen
said we would never allow this nonsense to happen because our
reputation is too important. Well, guess what? On an individual
basis, they obviously did bend their standards with Enron,
WorldCom and the others.
You mentioned Goldman Sachs and others. Sometimes they have
liability. In fact, in the case of WorldCom, they were the
underwriters for I think it was about $11 billion worth of debt
that WorldCom issued about 10 months before bankruptcy. They
had to pay $12 billion. So there are checks and balances. It is
rare that the rating firms have to pay anything for their
inaccuracies.
Mr. Issa. Thank you. And thank you, Mr. Chairman. I think
the word ``recourse'' has come out of this discussion. Thank
you.
Chairman Waxman. Thank you, Mr. Issa.
Mr. Cummings.
Mr. Cummings. Thank you very much, Mr. Chairman.
Mr. Raiter, Deven Sharma, the president of Standard &
Poors, is probably going to sit in the seat you are sitting in
in a few minutes. And one of the things that he is going to say
to us is that they received inaccurate information and
therefore had no duty to look at individual mortgages. And one
of the things I think that concerns the American people is how
it seems that everybody is passing the buck, passing the blame,
and nobody seems to want to take responsibility for this
phenomenal fiasco.
So I want to ask you--you and other panel members--about a
particularly complex type of financial product, a CDO squared.
A CDO squared is created when CDOs are constructed from pools
of securities issued by other CDOs. They are also sometimes
called synthetic CDOs because they can be backed by no actual
mortgages. The complexity of these instruments can be simply
staggering.
Let me show you an e-mail exchange between three analysts
at S&P that took place on December 13, 2006. They are trying to
figure out if the rating they are giving a CDO squared is
justified.
In this first e-mail, an analyst named Chris Myers says he
is worried about the CDO problems; and this is what he writes:
Doesn't it make sense that a triple-B synthetic would
likely have a zero recovery in a triple-A scenario? If we ran
the recovery model with the triple-A recoveries, it stands to
reason that the tranche would fail, since there would be lower
recoveries and presumably a higher degree of defaults.
Now Mr. Myers then writes: Rating agencies continue to
create an even bigger monster, the CDO market. Let's hope--and
this is--this is striking--let's hope we are all wealthy and
retired by the time this house of cards falters.
Mr. Raiter, I know you usually rated mortgage-backed
securities and not CDOs, but this is a striking statement for
an S&P analyst to make. What do you think Mr. Myers meant when
he called the CDO market a house of cards? And this would seem
to almost go directly against what Mr. Sharma has written in
his written testimony that there were certain--that they had
come to a point where they didn't have information and
therefore they had no obligation and therefore let the buck
pass to somebody else.
Do you have a response?
Mr. Raiter. Well, my short response is Mr. Sharma wasn't
there at the time, so somebody else wrote his----
Mr. Cummings. What he has done is he has talked about what
has happened over that time.
Mr. Raiter. I don't believe they didn't have the
information. I believe it was available on both the residential
side and on the CDO side. I believe there was a breakdown in
the analytics that they relied on. And that the house of cards,
intuitively, to a lot of us analysts that were outside the CDO
area but were looking at it through the glass, intuitively, it
didn't make a whole lot of sense.
And as Mr. Egan has suggested, we are all relatively well
educated and intelligent people; and if you couldn't explain it
to us, we were real curious how this product was enjoying such
a tremendous success. And, unfortunately, anecdotally, we were
told that it was enjoying a lot of success because they were
selling these bonds in Europe and Asia and not in the United
States, particularly the lower-rated pieces.
Mr. Cummings. It sounds like Mr. Egan and you and perhaps
Mr. Fons believe, as Nobel Prize winner, Mr. Krugman, believes,
is that there may have been some fraud here.
Mr. Raiter. Well, I wouldn't use fraud, sir. I would
suggest that there became a tremendous disconnect between the
business managers at our firm that were trying to maximize
McGraw Hill's share price----
Mr. Cummings. Clearly, would you agree there was greed?
Mr. Egan. I think that there was. Look at the definition of
fraud. When you have--when you hurt somebody and you do it
willfully, then it is fraud.
And in the case--I am relying on the information provided
by the Financial Times, Moody's knew there was problems with
the model and withheld that information because they didn't
want to move off of the triple-A. They hurt investors in the
process. They knew they were hurting investors if the
information in the Financial Times report was accurate. So,
yes.
Another comment on fraud.
Mr. Cummings. Yes, what?
Mr. Egan. It meets the normal definition of fraud, exactly.
You have to do some additional investigation, but if the
Financial Times is right, yes, there is fraud.
Also, in terms of fraud in the underlying securities, I
stated in connection with the Enron and WorldCom hearing that
there's always fraud connected with financial matters where
people--where firms are failing. It is normal. OK? It is normal
for the WorldCom executives to say everything is fine, don't
worry about it. But yet it is the job of the credit rating firm
to assess that and to get to the truth.
And that's where the alignment of interests is absolutely
critical. If you don't have that, you have a breakdown in the
system; and that is exactly what we have right now.
Mr. Cummings. Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Cummings.
Before I recognize the next questioner, I want to ask
unanimous consent to allow all documents referred to in
statements and questions throughout this hearing to be part of
the record.
Without objection, that will be the order.
Mr. Bilbray.
Mr. Bilbray. Thank you, Mr. Chairman; and I want to thank
all the panel for being here.
And I really want to say, Mr. Egan, thank you for saying
bluntly what a lot of people have been thinking, wanting to
have open--and saying, look, this thing has reached the point
to where there is no reasonable way to say that it has not
crossed fraud. Now how much over? We could say who would have
thought that real estate would ever go down in this illusionary
time. That is the difference between the expert and the general
public, supposedly.
Do you think the rate shopping played a major role in this
crisis?
Mr. Egan. Absolutely.
Mr. Bilbray. And that--would you say that rate shopping and
the way it was done would be defined to reasonable people as
fraud instead of just a normal business cycle?
Mr. Egan. Well, it is incremental. So it is harder to throw
it in--in my opinion, it is harder to throw it into the
category. To ultimately reach that level where you are hurting
the public, you knew were hurting the public and yet as a firm,
a publicly held rating firm, you are pressured into it.
But I think there is a deeper problem, and the deeper
problem is addressing the question why is there ratings
shopping? Why can issuers go from one firm to the other firm to
the other firm and get the highest rating and there is
relatively little downside for the rating firm because they
have the freedom of speech defense?
I think you have to step back and say, how do we fix this?
And I think you fix it from the institutional investor
standpoint, which will trickle down to the individual. The
institutional investor should know darned well that these
ratings are paid for by the issuers--99.5 percent. Why in the
world do they have all their investment guidelines geared to
conflicted ratings? They should make the adjustment, because it
is a fool's error to try and rein in the activities of S&P and
Moody's. It won't happen over the long term, because there is a
natural tendency to serve their master's, the issuers.
Mr. Bilbray. Following your analogy to the meat inspector,
the fact that if the meat inspector gets paid per side of beef
that is approved, there is an inherent conflict with him
finding the tainted meat and throwing it off the line because
they get paid less.
Mr. Egan. Absolutely. Yes, sir.
Mr. Bilbray. That is the analogy that you worked on.
The other analogy that you used--Saint Augustine teaches us
that when we want to find fault then we should start looking at
what we're not doing properly.
Mr. Egan. Sure.
Mr. Bilbray. The analogy that you used of the elderly man
getting a triple bypass needs to be required to pay more
because there is more risk there.
Mr. Egan. Yes.
Mr. Bilbray. And that more is not punitive. It is just
common sense--I mean, it is not punitive, but it is prudent.
Mr. Egan. It is sustainable. You could set up a firm just
to insure those people.
Mr. Bilbray. And you realize in this town, in Congress,
they would call you mean spirited and that attitude picks on
those who can least afford to pay on that. And I'll give you an
example. We have the same thing here. We were talking about, I
have to assume, that the degree of subprime loan, the general
population that received those subprime loans tended to be in
the lower socioeconomic rating, wouldn't you say?
Mr. Egan. Yes.
Mr. Bilbray. OK. Now in this town you start requiring those
people to carry more of the burden of ensuring their loan,
there are a lot of people here that would be the first ones to
attack you for doing that because you are targeting those who
could pay the least.
Mr. Egan. There is a place for public policy interests, and
there is a place for good business decisions. We are in the--
our job is to protect investors, and everything is geared
toward that.
Mr. Bilbray. And I understand that. And I will just tell
you something. There are a lot of people in this town on our
side of the dais who would love to turn every program into a
welfare program--be it loans, be it the tax system or
everything else. And then when the system starts crumbling
because it cannot maintain itself, it is the little guy that
gets hurt the worst in these crises. And I wish we would
remember that when we mean to help the little guy we actually
can do damage.
Mr. Egan. Absolutely. One case in point is the commercial
paper crisis. It might be that GE is helped out because it is a
large, important issuer. But what about the secondary and
tertiary issuers of commercial paper?
That is why we encourage a return to a sustainable system.
The government can't--the Fed and the Treasury can't issue a
new program every week and hope to save the market. What is
needed is a return to the policies that have worked over time.
And that is basically checks and balances, two forms of ID.
Make sure that the credit quality is properly assessed so that
the money will flow in. So that the French treasurer who is
burned because he invested in triple-A of Rhinebridge and
Automo was rated triple-A and was slammed down to D in a period
of 2 days will come back into the market after there are some
checks and balances reinstalled.
Mr. Bilbray. Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Bilbray.
Mr. Kucinich.
Mr. Kucinich. Thank you, Mr. Chairman.
Mr. Fons, did you write a white paper on rating competition
and structured finance?
Mr. Fons. I did.
Mr. Kucinich. And in that paper did you say that recent
rating mistakes, while undoubtedly harming reputations, have
not materially hurt the rating agencies? On the contrary,
rating mistakes have in many cases been accompanied by the
increase in the demand for rating services. Did you say that?
Mr. Fons. Yes.
Mr. Kucinich. And so we have a situation where the rating
services are actually profiting even though their ratings may
not in fact have been created; is that correct?
Mr. Fons. [Nonverbal response.]
Mr. Kucinich. Thank you, sir.
Mr. Chairman, members of the committee, look at this
system. Investment banks need high ratings. Moody's, Standard &
Poors need lucrative fees from the investment banks. Investment
banks get the ratings, Moody's gets the fees, we know what the
investors get, and we know what the taxpayers get.
Now, Mr. Fons, we have a document here called Ratings
Erosion by Persuasion, October 2007. It is a confidential
presentation that was prepared for the company's board of
directors at Moody's. I want to read you one part of the
section that says: Analysts and managing directors are
continually pitched by bankers, issuers, investors, all with
reasonable arguments whose use can color credit judgment,
sometimes improving it, other times degrading it. We drink the
Kool-Aid.
What does that mean?
Mr. Fons. I think it's human nature to be swayed to some
extent by the people you interact with. And they are being
pressured--they are being pitched because their ratings are
important, their ratings carry weight in the market. At least
they had at that time. And they had a lot of incentives to
listen to these people.
Mr. Kucinich. Thank you.
I would like to submit for the record from the Oxford
dictionary of American Political Slang: To drink the Kool-Aid:
To commit to or agree with a person, a course of action, etc.
Mr. Fons, did Moody's offer a German insurance corporation,
Hannover, to rate its credits? Do you have any knowledge of
that?
Mr. Fons. I'm not sure. No. I don't know exactly what
happened there.
Mr. Kucinich. Could you provide to this committee the
answer to this question: Whether or not Moody's offered to rate
Hannover's credit and when Hannover refused, whether it gave it
an adverse rating?
And I'm raising this question, Mr. Chairman and members of
the committee, for this reason. On January 10th, the same day
that you wrote your article, according to Alex Coburn in
Counterpunch, he said that Moody's gave the U.S. Government a
triple-A credit rating. But while it was giving the U.S.
Government a triple-A credit rating, it said, according to this
report, that in the very long term, the rating could come under
pressure if reform of Medicare and Social Security is not
carried out, as these two programs are the largest threat to
the financial health of the United States and to the
government's triple-A rating.
Are you familiar with that report.
Mr. Fons. I didn't read that. No.
Mr. Kucinich. I am going to submit this for the record, Mr.
Chairman.
[The information referred to follows:]
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Mr. Kucinich. Because we know that Wall Street has been
trying to grab Social Security forever. Imagine, Mr. Chairman,
if we had gone along with these privatization schemes and all
the people on pensions in the United States lost their Social
Security benefits because the market crashes.
Here we have Moody's--according to this article, Moody's is
involved in promoting not only privatization of Social Security
but privatization of Medicare. If we privatize Medicare, the
insurance companies Moody's rates can make more money. You
privatize Social Security, Wall Street investors make a
windfall.
Now this racket known as ratings has not just a whiff of
fraud, as pointed out by Mr. Cummings in a conversation with
Mr. Tierney, but if the investment banks are paying to get a
form of a high rating, that is kind of extortion. If they pay
to make sure--can they also pay to make sure their competitors
get low ratings? Which would be a type of bribery.
If Moody's could essentially offer credit to rate someone
and then if they don't accept the rating, give them an adverse
rating, that is a form of a racket. And if they could go to the
U.S. Government and tell the U.S. Government either you go
along with privatization of Social Security and Medicare or we
are going to downgrade your rating. I mean, this is criminal.
Mr. Egan, would you like to comment on that?
Mr. Egan. You have a current example of that process
whereby reportedly S&P and Moody's went to the monoline
insurance companies, the MBACs and the MBIAs, and said--they
were at that time involved only in municipal finance--and said
that if you don't get involved in structured finance we're
going to have to take a negative action on you because your
funding sources aren't sufficiently diversified. A core aspect
is do they really believe it or were they pressuring them to
bolster the structured finance market? Don't know. But your
point is well taken that they can abuse the power that they
have.
And, by the way, the best source of information on Hannover
reinsurance is an article by Al Klein in the Washington Post.
It is probably about 2\1/2\ years ago. And there is a subtlety.
Because this came up when I testified in front of the Senate
Banking Committee. The subtlety was that Moody's was providing
a rating for Hannover Re but is looking for additional
compensation on another form of rating. I think--what was it--
their insurance side. But they wanted to be rated, I believe--
they wanted to be paid for the rating on the debt side.
So Moody's answer was we are already being paid, but the
response was a little bit more nuanced than that. They wanted
to be paid on the more lucrative part, the one where they had
the more extensive relationship; and, according to Al Klein's
story, they took negative action while S&P and I think it was
A.M. Best did not.
Basically, the opportunity, the means for mischief is
there. And that is why we press that there at least be one
rating that has the interest of the investors at heart. Because
you can check these things. You say, hey, wait a second. This
is a real credit rating and forget about this nonsense that is
going on.
Chairman Waxman. Thank you, Mr. Kucinich. The time has
expired.
Mr. Souder.
Mr. Souder. All of us are really crashing and learning as
much as we can about the finances. And every time I think I can
get into a couple of questions that I want to, but some of the
answers just appall me. It is clear that greed led to not only
``see no evil, hear no evil'' but ``report no evil''. It is
clear that there was fraud here. But there is also to me
incredible gross incompetence.
It is an embarrassment to the business profession to have
businesspeople stand up here, and even some of you who have
been warning, to make some of the statements you have made in
front of these hearings.
For example, Mr. Raiter, you said we didn't have the
ability to forecast when these were going awry. You also said
there was a breakdown on fundamental analysis.
My background by training is business management. I spent 2
years in a case program where you basically analyze what is the
core source problem? What is the secondary problem? What is
tertiary? How do you do this? And you wake up at night and,
basically, everything for the rest of your life you are tearing
it apart in that system.
This just screams out in 60 minutes of analyzing what
happened certain base management things that were not done.
That if you have basic mortgages, you come out and start to try
to separate these into no-risk mortgages. Then you come down to
a six-pack of derivatives with some toxic things inside that.
Then you do another derivative package off of that, and then
you do another derivative off of that.
No. 1 management theory is, if you are building a house
like this, every level you go you should be drilling down where
the foundation is and know every variation of that foundation
because you built an entire system of ratings on a foundation
that requires increasing scrutiny. Not we don't quite know
this. I wonder how we're going to do this. And so on. Basic
core management.
If you say you are a business exec, you would be crawling
all over the specifics of that. Then, guess what? Because these
new vehicles came that were supposedly, ``risk free,'' now out
three and four levels, some without even a mortgage behind it,
demand came. It was no secret that whether it was political
driving on Fannie Mae, whatever, part of this was demand for
everybody who wanted higher returns to go get these packages.
So we have an artificial doubling of the housing market without
anybody asking where are these coming from? Where did all of
these new people come to get these new homes? Who was building
this foundation?
Yes, some of it is a conflict of interest. It is clear that
when the temptation was there the conflict of interest came in.
But the core problem is we have this in multiple categories in
the financial, and not all of them had conflicts of interest.
We have a conflict of interest here, but we also have a core
problem founded in what were the bond rating managers doing?
You could tell from the change in the market. You could tell
why are some of these yielding so much? Guess what? They are
yielding more because they are getting charged more points.
They are having to pay higher interest rates. Any manager--any
manager looking at that should have said these are higher risk.
What are we getting here?
How can you say that this wasn't predictable? Are you--the
things were all there.
Mr. Egan. In our opinion, it is not, by the way,
incompetence. If you look at the job of a manager of a public
company, it is to increase the revenues, increase the
profitability. You probably could come to the conclusion that
they did everything possible to do that.
Mr. Souder. I understand your point. You are making an
ethical argument. I would argue that presumes that they
actually knew the danger, rather than they were just trying
to--I believe there is possible legal culpability.
Because, in fact, another thing that was stated here, in
the multiples of memos, but in the--I think Mr. Raiter said the
question was, did we want to come up with two categories of
triple-A bonds? Because some of these were more risky. Yes,
that is an ethical obligation. It's probably a legal
obligation. If there were inside triple-A bonds some things
that didn't really have the criteria that is the public
definition of a triple-A bond, there should have been another
category. Because that suggests that management actually knew.
Now, I understand your point. Their goal is to maximize
revenue, if you take that model. But, by the way, in
agriculture, agriculture does fund some of the inspectors. But
the reason they don't have a conflict of interest is they know
if there is tainted meat or tainted chicken their entire
category goes under. Nobody will buy their meat as in mad cows.
And there can be a conflict of interest and still, in fact,
maintain inspectors.
The problem is if they're incompetent and greedy and
corrupt and behaving illegal, then the conflict of interest
pushes them over the top and it destroys their industry, which
is what happened here. It has not happened in agriculture. The
examples that were being used in agriculture are wrong.
Mr. Egan. Can I address that, since it is my example? I
think in economics--this is from going back 20 years--it is
what is called the tragedy of the commons. And that is that,
given a town in the 1700's, you let people put the cow on the
commons to graze. The problem comes in when everybody puts
their cow. Then the commons deteriorates, and it doesn't
support any of the cows. And so there is a delay in the
reaction.
Did the investment banks--did they want to see--did the
industry want to see three of the five investment banks
disappear? No. But the decision isn't being made on that level.
It is being made on the individual level, just like the cow
example. We want to get this deal through. We want to get the
lowest possible issuance cost. Let's do what we can to do it.
I think this breakdown surprised a lot of people in the
industry, in the finance sector. But here we are, and we have
to step back and say what is the underlying cause and how can
we address it.
Chairman Waxman. The gentleman's time has expired.
In this example, it is the aggregate of the excrement on
the commons with all the cows that becomes the problem.
Mr. Tierney.
Mr. Tierney. Thank you, Mr. Chairman.
Mr. Raiter, I'm not sure that we need any more examples of
things gone awry. I think we want to find out how far up the
chain this goes.
But I do want to ask you about one remarkable incident
during the time you were at S&P. Around 2001, my understanding
is that you were asked to do work on rating a collateralized
debt operation call Pinstripe. Do you recall that?
Mr. Raiter. Yes, sir.
Mr. Tierney. Now a collateral debt obligation is
essentially a collection of the different mortgage-backed
securities; and I think you were asked to look at one segment
of those mortgage-backed securities; is that accurate?
Mr. Raiter. I was asked to put a rating on a bond that has
been rated by Fitch. It was being included in the CDO.
Mr. Tierney. Now the foundation for the ratings analysis is
usually the value of the underlying mortgages?
Mr. Raiter. Yes.
Mr. Tierney. And I suppose the information like the credit
worthiness of the borrower, the borrower's credit score, things
of that nature would be important to you.
Mr. Raiter. That was the tape that we asked for.
Mr. Tierney. OK. Well, that is exactly what I want to get
into. You sent an e-mail; and in the e-mail on March 19, 2001,
you asked for collateral tapes. What was on the collateral
tapes that you sought?
Mr. Raiter. That would have been the information on every
loan that was in the pool. It would have had the FICO score. It
would have had the loan-to-value information, the kind of note
that was written, whether it was fixed or floating. A variety
of information about the house's price, where it was located.
The tape had about at that time 85 or 90 data points for every
loan on the tape.
Mr. Tierney. To most of us sitting here, that seems like a
reasonable request. It seems exactly what we would expect
somebody to do in underwriting, whether or not they were going
to make that rating.
But the S&P executive in change of those ratings, Mr.
Richard Gugliada, I want to show you an e-mail he sent back to
you when you made that request.
He answered back: Any request for loan level tapes is
totally unreasonable. And he made the words ``totally
unreasonable'' in bold. Most investors don't have it and can't
provide it. Nevertheless, we must--again in bold--produce a
credit estimate. It is your responsibility to provide those
credit estimates and your responsibility to devise some method
for doing so.
Now that's a little hard for us to understand, given what
we just discussed and the need for those documents. So you were
told to assign a credit risk for the mortgage-backed securities
that backed a CDO; and now you were being ordered, apparently,
to give the rating without having the backup information that
you need.
You forwarded that e-mail on to a number of other officials
at S&P, and here is what you wrote, ``This is the most amazing
memo I have ever received in my business career.''
Why did you write that and what did you intend to imply by
that?
Mr. Raiter. Well, it was copied to the chief of credit
quality in the structured finance group, and earlier in the
memo, I had also said I want some guidance from Mr. Gillis to
tell me what we are supposed to, otherwise I have no intention
of providing guess ratings for anybody. And there were no
responses to the memo, so we just let it die. We never gave
them a rating.
Mr. Tierney. Never gave them a rating?
Mr. Raiter. No.
Mr. Tierney. Good for you. Mr. Egan what is your reaction
to that scenario, that someone would send an e-mail to Mr.
Raiter demanding that he give a rating without the back up
materials?
Mr. Egan. I think it is reasonable if you are being paid by
issuers and unreasonable if you have the investor's interests
at heart.
Mr. Tierney. Why wouldn't the government just get out of
the business of certifying agencies like yours? Why wouldn't we
just say that this is too fraught with errors and problems and
risks. We are going to get out of the business of certifying
agencies and we will establish our own standards. Then you can
do what you want to do. We can't put you out of business. It
would be an overstep to do that. But there is no reason we
should certify you as a government. You give your ratings and
let the market decide whether or not you are worthy of them and
sort out of conflicts issue, but we're not going to do it
anymore. We're going to step in and be the regulators instead
of contracting it out to you. Why wouldn't we do that?
Mr. Raiter. If I could just--there is no reason why under
the certain circumstance that you don't take those steps. There
is a big difference in this market between the rating at issue
and the surveillance. A breakdown occurred both in the proper
sizing of the rating at issue. But surveillance has been
atrocious. And the NRSRO designation that has been provided to
the three majors, and A.M. Best and maybe others, it doesn't
distinguish across what kind of ratings you can give. If you
get rid of that designation, you can keep the investment policy
guidelines that say if you are the investment manager, you have
to get two ratings. But let the responsibility fall on the
investor to find the best rating, and then to find the best
surveillance that would keep them informed on a timely basis as
to how that rating is performing.
Mr. Tierney. Wouldn't that be the better course? Mr. Fons,
would you agree?
Mr. Fons. Yes, I advocated that in my oral testimony that
the NRSRO designation should be abolished.
Mr. Tierney. Mr. Egan, do you agree as well?
Mr. Egan. The government has been part of the problem in
this industry. It took us 12 years to obtain the NRSRO----
Mr. Tierney. Excuse me, but when you say the government is
part of the problem, are you referring to the SEC?
Mr. Egan. The SEC, exactly. It took us 12 years to obtain
an NRSRO, and yet there is proof from the studies of Federal
Reserve Board of Kansas City and from Stanford and Michigan
that pointed out that we had much better ratings than S&P and
Moody's but yet there is still no response.
In that time period, what has happened is that because the
government only recognized those few rating firms and continued
this unsound business model, it enabled the issuer-compensated
rating firms to grow much faster, much further, and have a more
consolidated industry than it would be otherwise. Think the
equity research industry. There are a lot of equity research
shops out there. In the case of the rating industry, as Jim
Graham said, it is a 2\1/2\ firm industry. That was before we
got the NRSRO. Now he puts us in the category.
But I think that what has to happen at this point--clearly
there is a breakdown--what has to happen is something that
gives confidence for the investors that are not in the market
and they happen to be in many cases non-U.S. investors. The
Asian and European investors, to get back in the market.
Because they can't do the work themselves. They have to be able
to rely on a credible agent to be able to properly assess
credit quality. You are not going to change significantly S&P
and Moody's and Fitch's way of doing business. You can't do it.
These are rating opinions; they will remain rating opinions.
What is needed is an alternative business model to be more or
less on the same plane so that people have some confidence and
get back into the market and get credit flowing again.
Mr. Tierney. I think you can change the nature of that
model because we can set standards at the Securities and
Exchange Commission saying that we don't accept it when the
issuer makes the payments as opposed to the investors.
Mr. Egan. We've argued for that----
Mr. Tierney. Rather than having the government stepping in
and protecting that conflict and then leaving it there. I think
the idea is right. Mr. Raiter is right. Set the standards and
leave your standards out there, but don't start picking winners
and losers.
Chairman Waxman. Thank you, Mr. Tierney. Ms. Watson.
Ms. Watson. Thank you, Mr. Chairman. On July 10, 2007,
Moody's downgraded over 450 mortgage-backed securities. It
placed another 239 on review for possible downgrade.
Although many of these bonds were not rated highly to begin
with, Moody's had awarded them its highest rating of triple-A.
The committee has obtained an internal Moody's e-mail
written the next day, July 11, 2007. I think it is going to be
up on the screen in a moment. And this e-mail was written by
Moody's vice president, who took multiple calls from investors
who were irate about these downgrades. And I would like to get
your reaction to these comments.
First the e-mail describes a call with an investor from the
company PIMCO and the vice president writes: PIMCO and others
have previously been very vocal about their disagreements over
Moody's ratings and their methodology. He cited several
meetings they have had questioning Moody's rating methodologies
and assumptions. And he feels that Moody's has a powerful
control over Wall Street, but is frustrated that Moody's
doesn't stand up to Wall Street. They are disappointed that
this is the case Moody's has toed the line. Someone up there
just wasn't on top of it, he said. And mistakes were so
obvious.
So this goes to Mr. Fons. PIMCO is a very highly regarded
investor management. It's run by Bill Gross, who is widely
regarded as one of the Nation's most experienced fixed-income
investors. Does it surprise you, Mr. Fons, that PIMCO would be
so critical of Moody's?
Mr. Fons. No, it doesn't surprise me. I personally met with
folks at PIMCO and they are eager to express their opinions
about how they think the ratings should be run and how we
should be doing our business. So this doesn't surprise me at
all.
Ms. Watson. This e-mail described a similar call from an
investor from Vanguard, which is one of the Nation's leading
mutual fund companies. According to the e-mail, Vanguard
expressed frustration with the rating agency's willingness to
allow issuers to get away with murder.
And so again, Mr. Fons, why would Vanguard say credit
rating agencies allow people to get away with murder?
Mr. Fons. They are addressing the rating shopping issue,
the erosion in standards that were obviously clear to them and
clear to many others in the market. And the delay by the rating
agencies to adjust their methodologies and ratings accordingly.
Ms. Watson. I want to read three more lines and they are up
on the screen. Vanguard reports it feels like there is a big
party out there. The agencies are giving issuers every benefit
of the doubt. Vanguard said that portfolio managers at Vanguard
began to see problems in the work of the rating agencies
beginning about 18 months ago. At first, we thought that these
problems were isolated events. Then they became isolated
trends. Now they are normal trends. And these trends are
getting worse and not getting better.
So Mr. Egan, down at the end, what do you make of this e-
mail and do you agree that these isolated events turned into
worsening trends?
Mr. Egan. It is not at all surprising. In fact, we argued
that the current ratings system is designed for failure and
that's exactly what we have.
Ms. Watson. I want to thank you particularly, Mr. Egan,
because you have been one of the clearest speaking people that
we have had up here since we have been looking at the collapse
of the market. What we need is plain English to try to
unscramble these eggs that we find ourselves in and they are
rotten eggs at this time. I appreciate all the panel being here
and I appreciate clear responses that the public out there can
understand. Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Ms. Watson. Mr. Lynch.
Mr. Lynch. Thank you, Mr. Chairman. And I also want to
thank the witnesses.
I also have the dubious honor of serving on the Financial
Services Committee and in our hearing yesterday, I began my
remarks by saying I wasn't interested in assigning blame or
responsibility. And that I was more interested in hearing about
how we might go forward and build a regulatory framework that
would actually be reliable and would secure the markets. That
was the Financial Services Committee.
This is the Oversight Committee which actually, in my
opinion, does have a responsibility to identify those who are
responsible and to hope in a way to hold those people
accountable. It is a fact that Moody's and Standard & Poor's
especially as rating agencies held a position of trust in
relation to investors and market participants and over time
over the past 75 years or so investors and market participants
were induced to rely on the ratings that were produced by those
agencies.
It is also a fact that while there were other bad actors in
this crisis, none of the others held a special responsibility
as being a gatekeeper or to serve as a firewall in the event
that this toxicity arrived in order to prevent it from, first
of all, being systemic, and in this case, actually going
global. But the rating agencies facilitated that by putting
triple-A stamps on this. They were facilitators of allowing
this whole problem to go systemwide and then go global.
And as a result, I have a lot of families in my district
and across America who had their life savings wiped out and had
their pensions cut in half. Their investments have disappeared.
Some have been thrown out of their houses. I have retirees
coming out of retirement asking me to find them a job in this
economy. There is a human side to this that I think that some
of our ratings agencies and financial services do not
recognize.
My constituents were not in the position to understand what
a binomial expansion was or did not have the ability to
scrutinize the different tranches of securities. They just did
not have that ability And they were not sophisticated like
this. But they knew what triple-A meant--and what it has meant
for the past 75 to 100 years--and they relied on that. And they
were induced to rely on that. These securities are so complex.
People in America and across the globe knew what triple-A meant
because Moody's and Standard & Poor's as agencies were trusted.
They were trusted to be accurate and honest. And that was then.
I have a lot of people in my district who feel that they
have been defrauded. And they are mad as hell. And they think
that in light of what has happened to them, that somebody ought
to go to jail. And the more I hear in these hearings, the more
I read, I am inclined to agree with them. I am inclined to
agree.
Mr. Egan, you have been very helpful and I just want to
touch on one of the things that is at the root of this and that
is this firm shopping or ratings shopping. I want to ask you
about the problem of ratings shopping when the investment banks
go around and take their mortgage backed securities to various
credit agencies to see which one will give them the highest
rating. And under the current system, a rating agency gets paid
by the issuer as we have talked about here.
Let me show you an example. We have an e-mail that was sent
on May 25, 2004, from one of the managing directors at Standard
& Poor's to two of the company's top executives. The subject
line of this e-mail is ``competition with Moody's.'' It says:
We just lost a huge Mazullo RMBS, which is a residential
mortgage-backed security deal, to Moody's due to a huge
difference in the required credit support level. That is the
amount of other mortgages supporting the upper tranche.
Later on, the S&P official explains how Moody's was able to
steal away the deal by using a more lenient methodology to
evaluate the risk. He says this: ``They ignored commingling
risk and for the interest rate risk they took a stance that if
the interest rate rises they will just downgrade the deal.''
Mr. Raiter, you used to work at Standard & Poor's. And were
officials at the company concerned about losing rating deals to
your competitors?
Mr. Raiter. Well, I believe that might have been a deal
that was rated in Tokyo. And in the United States we had, as I
believe my statement explains, we had delivered our models out
to the street. So there was no real rating shopping in our
market share, because they could basically run the pool of
mortgages through the model on their own desk and get exactly
the same answer that we got.
Mr. Lynch. Are you saying there is a difference between
what you did in the Asian market versus what you did here?
Mr. Raiter. Yes, there was a difference in every market.
The U.S. market had its criteria, the Japan had a separate set
of criteria, the Spain, England, based on the nature and
structure of the market and the securities.
Mr. Lynch. But this is Moody's stealing accounts from S&P
and vice versa. This is competition between the two firms we
are talking about here.
Mr. Raiter. Predominantly, yes between the two firms.
Mr. Lynch. Whether you are stealing work that was in Asia
or the United States, it is the competition between the firms.
Let me ask Mr. Fons, you were a senior official at Moody's----
Chairman Waxman. The gentleman's time has expired. Do you
want to conclude with one last question?
Mr. Lynch. Sure this will be it. Let me read the rest of
the e-mail. After describing the loss to Moody's the S&P
officials say this. This is so significant that it could have
an impact on future deals. There is no way we can get back this
one, but we need to address this now in preparation for future
deals. I had a discussion with the team leaders and we think
the only way to compete is to have a paradigm shift in
thinking, especially with interest rate risk.
My last question would be, Mr. Raiter, what is your view
about these e-mails? They seem to indicate that credit rating
agencies are engaged in a race to the bottom in terms of credit
ratings quality. And I'd like to hear your comments on it. And
I thank you for your forbearance, Mr. Chairman.
Mr. Egan. I think we have had ample evidence that ratings
shopping is alive and well. And when you couple that with the
fact that ratings have been viewed as opinions and therefore
there is relatively little downside to inaccurate opinions, you
have a condition that has led to the collapse that we are
experiencing.
Mr. Lynch. Thank you, I yield back.
Chairman Waxman. Thank you, Mr. Lynch.
Ms. McCollum.
Ms. McCollum. Thank you, Mr. Chair. Credit rating agencies
are viewed as sources of information for independent analysis.
Investors--and that includes the families in my district who
purchase these products--they look for the credit rating agency
to speak to the financial conditions, the creditworthiness, so
that they can assess their risk or lack of risk.
I want to cite an April 26th, New York Times piece that was
called Triple Failure, ``Moody's used statistical models to
assess CDOs. It relied on historical patterns of default. It
assumed the past would remain relevant in an era in which the
mortgage industry was metamorphosing into a wildly speculative
business.'' In fact, the chief executive of JPMorgan and Chase
said, ``There was a large failure of common sense by the rating
agencies.''
Mr. Fons, from your testimony, ``The focus of Moody's
shifted from protecting the investors to being a market driven
organization.''
So my question for you gentlemen. I want to ask about July
10, 2007, when Moody's downgraded over 450 mortgage-backed
securities and threatened to downgrade over 200 others. The
investors were irate because Moody's had previously rated some
of these bonds as triple-A, equivalent to Treasury.
One of the documents that the committee has obtained is a
Moody's internal e-mail from July 12, 2007, only 2 days after
these downgrades, which shows how these complaints continued
and they rose all the way up to the CEO level.
In this e-mail Moody's officials described a tough phone
call with the chief investment officer at Fortis Investments.
The Moody's official wrote that the Fortis investor requested
to speak to someone very senior very quickly. She said she was
extremely frustrated and had a few choice words, and here's
what she told the Moody's official: ``If you can't figure out
the loss ahead of the fact, what's the use of your ratings? You
had legitimized these things,'' referring to subprime and ABs,
that's asset-backed CDO assets,'' as leading people into
dangerous risk.
``If the ratings are BS, the only use in ratings is to
compare BS relatively to BS.''
Mr. Fons, you used to work at Moody's, so my question for
you is, that's a pretty damning indictment of the entire
system, to use the phrase, to use only ratings ``compared BS
relatively to BS.''
So my question to you, does Fortis have a point?
Mr. Fons. Absolutely. The deterioration in standards was
probable. As I said, evidence first arose at least in 2006 that
things were slipping, and the analysts or the managers for
whatever reason turned a blind eye to this, did not update
their models or their thinking and allowed this to go on. And
what these investors are most upset about clearly, is the fact
that a triple-A was downgraded.
Triple-As had historically been very stable ratings through
time. And so there was an implicit compact, if you will, that
the triple-A was to be something that was to last at least for
several years without losing that rating. And when you see
something go from triple-A to a low rating in such a short
period of time, clearly that's evidence of a massive mistake
somewhere.
So she's venting her frustration.
Ms. McCollum. So the triple-A is like the gold standard?
Mr. Fons. It is, yeah. It's the brand. That's what Moody's
is selling.
Ms. McCollum. According to the e-mail, a Fortis Investments
manager had come to Moody's the year before to discuss their
concerns about the company's methodologies. So she's been
concerned before. In fact, she told Moody's, that she and
``other investors had formed a steering group to try to get the
rating agency to listen to the need of the investors.''
So, Mr. Egan or Mr. Raiter, what does it say about a system
when the investors that--the people these ratings are supposed
to be serving, their customers have to form a steering group
just so the credit agencies won't ignore them?
What does that say about the credit agencies?
Mr. Raiter. Well, I just think it's a further indictment
that there was a big breakdown between the people that were
trying to maximize profits and the people that were trying to
maximize the credit ratings methodology and activities, and
that the people with the profit motive won.
Ms. McCollum. Mr. Egan.
Mr. Egan. I think it is similar to a Yiddish saying, which
is that we have to get smart quickly, OK, that we're stupid
right now. This system is stupid; we need to make some
adjustments. It's not fair and it's not going to be a good use
of your time and energy and effort to try to curb the behavior
of S&P and Moody's and Fitch.
Why? Because that's the way they're set up. Ratings are
opinion; and you're stuck. Accept them for what they are and go
around and get another check and balance in this system.
Yes, the investors are upset, but you need to provide a
pathway for some other independent voices. We're out there.
There are other firms that are out there that are similar to
us, but we have a small voice compared to S&P and Moody's. And
so we, yeah, we can continue on the current path, have more
failures.
The United States slips in importance. The financial
services industry is one of the most important industries, and
we see it fall apart. We can continue along the path or we can
take some tangible actions to correct the problems. And I think
that would be much more fruitful than beating up on S&P and
Moody's for doing what they have an incentive to do, basically,
which is to issue the ratings that will satisfy the people who
pay 90 percent of their bills, that is, the issuers.
Ms. McCollum. Thank you, Mr. Chair.
Chairman Waxman. Thank you, Ms. McCollum.
We are checking out that Yiddish quote to see if it's
accurate.
Mr. Sarbanes.
Mr. Sarbanes. Thank you, Mr. Chairman.
It seems like the rating agencies were ignoring risks in
two directions. We have talked a lot about one direction which
is they were ignoring the risk inherent, it seems, in these
subprime, mortgage-backed securities by not doing the level of
due diligence that they should have done; or once they had done
it, ignoring the analysis that they performed.
But in the other direction, I gather they were also
enhancing the status of these risky securities based on the
fact that the investment banks were going out and purchasing
this, ``insurance'' in the form of the credit default swaps,
which were themselves very risky instruments. You had this kind
of perverse situation where because the CDS was there, that
kind of insurance product, they would take something that was
already risky and suggest that somehow the risks have been
reduced because you had gotten this insurance product, this CDS
product, which we know from our AIG hearings was inherently
risky itself.
And I just ask a couple of you to speak very briefly to
that side of the equation, as well, in terms of them ignoring
this credit.
Mr. Fons. I would like to comment.
First of all, the insurance that the rating agencies looked
to, it was typically from a monoline insurer to back the
mortgage-backed securities. The credit default swap activity
you mentioned was typically used by financial institutions to
hedge their exposures to these things. And so it would have
been on the financial institutions' ratings side where they
would be depending on that; or the institutions were at least,
you know, asserting that this protected them to a certain
extent.
Mr. Sarbanes. But the rating agencies were giving them some
credit for that, were they not?
Mr. Fons. Yes. I think they counted that as hedging to a
certain extent.
Mr. Egan. In fact, I'm glad you brought out the monolines.
We were on the record probably about 18 months ago, in fact,
even earlier than that, in 2003, I think I was quoted in
Fortune saying that MBIA is not a triple-A rated credit.
Triple-A is a special standard. Basically it means that an
obligor can pay its obligations come hell or high water. No
matter what, they can pay the obligations. And there are
relatively few issuers that rise to that high level.
In our opinion, the monolines didn't fit that. Basically we
looked at their liabilities and found that they had--was
exposure to--I think it was about $30 billion in collateralized
debt obligations. We took a 30 percent haircut on it as $10
billion, and we said, those are just the pipeline losses; and
to cover it, to come up to the triple-A, they'd have to raise
that to about three times that. So that would have been $30
billion just for one issuer.
We multiply that, too, by seven issuers, and we got to 210,
but we backed it down to $200 billion. We issued that statement
publicly, I think it was probably about 9 months ago. And a lot
of people said we were ridiculous.
But that is the crux, that these are not triple-As, and a
lot of people have been making investment decisions and have
not taken markdowns, assuming they were true triple-As, but yet
we're talking about bailing out these supposedly triple-A-rated
firms.
It makes no sense. The sooner we get back to reality, the
better off we'll be.
Mr. Sarbanes. Thank you.
Let me ask you, Mr. Fons, because this sort of follows up
on Mr. Tierney's questions earlier about what do we do next. In
your testimony you talked about wholesale change, right? That's
the term you used. And you talk about change in the government
in senior management levels. And you don't really buy the
notion that the reforms that have been announced so far meet
that standard.
I was reading ahead a little bit the testimony of Mr.
Sharma, who is coming next, where he talks about 27 new
initiatives and other things that have been undertaken to
address the breakdown that you've all alluded to: new
governance procedures and controls, analytical changes focusing
on substantive analysis, changes to information used in the
analysis, new ways to communicate.
You basically list out everything, which is what the rating
agencies should have been doing in the first place. I mean,
it's not like saying, we've got to come along and change a
couple of things. If you read the list, it's basically saying,
everything we were supposed to do we weren't doing, and now we
are going to start doing it.
Which gets to the question of, you can change procedures,
you can change controls, you can change protocols, etc., but
why should we trust the same people who ignored these warnings
to fix the problem in a way that means it's not going to happen
going forward?
So I think that's what you're getting at. If you could just
speak to that a little more specifically, I'd appreciate it.
Mr. Fons. I think that's exactly what I meant, that you
still have the same overall incentives in place, you still have
the same structures; and as you said, they should have been
doing those things in the first place. These are not reforms;
these are just doing business properly and doing them better.
So at the governance level you need the board of directors
who are actually acting in shareholders' interest and that
interest is preserving the franchise and preserving the
reputation of the firm. And I didn't see that happening. They
weren't interested in hiring good businessmen and seeing a
business run; and as I said, that's why I have advocated
wholesale change at those levels.
Mr. Sarbanes. Mr. Chairman, my time is up. I would just
point out there is going to be huge resistance to that notion
because the same people that were part of this are going to
want to say, we screwed up, things broke down, but we know how
to fix it and everything will be fine going forward.
And we're going to have to look past that.
Chairman Waxman. Members of the Sarbanes family have heard
that story before. Thank you, Mr. Sarbanes.
Ms. Speier.
Ms. Speier. Thank you, Mr. Chairman.
Gentlemen, thank you for your testimony. You have provided
us with a definition of corruption that I think is bone
chilling. I can't begin to tell you how dismayed I am by what
you have told us today.
Mr. Egan, let me start with you. You said that in 2003 you
alerted Congress to what was coming down. It sounds like
Congress didn't listen to you. You don't have to respond to
that, but I want to ask you a question today. What's the next
shoe that's going to fall? And maybe we can listen to you this
time.
Mr. Egan. People pay us a lot of money to get that answer.
Basically, there's a series. You have investment banks that are
way undercapitalized right now, investment now--commercial
banks that are way undercapitalized. You have the commercial
banks that are undercapitalized. You have the money market
funds that are in fear of breaking the buck.
So basically anything that isn't propped up by the Fed or
the Treasury is going to drop, unfortunately; and what is
needed--and it should drop, actually. It should drop until it
reaches a point where it's sustainable.
So there's a variety--we tell our clients that the
ecosystem, if you will, in funding has broken down. Everybody
connected with the mortgage market, you've seen them fall; the
mortgage brokers, the mortgage bankers, the investment banks,
the commercial banks, they're all in terrible shape.
So if you want to protect your investments, there are
certain industries that you want to look at that aren't
dependent on that ecosystem and aren't dependent on the
consumers that will do all right. So it's basically--and this
came up in an interview I had yesterday on Bloomberg
Television. It's basically those firms that are either propped
up by the Federal Government--and that propping will remain,
won't expire after 2009, which is the case of Fannie and
Freddie--or are not dependent on the ecosystem or anything
directly or indirectly connected to that ecosystem.
Ms. Speier. All right. Thank you.
I would like to move to the motivation for much of what
you've told us today, which appears to be money. I want to show
you how the revenues for rating residential mortgage-backed
securities and CDOs became a significant part of these rating
agencies' bottom line. Let's start with S&P.
As you can see from this chart, S&P increased its share of
revenue for rating mortgage-backed securities from 24 percent
of U.S. rating revenue in 2002 to as much as 37 percent in
2006.
Let's now show you Fitch. As you can see from this chart,
Fitch's revenues for rating these bonds increased steadily,
accounting for 35 percent of its U.S. rating revenue in 2004
and 2005 before dropping slightly in 2006.
Now, we have a slightly different chart with Moody's, but
it shows the same trend. By 2006, Moody's structural finance
position, which rates mortgage-backed securities and CDOs,
accounted for more than half of the company's total rating
revenue.
So profits have played a huge role in the rating of these
exotic instruments; is that not the case? And if you could just
each indicate that.
Mr. Raiter. Well, profits were what drove it starting in
about 2001 at Standard & Poor's. It was the growth in the
market and the growth--profits were running the show. In a
nutshell, that was the simple answer. And the business managers
that were in charge just wanted to get as much of the renew as
they saw like this, growing out in the street, into their
coffers.
And the breakdown, in my opinion, was that while we can
talk about or you all can consider different ways of fixing the
rating agencies' current situation, by and large, the analysts,
as we have seen in the e-mails, they were honest, hardworking
people. And they were sending messages to the business managers
through the MDs, etc., and they weren't getting any response.
So there was a big breakdown, and that reputation that was
lost shouldn't be totally blamed on the analysts because most
of them were trying to do the right thing, but the money became
so great that the management lost focus.
In residential mortgages alone, just that piece of the
business, from 1995 when I joined the firm to 2005, grew from
$16 million a year for S&P to $150-plus million, a tenfold
increase. And the market was just being driven by low interest
rates, by these new products that were coming out so fast and
furious that it took a lot of money to track them and analyze
them, and the money wasn't available. So our analysts spent
their time just trying to get the ratings out the door and to
alert management what was going on, and none of that money was
plowed back and reinvested.
And I firmly believe that had we continued to track at the
loan level those new products, we would have seen things in
2004-2005 that would have forewarned us.
And when you talk about the way these deals work, you can't
lose the fact that triple-A bond has support; just like you
should have equity in your house, the support underneath that
was established by the rating. With more information about
those new products, that support requirement could have gone up
significantly and made some of those products uneconomic to
originate. But because they weren't tracking the data, they
weren't allowing the analysts to collect it and analyze it
continuously, those alerts waited until 2007 when everything
collapsed.
There were good people in those firms at Moody's and S&P
and Fitch that saw what was coming, and they tried to make
management aware of it. And money was the overriding concern at
the top of the firm.
And the point Mr. Sarbanes made is right on the money. Some
of these people are the same ones that brought Enron and
WorldCom to us, and now they're going to give us another list
of things. And you can go back and check; a lot of things on
that list they promised to do after Enron and WorldCom
exploded, and they still haven't done it--so the same people
still in charge of the hen house.
Chairman Waxman. Thank you, Ms. Speier.
Mr. Shays.
Mr. Shays. We passed Sarbanes-Oxley in response to WorldCom
and Enron. And Oxley was pretty strong. Sarbanes was stronger,
because by then WorldCom went under.
The scariest hearing that I have ever had, that rivals this
by far, was that when Enron went under, the board of directors
didn't direct, the administration didn't manage properly, the
employees didn't speak out, the law firms were in cohoots, the
rating agencies were just in left field. Every part of the
system broke down.
So we passed Sarbanes-Oxley.
What I want to ask, from the three of you, how is it
possible when the German company that was looking at VEBA, V-E-
B-A, was looking to unite two equals of Enron that they
determined that Enron had taken 70 percent of its stuff off the
books and that they had about a $2 billion unfunded liability
that was not recognized; and still the rating agencies rated
this company like it was an extraordinary, well-run company
even after that?
I happen to think the rating agencies are useless now. I
think they have no brand. I wouldn't trust them if I had money
to invest.
So the second part of my question is, tell me how they get
their brands back. Tell me why there should just be the so-
called ``Big Three'' when actually, had they done their job, we
wouldn't be in this mess?
So walk me through that. Mr. Egan, you can start.
Mr. Egan. Well, thank you.
First of all, I'd prefer they use an adjective in front of
the noun ``rating firm'' because we are a rating firm, but our
behavior, our actions, are significantly different than the
issuer compensated----
Mr. Shays. I don't want to get into that. I'm sorry; you've
had your chance to do that. But frankly I think buyers have had
almost as much conflict as sellers, so I'm not as impressed
with that point.
Just tell me why the rating agencies failed to identify
what happened at Enron, why the whole banking community failed
to undersee it. I don't get it.
Mr. Egan. Well, you know, we're not geniuses. And we got
it, OK? Why did we get it? Well, because in Enron's case, the
business model failed. Same as in WorldCom's case. Enron's core
business was--and they were smart in one way, but they didn't--
--
Mr. Shays. Was that an indication we didn't understand the
business model with all these new instruments, that they are
like Greek to the rating agencies even?
Mr. Egan. I think you get rid of the people that did
understand it. I think there's an incentive.
In fact, there are some articles. Aaron Lucchetti of the
Wall Street Journal documented how some analysts were sounding
the alarm, and they didn't maintain market share, and one way
or another they were pushed out the door.
Mr. Shays. Mr. Raiter.
Mr. Raiter. Well, if the broader question is, how do you
think they might go about----
Mr. Shays. I want to know first about Enron. I don't get
it. I don't understand why none of the rating agencies didn't
take a second look when this deal fell apart and the German
company said this company has $2 billion of unfunded
liabilities.
I don't get it. Why wouldn't that have shown up?
Mr. Raiter. Well, either they weren't digging deep enough
or they weren't looking in the right place. I mean, there are,
as Mr. Egan has suggested, human beings involved in this.
I don't believe on the S&P side there was fraud. It might
have been a little less than diligent in terms of the work they
did, but they come back with the fact that it's an opinion----
Mr. Shays. Mr. Fons, maybe you can help me with this. I
don't get it.
Mr. Fons. I think the mistake was talking to those
companies in the first place, instead of sitting down as a
disinterested observer and looking at the financials and
looking----
Mr. Shays. Price Waterhouse did the due diligence for the
German company and said, don't go there. Well, Price Waterhouse
did it. The deal fell through, and the rating agencies still
rated Enron quite significant.
Mr. Fons. There were a lot of mistakes made in the Enron
situation, and then----
Mr. Shays. My last question then is, is it conceivable that
the rating agencies just don't understand the market that they
are having to evaluate, that they don't understand these
instruments? And if that's the case, do they have a moral right
not to rate these businesses?
Mr. Fons. I think the overall track record of rating
agencies have been, up until this time, pretty good. They have
successfully differentiated defaulters from nondefaulters.
That's the job of the rating system.
The track record is what allowed the reputation to grow.
They built that reputation and milked it for what they could,
and started lowering standards. But over time credit analysis
is a reputable discipline. It think it's doable. It's just, you
know----
Mr. Shays. They have no brand, they have no credibility
whatsoever. I can't imagine any investor trusting them.
Mr. Fons. It's going to be a while to build that up, I
agree.
Chairman Waxman. The gentleman's time has expired.
Ms. Norton.
Ms. Norton. Thank you, Mr. Chairman. I think this hearing
is about something that's been on the minds of lots of people
in trying to figure out how did this happen, and they go back
to the credit rating agencies and the enormous, apparently
undeserved, respect they have enjoyed.
I want to ask about a word I have not heard before,
``ratings withdrawal,'' where apparently after a credit agency
rates a security, the agency can be terminated if there is a
threat to downgrade the security.
I'm not making this up. This is true. I want to refer to a
few examples.
The New York Times reported on Mrch 8th that the world's
largest bond insurance company, MBIA, fired Fitch ratings
because Fitch was considering downgrading the company's bonds
from triple-A to some lower rating of some kind. According to
the Times, all three rating agencies had rated MBIA's bonds but
only Fitch was considering a downgrade.
And I'm familiar with that happening in cities and States
all the time. One rating agency does one thing and the others
don't.
Mr. Egan, you mentioned this specific incident, I believe,
in your written testimony. How does it affect an agency's
ratings if that agency knows it can be fired anytime it
downgrades a bond?
Mr. Egan. You have to assume that it's considered very
carefully. If you're relying on the issuers for compensation,
you hate to see that revenue go away.
In our case, we never had MBIA at triple-A. It never rose
to that level. I think our current rating is down about single
B or thereabouts, which is about nine notches, which is lower
than the others. That's a Grand Canyon-type difference. They
never fired us--that's MBIA--because they never hired us.
So far as your specific question about firing, yes, it
would have a big impact.
Ms. Norton. It seems----
Mr. Fons. We have policies that we would not withdraw a
rating just because somebody said, you're fired. If we believe
and we had enough information to rate the thing at Moody's, we
would continue to rate it. They couldn't fire us.
They could fire us, they could not pay us, but we could
still offer our opinion and express our first amendment right.
Ms. Norton. But then you would have the situation that
Fitch had where apparently it tried to keep a company called
Radian, even without the company's cooperation. And don't you
have to have the company's cooperation?
Mr. Fons. I don't believe so. I believe it's not helpful.
Ms. Norton. We have quite a conundrum here, don't we?
Here's another example: Fitch downgraded the insurance
company Radian from A to A-; and a publication called Business
Wire, on September 6, 2007--said that Radian sent a, ``formal
request that Fitch immediately withdraw all of its ratings on
Radian.''
Now, are you concerned about this practice, first of all,
is that unusual--just withdraw your ratings?
Mr. Egan. No, it's not. In fact, sometimes you don't even
get hired. It's another manifestation of the rating shopping.
Basically, if you're not going to go along with the highest
rating possible, there's a good chance you won't be hired
initially to do the rating or you will be fired later.
Ms. Norton. How about take all my ratings off? You have to
do that if they ask for it----
Mr. Fons. We have specific policies surrounding the
withdrawal of a rating, and we would only do it under certain
circumstances.
Ms. Norton. What kind of circumstances would you do it?
Mr. Fons. One would be, we didn't have enough information
to rate something. We would do it there. If the issue had
disappeared or the bonds no longer existed, we would withdraw
the ratings, for example.
Ms. Norton. I spoke of a conundrum. Surely there is some
way out of this problem which everybody apparently knew about.
It's been transparent; everybody knew it happened.
How do you deal with this problem of the issuer not giving
you information that you need in order to rate and the circular
problem you find yourself in, and all of us who depend upon
you, therefore, find ourselves in?
Show me a way out of this problem.
Mr. Fons. If they're issuing public securities, laws are,
there are disclosure requirements for companies. That should be
sufficient to draw a rating assessment.
Ms. Norton. How do you enforce that?
Mr. Fons. SEC does that. Isn't that their job?
Ms. Norton. Has it done that before? Has SEC enforced that,
to your knowledge?
Mr. Egan. I think in the corporate area they have. But the
answer here to your question is a little bit more subtle
because what happens in the case of MBIA, because that's a
current example, it's an important example in the industry
because there are so many firms that are relying on MBIA's,
Ambac's support for various securities. If they lose that
support, they're going to have to mark down those securities.
What happens in the industry is that the issuer will say--
in the case of Fitch or in our case, they'll say that rating
firm, don't pay attention to their ratings because they don't
have the additional information.
We say, look at our track record; you know we are right.
Look at other manifestations of the deterioration of the
company's fall. But nonetheless, that's the company's response,
that if you want the true rating, go to those that we support
that we still, pay which is a little bit odd.
Ms. Norton. How common is this practice of just saying,
Just withdraw the rating? Is it an everyday occurrence?
Chairman Waxman. The gentlewoman's time has expired, but I
would like to hear an answer.
Mr. Fons. It's unusual.
Mr. Egan. It happens from time to time.
Ms. Norton. I'm sorry?
Mr. Fons. It's unusual. It's unusual.
Ms. Norton. Thank you very much.
Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Ms. Norton.
Mr. Davis.
Mr. Davis of Virginia. Mr. Chairman, I just have one more
question. In Mr. Raiter's written testimony he states the
foundation of the rating analysis is the data relied on for
determining credit enhancement levels.
Rating agencies don't perform due diligence on the data; am
I right? They just rely on representations and warranties that
come from the issuer that the data submitted is indeed
accurate; is that----
Mr. Raiter. That is--the structured side of the transaction
is reading the documents and relying on the information
provided, and we do not do due diligence. Our lawyers have said
that is an SEC-defined term, and it's the issuers that are
required to do the diligence on their filings.
So we relied on reps and warranties, the guaranties.
Mr. Davis of Virginia. That leads to my question. I just
wanted to make sure I was right in my understanding.
Now, the rating can only be as good then as the data that's
put into the models?
Mr. Raiter. Correct.
Mr. Davis of Virginia. But there is no independent
verification that the data is accurate?
Mr. Raiter. No independent verification of the tapes,
that's correct.
Mr. Davis of Virginia. All right.
From the loan originators and the borrowers who might have
fudged home buyers' creditworthiness, employment history, to
the issuers who package these mortgages and want to get the
highest possible rating, it looks to me like there were a lot
of places along the line where the data that ultimately makes
it to the rating agencies could be made unreliable.
Mr. Raiter. That it could have been made more reliable?
Mr. Davis of Virginia. That it could have been made more
unreliable just as it passes----
Mr. Raiter. Right.
Mr. Davis of Virginia. OK.
Now, if it's not the rating agency's job to ensure the
accuracy of the data it's using to rate these securities, whose
job is it?
Mr. Raiter. That's correct. We determined that it was
better to put the onus on the issuer as we required, as I
spelled out in reps and warranties.
Mr. Davis of Virginia. Let me ask this: Was there a
computer model that could evaluate the risks and the values if
you had all of the correct info through these documents? I
understand that a single prospectus for a mortgage-backed
security I have looked at, they run 2,000, 3,000, 4,000 pages
sometimes.
Mr. Raiter. I haven't seen one quite that large, but they
are multiple hundreds of pages, and if they give you the detail
on the tapes, they could run to quite an extensive length.
Mr. Davis of Virginia. Is there a computer model--given if
you've got all the information in that, and there probably were
some inaccuracies, but if you had all of that you could have
given an appropriate evaluation?
Mr. Raiter. The model would give an appropriate evaluation
on the collateral, what the enhancement requirement was, how
much insurance you need to put under the triple-A bond. They
were calculating the default expectations for each of the
mortgages and what the loss would be if the mortgage defaulted;
that was the model on the data side.
The structure side of the transaction was then looking at
the documents to make sure that the investors were being
protected in the servicing of the loans, in the pass-through of
the payments, part and parcel.
And someone asked what the next shoe might be to drop. This
could be another shoe that hasn't hit yet. That was the reps
and warranties that were put on the data. As these loans are
going bad and the bonds have been downgraded, there are people
that are going through each one of those in foreclosure; and if
they find out that the appraisal was inflated or that any other
information that was supplied to the rating agency was
incorrect or inaccurate or just fraudulent, they have the right
to put it back to the issuer.
And what we're faced with today is, a number of the
institutions that have received government bailouts or have
been in fact merged out of existence--Lehman, WAMU, Bear
Stearns, Countrywide and IndyMac--they were all providers of
huge rep and warranty guarantees; that if those loans start
getting identified as having appraisal problems and put back,
the question is whether the people that bailed those
organizations out are going to make good on those reps and
warranties, or are they going to go by the board and they just
won't have any value?
Mr. Davis of Virginia. You anticipated where I was going.
Any comments on that, Mr. Egan or Mr.----
Mr. Fons. I think that the assumption here is that the
models were right, even with the right data, and in any opinion
there wasn't a strong history, first of all, with the subprime
mortgage market. We didn't really know how these things--there
was no good model in existence.
Mr. Davis of Virginia. So we don't know for sure if the
model holds up, because it wasn't really utilized as much?
Mr. Fons. It hadn't been tested thoroughly, I'd say,
through experience.
Mr. Davis of Virginia. But, you know, you could--as we go
through this from here on out, you can test it and maybe refine
it a little more.
Mr. Fons. Well, I think this will be a great test case for
future securitizations, pointing to this episode, absolutely.
Mr. Egan. There's been a breakdown. If you look at the old
model that worked, and that is where there was the local banker
who was going to hold the paper and look at it, why would that
local banker make sure that the property--do some spot checks.
Let's say they were going to fund 100 mortgages. Well, you
don't have to check every single one, but maybe a handful, to
make sure that the properties were appraised properly. Check
some of the documentation that is documented. Make sure that
the mortgagees can pay--the obligors can pay their obligations.
And that hasn't happened.
What has happened in the market is, because of the
dominance of the major rating firms, they've constricted what
they view as their job, which might serve their interests very
well, but has not served the public's interests very well.
In fact, there's been a breakdown because the assumption is
that if it's a triple-A, it really is a triple-A, that you've
done what is necessary to ascertain that everything can be done
properly. And that's not the case.
So if you go back to--and you can't micromanage it and say,
well, in this transaction do this, in the other transaction do
that. That's a waste of time. What you want to do is make sure
there are some agents in there that are protecting the ultimate
investors. That's the key here.
Mr. Davis of Virginia. Thank you.
Chairman Waxman. Just to followup on that point: But if the
people doing the rating realized that there was no money being
put in by the purchaser of the home because they were borrowing
the down payment, as well as the rest of the loan, one would
have assumed that they might have concluded that a default is
more likely wouldn't they?
Mr. Egan. Absolutely. And just rate it as such. That's all.
It's like the 90-year-old man that I gave as an insurance
company. It's fine that there are certain segments of the
population that maybe because the houses are appreciated, you
know they're going to appreciate. Maybe there is a big plant
going in that area and there is a bargain deal that the
builder--it's fine that you actually rate those. But make sure
you rate it properly. Make sure again that there is an
alignment.
In fact, right now, there is a lot of opportunity to be
made in the mortgage area. You don't have money flowing in
there because people have seen the ratings slam down. So now
when, let's say, they're being priced at about 40 cents on the
dollar, you could see half the portfolio disappear and you
could still make your money back.
People, institutions aren't putting money into it because,
again, the ratings aren't high enough. They're BB. So we will
go to investors and say, listen, at a new money basis, it
should be rated higher than what it is.
There's some interest, but the ratings are so key in this
whole process. You have to fix that problem.
Chairman Waxman. I thank the three of you very much.
Ratings are key, and they are relied on by investors. And when
they see a triple-A rating, investors assume this is a good
investment, even though there is no liability, even if they
just made up an opinion without having the facts to
substantiate that opinion. And that's one of the reasons we are
in the situation we are in today and why we have had this
hearing.
So I thank the three of you for your presentation, and we
are going to now move on to the next panel.
But before we move on to the next panel, I would like to
make a clarification for the record. In my opening statement, I
referenced an e-mail by a Moody's employee named Christopher
Mahoney. It has now come to our attention that although Mr.
Mahoney was the author of the e-mail, he was forwarding the
opinion of somebody outside of the company.
I do want that to be clarified. We will be glad to give you
that information.
We now move on to our second panel, and while we are making
this transition, why don't we have a 5-minute recess, if that's
OK. Those who are leaving will leave and those who are coming
in will come in.
[Recess.]
Chairman Waxman. The meeting of the committee will please
come back to order.
Without objection, questioning for panel 2 will proceed as
follows: The majority and minority will each begin with a 12-
minute block of time with the chairman and ranking member each
having the right to reserve time from this block for later use.
And without objection, that will be the order.
We are pleased to welcome to our hearing for this panel
Deven Sharma, who is the president of Standard & Poor's;
Raymond W. McDaniel, who is chairman and chief executive
officer of Moody's Corp.; and Stephen Joynt, who is president
and chief executive officer of Fitch Ratings. We're pleased to
have you here today.
It's the practice of this committee that all witnesses who
testify before us do so under oath, so I would like to ask you
to please stand and raise your right hands.
[Witnesses sworn.]
Chairman Waxman. The record will indicate that each of the
witnesses answered in the affirmative.
Mr. Joynt, why don't we start with you?
I might indicate to each of you that your prepared
statement will be in the record in its entirety. What we will
request, and we are not going to be very strict on this, but we
request that you observe the clock that we will give you 4
minutes green, then 1 minute orange; and then after 5 minutes,
it turns red, and we'd like to have you at the end of that time
conclude your testimony.
STATEMENTS OF STEPHEN W. JOYNT, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, FITCH, INC.; RAYMOND W. McDANIEL, CHAIRMAN AND CHIEF
EXECUTIVE OFFICER, MOODY'S CORP.; AND DEVEN SHARMA, PRESIDENT,
STANDARD & POOR'S
STATEMENT OF STEPHEN W. JOYNT
Mr. Joynt. Thank you very much.
Since the summer of 2007, the global debt and equity
markets have experienced unprecedented levels of stress and
volatility. The underlying factors contributing to the credit
crisis have been many, namely, historically low interest rates,
greater global demand for relatively riskier and higher
yielding assets, lax underwriting standards in the mortgage
origination markets, inadequate discipline in the
securitization process, insufficient risk management practices
at financial institutions, an outmoded global regulatory
framework, and credit ratings in RMBS and CDOs backed by RMBS
that have not proven as resilient as originally intended.
As I noted in my testimony before the Senate Banking
Committee in April, the crisis began with severe asset quality
deterioration in the U.S. subprime mortgage market and related
RMBS and CDO securities that caused large market price declines
because ultimate credit losses will be far greater than anyone
had anticipated.
Today's market stresses, however, have become more broad
based--by asset, institution, and geography--and emanate from a
global reassessment of the degree of leverage and the
appropriateness of short-term financing techniques inherent in
today's regulated and unregulated financial companies.
Deleveraging is dramatically reducing liquidity and
contributing to price volatility, both for individual
securities and for the institutions that own them or ensure
them.
With the benefit of hindsight, it is clear that many of our
structured finance rating opinions have not performed well and
have been too volatile. We have downgraded large numbers of
structured finance securities, particularly in the subprime
mortgage and CDO areas, and in many cases by multiple rating
notches. Why is this happening?
While we were aware of and accounted for in our models and
analysis many risks posed by subprime mortgages and the rapidly
changing underwriting environment in the U.S. housing market,
we did not foresee the magnitude or the velocity or the decline
in the U.S. housing market nor the dramatic shift in borrower
behavior brought on by changing practices in the market, nor
did we appreciate the extent of shoddy mortgage origination
practices and fraud in the 2005 and 2007 period.
These dynamics were magnified in the CDO market. Structured
securities are specifically designed for lower-rated, riskier
and therefore higher-yielding bonds to absorb losses first.
However, radically and rapidly changing markets have led to
dramatic rating changes that have affected even highly rated
bonds. As we now have learned, building complex highly tranched
securities on historical default probabilities does not always
provide enough cushion for extraordinarily variable
performance.
We need to reemphasize the art, learned through experience,
to complement the science of quantitative analysis. Reflecting
the crisis still unfolding, we began in 2007 to build
significantly more conservatism into our analytical approach as
we reassess past ratings or consider rating any new securities.
Problems in the subprime mortgage and CDO assets represent
a major portion of asset losses and breakdowns. They are one of
the original catalysts for today's financial crisis, but that
is not a complete picture. Derivative exposures relating to
these assets, but also other assets, have created major stress.
Balance sheet leverage is too high for the volatility we are
experiencing, and the ongoing deleveraging process is
dramatically pressuring markets and prices.
Further, the leverage of synthetic exposures, that normally
is not transparent, has become painfully transparent as
counterparties lose confidence in each other and require
physical collateral to protect synthetic positions.
It has been difficult to find balance in assigning ratings
to major global financial institutions during this current
financial crisis. While the public ratings reflect the
fundamental analysis of each company, they do not and have not
anticipated completely illiquid markets. In fact, our ratings
reflect the expectation that in crisis environments regulators
and governments will support major banks and financial systems.
With that in mind, we have continued through recent months to
maintain high ratings, mostly AA category, on the majority of
the top 25 largest global financial companies, despite market
stresses from capital raising, liquidity and profitability,
anticipating government support that has been largely
forthcoming.
Having mentioned some limitations of rating at this point,
I feel I should note, however, that Fitch has and continues to
produce much high-quality research and ratings of value to many
investors in many market segments.
I recognize the purpose of today's hearing is to focus on
the crisis and the problems and, hopefully, forward moving
solutions. So with that in mind, how is Fitch functioning in
the market today?
We have reviewed our original ratings on entire vintages of
subprime and CDO securities, and now find that many were too
high. Our continuous goal has been to undertake new analysis
that provides investors with our latest opinion about the risks
of these securities, even though the result in many cases has
been significant downgrades.
We have paid special attention to modulate our
communication to the importance of our rating decisions. In
calmer times, small changes in credit ratings are notable for
investors. In today's crisis environment, I have directed our
teams to identify important and critical changes in credit
quality and immediately bring those forward to the market.
Minor changes in quality need to be communicated with
balance and proper perspective. Rating changes should not be
continuously contributing noise to the crisis, but instead be
simple, clarifying gradations of risk or credit strength.
Returning to problem mortgage and CDO securities, ratings
were designed to identify the relative probability of full
repayment of these securities. Today, we expect many junior
securities may have significant or total losses. The variance
in projected repayment and the related valuation of highly
rated securities, triple-A, is a critical market problematic.
Some may have sizable losses, but many large-balance, triple-A
securities may receive full payment or experience relatively
small percentage losses.
We are shifting our analytical resources in modeling to
provide information to investors and other interested parties
such as the Federal Reserve and the U.S. Treasury to support
greater transparency and price discovery to help finally define
and stabilize these asset valuations. To win back investor
confidence, our ratings opinions must be more predictive and
our research and analysis must be more insightful and forward
looking. We remain committed to the highest standards of
integrity and objectivity.
I'd like to add one thing to my prepared opening remarks.
Having listened this morning to the panels, I accept that our
ratings did not project, as I have described, the full risk in
many mortgage-backed and CDO securities. But regarding the
question of intent that also this committee is discussing, I
would like the committee to consider Fitch on the merits of how
we've performed as a company rather than on the many colorful
things that we have seen this morning from e-mails and others.
I believe that we have operated with very strong intent. I
personally have operated with very good integrity, and I
believe our culture has supported the effort to operate with
good intent and good integrity, both; and I'm happy to describe
during the questions and answers information that would, in my
opinion, would support that conclusion.
Thank you.
Chairman Waxman. Thank you, Mr. Joynt.
[The prepared statement of Mr. Joynt follows:]
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Chairman Waxman. Mr. McDaniel.
STATEMENT OF RAYMOND W. McDANIEL
Mr. McDaniel. Good morning, Chairman Waxman, Congressman
Davis, and members of the committee. I'm Ray McDaniel, chairman
and chief executive officer of Moody's Corp., parent of Moody's
Investor Service.
Moody's is the oldest bond rating agency in the world,
having issued its first ratings in 1909. Our company was
founded on the great American traditions that encourage and
protect the marketplace of ideas. Today, Moody's has 20 offices
around the world and employs almost 2,500 people worldwide,
including approximately 1,500 people in the United States.
On behalf of all my colleagues at Moody's, I thank the
committee for the opportunity to participate in today's
hearing.
Over the past several weeks, we have witnessed events that
have sent shock waves around the world and undermined
confidence in the capital markets. American families are
directly affected by this loss of confidence. Many have lost
jobs, homes or retirement savings, and they are suffering.
The problems being faced by the financial markets extend
well beyond housing, and have exposed vulnerabilities in the
overall infrastructure of the world's financial system. These
weaknesses include exceptional leverage, loss of liquidity in
periods of stress, the rapid changes of asset valuations and
capital needs, insufficient risk management practices,
interlinked market participants and limited transparency. We
believe it is important to consider all of these issues as new
regulatory structures for the financial markets are developed.
With respect to the rating agencies, many have asked what
happened in the rating process that led to large downgrades in
the subprime market. As is now well understood, the
deterioration of the U.S. housing market began with the
loosening of underwriting standards for subprime mortgages.
Moody's did observe the trend of weakening conditions.
Beginning in 2003, we published warnings about the increased
risks we saw and took action to adjust our assumptions for the
portions of the residential mortgage-backed securities market
that we were asked to rate. We did not, however, anticipate the
magnitude and speed of deterioration in mortgage quality or the
suddenness of the transition to restrictive lending.
We were not alone, but I believe that Moody's should be at
the leading edge for predictive opinions about future credit
risks, and we have learned important lessons during these fast-
changing market conditions. Indeed, I believe that we now all
need to consider how to improve the U.S. mortgage origination
and securitization process. For our part, we have made specific
changes in our processes, including, among others, seeking
stronger assurances from the issuers and better third-party
review of underlying assets.
Beyond the housing market, Moody's believes that the
critical examination of our industry and the broader market is
a healthy process that can encourage best practices and support
the integrity of the products and services our industry
provides.
Rating agencies occupy an important but narrow niche in the
information industry. Our role is to disseminate opinions about
the relative creditworthiness of bonds and other debt
instruments. At Moody's, our success depends in large part on
our reputation for issuing objective and predictive ratings,
and the performance of our ratings is demonstrated over many
credit cycles on the hundreds of thousands of securities we
have rated. At the heart of our service is our long-term credit
rating system that rank-orders the relative credit risk of
securities.
In the most basic sense all bonds perform in one of two
ways: They either pay on time or they default. If the future
could be known with certainty, we would need only two ratings,
``default'' or ``won't default.'' Because the future cannot be
known with certainty, we express our opinions on the likelihood
of default on a 21-step rating scale ranging from triple-A to
C.
One common misperception is that Moody's credit ratings are
statements of fact or solely the output of mathematical models.
This is not the case. The process is, importantly, subjective
in nature and involves the exercise of independent judgment by
the participating analysts.
Although rating criteria will necessarily differ from one
sector to another, we use essentially the same rating process
in all sectors. The rating process begins with rigorous
analysis by an assigned analyst of the issuer or obligation to
be rated, followed by the convening of a rating committee
meeting where the committee members discuss, debate, and
finally vote on the rating. Once the rating committee has made
a decision, the rating is published and subsequently monitored
and adjusted as needed.
Importantly, the rating reflects Moody's opinion and not an
individual analyst's opinion of the relative creditworthiness
of the issuer or obligation.
In conclusion, we believe in this process, but continually
strive to do better. For example, as described more fully in my
written statement, we're refining our rating methodologies,
increasing the transparency of our analysis and adopting new
measures to reinforce and enhance existing processes and
policies that address potential conflicts of interest.
The Securities and Exchange Commission recently concluded
its own extensive examination of the industry and provided us
with specific tasks to enhance our services, which we are in
the process of implementing.
We know that there has been a loss of confidence in our
industry. Moody's is committed to working with Congress, with
regulators and with those affected by the markets to do our
part in restoring confidence in our industry and in the broader
financial system.
Thank you, and I will be happy to respond to questions.
Chairman Waxman. Thank you very much, Mr. McDaniel.
[The prepared statement of Mr. McDaniel follows:]
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Chairman Waxman. Mr. Sharma.
STATEMENT OF DEVEN SHARMA
Mr. Sharma. Mr. Chairman, Mr. Ranking Member, members of
the committee, good afternoon.
We at Standard & Poor's appreciate the severity of the
current disruption in the capital markets and its effect on the
economy and American families. As events continue to unfold,
the role played by leverage, liquidity, underwriting,
accounting policies and other factors is becoming clearer.
Let me state up front that we recognize that many of the
forecasts we use in our ratings analysis of certain structured
financed securities have not borne up. We have reflected on the
significance of this and are committed to doing our part to
enhance transparency and confidence in the markets.
For decades, S&P's ratings have been and we believe will
continue to be an important tool for investors, but it is
important to recognize and appreciate how they should be used.
S&P's ratings express our opinion about the ability of
companies to repay their debt obligations, but they do not
speak to the market value for the security, the volatility of
its price, or its suitability as an investment.
At Standard & Poor's we employ a number of measures that
promotes independent and analytical rigor. I have described
several of these measures in greater detail in my written
testimony.
Studies on rating trends and performance have repeatedly
confirmed that Standard & Poor's ratings have been highly
valuable in informing the markets about both the deterioration
and improvement in credit quality. That legacy, which is a most
valuable asset, has been challenged by recent events.
It is, by now, clear that the mortgage performance has
suffered more severely than we had estimated in relation to
stresses in the housing market. However, our estimates and the
ratings based on them were the result of a robust analysis of
the transactions themselves, our monitoring of markets, our
experience in rating these types of securities and the stress
test based on the historical data including market events going
back 75 years to the Great Depression. While we performed
analysis in good faith, events have shown that the historical
data we used in our analysis significantly underestimated the
severity of what subsequently occurred.
Having said that, it is important to put this issue in
context. While negative performance no doubt has been
significant, 1.7 percent of the U.S. structured financial
securities we rated in the worst performing period, 2005
through the third quarter of 2007, have actually defaulted and
about a third have been downgraded.
We constantly learn from our experience and we are actively
taking steps to improve our ratings process. We announced a
series of initiatives earlier this year, which I have outlined
in my written testimony speaking to the new governance
procedures and analytical improvements, data quality and
transferency enhancements to the market and education about
ratings.
Recent attention to our ratings has lead to questions about
potential conflicts of interest in the issuer pays business
model. Of course the receipt of money from any party, whether
an insurer or an investor, raises the possibility of potential
conflict. At Standard & Poor's, we have measures to protect
against conflicts and are implementing even still more. Indeed
the evidence speaks to S&P's independence. For example, from
1994 to 2006, upgrades of our U.S. RMBS ratings outpaced
downgrades by a ratio of approximately 7 to 1. Some critics
say, we are issuing inflated ratings as a result of the
conflicts. One would expect year after year to see more
downgrades than upgrades, as ratings are revised in light of
actual performance. In addition, the issuer pays model promotes
transparency as it allows us to disseminate our ratings for
free in real-time to the public at large.
One final point, we are taking steps to maintain and
strengthen our long tradition of professionalism. On that note,
certain e-mails cited in the SEC's recent examination report
are attributable to Standard & Poor's. Unfortunate and
inappropriate languages used in some of these e-mails does not
reflect the core values at S&P and we are redoubling our
emphasis on the importance of professional conduct.
In addition, during its recent comprehensive examination,
SEC staff found no evidence that we had compromised our
criteria or analytics to win business.
In closing, let me say that restoring confidence in the
credit markets will require a systemic effort. S&P is one part
of the equation. We are committed to working together with the
other market participants, Congress and policymakers to restore
stability in the global capital markets.
I would be happy to answer any questions you may have.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Sharma follows:]
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Chairman Waxman. Thank you, Mr. Sharma. I'm going to start
questions myself.
Gentlemen, you're giving us assurance that while mistakes
were made, you are correcting the problem, that there are a few
problems in your industry, but your ratings are honest, your
methods transparent and your internal controls appropriate.
That is what I'm hearing from the three of you. And it's really
not anything new. Because, Mr. McDaniel, in 2003 you said,
rating actions will reflect judicious considerations of all
circumstances and that the system is not broken. In 2005 you
said, ``we believe we have successfully managed the conflicts
of interest and have provided objective, independent and
unbiased credit opinions.''
These are the things that we are hearing from you in public
over the years. But Mr. McDaniel, behind closed doors you were
apparently more candid because on September 10, 2007, you had a
private meeting with your managing directors. You called it a
town hall meeting. And you said the purpose was to speak as
candidly as possible about what is going on in the subprime
market and our own business. And you told the gathering of
senior executives that there are a number of messages that we
just frankly didn't want to write down. But a transcript was
kept of that meeting, and we have obtained a copy of it. This
transcript has never been made public before. According to the
transcript, this is what you told your managing directors,
about why so many mistakes were made rating mortgage-backed
securities. ``Now, it was a slippery slope, what happened in
2004 and 2005 with respect to subordinated tranches is that our
competition, Fitch and S&P, went nuts. Everything was
investment grade. It didn't really matter. We tried to alert
the market. We said we're not rating it. This stuff isn't
investment grade. No one cared because the machine just kept
going.''
Mr. McDaniel, what did you mean when you said that Fitch
and S&P went nuts and started rating everything as investment
grade?
Mr. McDaniel. I was responding to a question that was
raised in the town hall meeting, and I don't recall whether I
was repeating a phrase from a question or whether this was
independent commentary that I made. But what I was discussing
more generally was in our opinion, the need during this period
to be raising credit enhancement levels or credit protection
levels which we did. And to the extent that made the credit
protection levels higher for certain instruments, it meant that
we might not be rating those instruments, and in fact, that was
part of the story during that period.
Chairman Waxman. You were saying your competitors were
going nuts and rating everything. You said that the entire
credit rating industry was on a slippery slope and went nuts
when it started to rate everything investment grade. Maybe I
should hear from Mr. Joynt and Mr. Sharma, this is what
apparently he was saying about you behind closed doors. Is it
accurate? Mr. Sharma.
Mr. Sharma. Mr. Chairman, there are many instances we have
chosen not to rate when either we have believed we do not have
enough information from the issuer or it doesn't meet our
criteria appropriately. So there have been many examples and
instances and we will be happy to provide that.
Chairman Waxman. So you don't agree with his assessment?
Mr. Sharma. We have continued to sort of, as I said, there
are many instances when we did not rate things, and as I said,
there are things----
Chairman Waxman. Sometimes you didn't rate. Sometimes you
didn't give a rating. Therefore, if you gave ratings
inappropriately in other cases, we should take that into
consideration.
Mr. Sharma. Mr. Chairman, we also make all our criteria
public. It is available to the investor. It is available to the
issuers and public at large for them to look at how we rate----
Chairman Waxman. Let me get back to the essential issue
here, because Mr. McDaniel solicited feedback from the
company's top managers about that meeting, and I want to read
what one of the managers said, ``We heard two answers
yesterday. One, people lied, and two, there was an
unprecedented sequence of events in the mortgage markets. As
for one, it seems to me that we had blinders on and never
questioned the information we were given, specifically why
would a rational borrower with full information sign up for a
floating rate loan that they couldn't possibly repay and why
would an ethical and responsible lender offer such a loan? As
for two, it is our job to think of the worst-case scenarios and
model them, after all, most economic events are cyclical and
bubbles inevitably burst. Combined these errors make us look
either incompetent at credit analysis or like we sold our soul
to the devil for revenue or a little bit of both.''
Mr. McDaniel, one of your top managers said Moody's was
either incompetent or sold its soul to the devil. It's a
serious charge. How do you respond?
Mr. McDaniel. I think the manager was referring to what the
perception could be based on the stress that assets that had
been rated in the mortgage-backed securities area were
undergoing. With respect to the comment they lied, I was not
referring to anyone at Moody's, or, in fact, anyone in the
industry. I was referring to media reports about the
deterioration in the veracity of information that was flowing
through the mortgage origination process.
Chairman Waxman. In other words, people were claiming they
could pay back the loan but they couldn't.
Mr. McDaniel. Yes.
Chairman Waxman. But that shouldn't be hard to figure out
when you have loans that are being given with an amount up 100
percent and no equity in the hands of the borrower.
Mr. McDaniel. Well, one of the----
Chairman Waxman. Wouldn't that be a more likely situation
for a default?
Mr. McDaniel. Certainly to the extent that there is more
leverage. In a mortgage or in the purchase of a home, there is
a greater risk of default.
Chairman Waxman. So people are lying, or you weren't
modeling for the worst-case scenarios. I'm trying to reconcile
what you have said publicly on a number of occasions, including
today, and what you said in a private meeting and it seems to
me you are saying totally different things in public than
you're saying in private. In public, you assure us that your
industry meets the highest standards but in private, you're
telling insiders that conditions in your industry could lead to
a financial crisis.
Mr. McDaniel. I am saying both internally at Moody's and
externally to the public, very consistently, that we seek to
maintain the highest levels of objectivity, independence, and
professionalism in assigning our ratings and I say that to both
groups.
Chairman Waxman. I know that is what you're saying here,
but it's hard to reconcile the transcript of that meeting. My
time has expired and I want to recognize Mr. Davis.
Mr. Davis of Virginia. Thank you, Mr. Chairman. You know,
the credit rating agencies have long maintained a fiction that
their ratings are consist across all asset categories but
according to the data published by Moody's in July 2007, we
learn that not all credit ratings are not created equal.
Moody's apparently found that BAA-rated corporate bonds, which
is the lowest investment grade Moody's rating, defaulted in an
average 5-year rate of 2 percent, but CDOs with the exact same
BAA rating suffered from an average 5-year default rating of 24
percent. How do you explain giving the same rating grades to
such wildly different kinds of debt?
Mr. McDaniel. That was research we conducted in order to
evaluate, just as you cite, the consistency of our ratings. I
think it is important that we do so. That is exactly the kind
of research work and self-assessment that we should conduct for
our firm. And there were findings that there were higher
default rates at the low investment grade level in one sector
versus another sector.
Mr. Davis of Virginia. Twelve times higher in this case.
Mr. McDaniel. For the period of time, that was being
assessed, that's correct. For other periods of time, we have
found that 12 times number, in fact, fell dramatically. And so
part of what we were considering was whether there were issues
about the point in time in the credit cycle or with respect to
certain types of assets that were receiving those ratings that
needed to be considered further.
Mr. Davis of Virginia. Mr. Sharma, let me ask you, Chris
Cox, who is the chairman of the SEC and a former colleague of
ours, will be before the committee tomorrow and he is going to
testify that the credit rating agencies sometimes help to
design structured mortgage-backed securities so that they could
quality qualify for higher ratings. Now, you testified that
Standard & Poor's doesn't do this. How would you respond to
Chairman Cox if he were here? And I would like the rest of the
panel to respond as well.
Mr. Sharma. Mr. Ranking Member, I can only respond for us.
We have very stringent policies and practices that our analysts
will not advise any firm on structuring of deals. Though there
are instances where when we look at the rating and our
procedure and process where people are bringing their analysis
to us and we are opine on that whether it meets our criteria or
not. That is the only thing we do is to opine on whether they
meet our criteria or not. Nothing more.
Mr. McDaniel. We do have interaction with issuers and with
investors around the credit implications our potential credit
implications of securities which they are contemplating issuing
into the market. Those discussions should relate solely to
credit. And it is in the interests of one, understanding the
information that is being delivered to us to make sure that we
reduce the likelihood of misanalysis of that information and
two, communicating back to those parties, information that we
think may have credit implications for the securities under
consideration. So that is the nature of the interaction.
Mr. Joynt. The regular dialog between analysts and anyone
working on issuer or a banker on putting together of financing
is there an iterative process that is, I think, unavoidable, so
for our employees to suggest that they become involved in
consulting and trying to design securities that is not part of
our approach. That is not part of our business. It's not their
job. So restrict them from any interaction of course is not
also constructive, and so I would say it's a back-and-forth
kind of iterative process. But our analyst interaction isn't
designed to create securities or to create the highest ratings.
Mr. Davis of Virginia. When Congress passed the Credit
Rating Agency Reform Act, we included language that prohibited
notching as an anti competitive practice. And as I understand
it, notching refers to when one credit rating agency reduces
its rating for a particular structured financial asset that
incorporates components like subprime mortgage-backed
securities that it hadn't previously rated. Some have asserted
that notching is a valid technique used by some credit rating
agencies to protect their reputations and provide more accurate
ratings, but others say it represents an anti competitive
practice. I ask each of you, is notching an anti competitive
practice and should Congress have gotten involved in this issue
and what impact does the prohibition of notching have on the
ratings of subprime mortgage-backed CDOs and other risky
structured financial products.
Mr. Joynt. So if I could address that first, because I
think Fitch was involved in suggesting that notching could be
an anti competitive practice and put that proposition forward,
so today I would suggest, as I did in my testimony, that we've
moved way beyond that question. In fact, notching, as
referenced then, referred to the creation of securities that
now we're discovering the ratings are changing by whole
categories not by notches.
So the fact that reliance on ratings generally and their
default probabilities specifically for some of the structured
securities since they have changed so dramatically as you
pointed out is a relatively small issue, not an important one.
The more important one, I think for rating agencies, is to
reflect on what is a steady state expectation for these
securities that we're now rating and have rated in the past and
that we're trying to change the ratings to make them more
active on, I would say, that is our more important mission.
Mr. Davis of Virginia. Mr. McDaniel, do you have anything
to say?
Mr. McDaniel. I believe it is a party of matter of intent.
I think there are valid credit analytical reasons to notch in
some cases and there may not be in other cases.
Mr. Sharma. I think ultimately, it is the responsibility of
the rating company on what rating they're given, what the
quality is, so I think the responsibility is to make sure
they're comfortable in assuming or making assumptions and that
is why there are valid reasons to continue notching.
Mr. Davis of Virginia. Was the congressional intervention
in this appropriate or not?
Mr. Sharma. It's brought into the analytical process, and
ultimately, it's the rating company that is responsible for the
ultimate rating, but independence has to be allowed for the
rating company.
Mrs. Maloney [presiding]. Thank you. I would like to
welcome all of the panelists.
Mr. McDaniel, in 2002, the Senate Governmental Affairs
Committee recommended that the SEC begin regulating credit
rating agencies. In 2003, the SEC agreed and issued what they
called a concept release that would have addressed conflicts of
interest at credit rating agencies. On July 28, 2003, you sent
the SEC a letter opposing this regulation. In your letter, you
claim that Moody's had dealt with this conflict of interest.
And I will read to you exactly what you said. You said, ``the
level of ratings are not affected by a commercial relationship
with an issuer.'' Do you remember sending this letter?
Mr. McDaniel. I do remember sending the letter. I don't
remember the sentence, but yes, I remember sending the letter.
Mrs. Maloney. In the letter, you made a very strong case
that you had vigorous protections in place to prevent your
ratings from being affected by your profits, and as a result of
your categorical strong assertions, no regulations were
adopted. My problem is that on October 23, 2007, you gave a
presentation to your board of directors, which said absolutely
the exact opposite of what you said publicly and to the SEC.
The committee has obtained a copy of that document. In the
document you described what you called, ``a very tough
problem.'' And under the heading conflict of interest, market
share, you said, ``The real problem is not that the market
underweights ratings quality, but rather that in some sectors,
it actually penalizes quality. It turns out that ratings
quality has surprisingly few friends. Issuers want high
ratings. Investors want ratings downgrades. Short sighted
bankers want to game the rating agencies. And you described in
this document some of the steps that Moody's has taken to
square the circle.'' But then you said this, ``this does not
solve the problem.''
Would you like to comment on what you said in this
document? You also said that keeping market share while
maintaining high quality, was an unsolved problem. Does this
internal presentation to your board contradict years of public
statements to the public and to the SEC by you and other
Moody's officials? In public, you said conflicts of interest
could be managed. But in private, you said your internal
procedures had not solved the problem.
And let me read you another passage. You also wrote this,
``Unchecked competition on this basis can place the entire
financial system at risk.'' To me, this is an astonishing,
amazing statement. Especially in light of what is occurring in
the markets now and the pain and suffering of Americans and our
economy, what exactly did you mean when you said competition on
this basis can place the entire financial system at risk? And
how can you sleep at night knowing that these risky products
that you were giving triple-A ratings could put the entire
financial system at risk?
Mr. McDaniel. First of all, I should restate the public
comments that I have made previously, which is that our ratings
are not influenced by commercial considerations. Our ratings
are the basis of our best opinion based on the available
information at the time.
Mrs. Maloney. But that is not what you said to your board
members. That is not what you said in this document.
Mr. McDaniel. It's not inconsistent with what I said to my
board members. What I said to the board is that it creates a
problem that to maintain the appropriate standards creates a
conflict potentially with maintaining market share. And that is
a conflict that has to be identified, managed properly and
controlled. I think that in raising these kinds of tough
questions with my senior management team with the board and
publicly is exactly the job that I should be doing.
Mrs. Maloney. But you also said that Moody's drinks the
Kool-Aid. ``Analysts and MDs, managing directors, are
continually pitched by bankers, issuers and investors all with
reasonable arguments whose views can color credit judgments,
sometimes improving it, other times degrading it. We drink the
Kool-Aid.'' What did you mean exactly when you said ``we drink
the Kool-Aid?''
Mr. McDaniel. It was a shorthand reference to the fact that
communications from individuals may either be more persuasive
or less persuasive. They may influence our subjective judgments
as to whether credit quality for an instrument or an obligor is
associated with a well-managed firm, or perhaps a not-so-well-
managed firm. And I made the comment with respect to the
potential for those assessments to affect ratings either up or
down.
Mrs. Maloney. I just would like to conclude by saying in
public you were saying in in one thing, in private you were
saying another. In public you were saying, ``the level of
ratings are not affected by a commercial relationship with an
insured.'' But in private, you were telling your board that
this was a huge risk, that Moody's, for years, ``has struggled
with this dilemma'' and it is hard for me to read this document
and believe that you believed what you were saying in public.
My time has expired.
Mr. Cummings.
Mr. Cummings. Thank you very much. You know gentlemen, I'm
sitting here and I'm trying, I'm trying to feel that honesty is
coming from that table. I'm trying. But as I listen to you and
I think about what has happened to the people in my district,
students not able to get loans, businesses closing, seniors
going back to work, people suffering, and then I listen to the
testimony that we heard earlier, I'm convinced that the
financial world and when I say ``world,'' I mean world,
worldwide, needed the ultimate trust from your agencies. And
I'm afraid to tell you and I hate to tell you this, but I
believe that a lot of that trust has been lost. Whether it was
intentional, unintentional, whatever, it has been lost.
And Mr. Sharma, in your testimony, you blame the models
that you used in your assumptions on how the housing market
would behave for S&P's failure to rate securities accurately.
But then Mr. Raiter stated in his submitted testimony that part
of the rationale for the failure was, the failure to implement
the new model, was one, it was too expensive; two, there was a
debate as to whether S&P needed that level data and three
improving the model would not add to S&P's revenues. Was it any
of those? You know, we're blaming everybody else for everything
but people are suffering. And I just want to know what is the
deal? I'm listening.
Mr. Sharma. Mr. Cummings, first of all, it is a severe
dislocation that we are all experiencing and what you're
describing is something that all of us feel it, all of our
4,000 analysts around the world feel it, because it is not
without pain that everyone is experiencing and seeing. What Mr.
Raiter was talking about was two things, one, a model that he
proposed or he was part of development when he was there, which
many of our analysts tested and concluded it was not as
reliable analytically. And so that is why the decision was made
not to use it. The second part Mr. Raiter highlighted was that
the model that he was instrumental in developing he has
indicated it may not have been updated. To just give you the
fact that since Mr. Raiter left, it has been updated eight
times which is about 2\1/2\ times per year since he left.
So we have been committed to sort of continue to update the
models as the environment changes, we observe the risks
changing, we observe what things we need to change a model and
we make the appropriate changes. So we are continuing to make
changes and we have learned from this experience as well.
Mr. Cummings. Well, you know, it's interesting, you said
something that was interesting. You said some of the statements
do not reflect the core values of S&P and I guess that includes
the statement from Chris Meyer, who says doesn't it make sense
that a V B synthetic triple-B synthetic would likely have a
zero recovery in a triple-A scenario, and if we ran the
recovery model with the triple-A recovery, it stands to reason
that the tranche would fail since there would be lower
recoveries and presumably a higher degree of default, and then
he went on to say that ``rating agencies continue to create an
even bigger monster,'' the CDO market, let's hope we all are
wealthy and retired by the time this house of cards falters.
It seems to me that there was a climate there, of
mediocrity because when we go on, we realize that there were
other people saying the same thing in your organization. Now
although you may not think it reflected the culture, I think it
reflected the culture and my constituents think it reflected
the culture, and to you Mr. McDaniel, you know this is your
watch. You made a nice statement about your organization being
around since 1909. But I wondered whether the folks who started
your organization in 1909 would be happy with what they see
today. Because there is, without a doubt, there has been a loss
of trust. And somebody has to recover that. You have to get
that trust back. We can never get these markets back, get them
back right unless the investors feel comfortable about what is
going on. And you're the gatekeepers. You're the guys. You're
the ones that make all the money. You're there. That is why
you're there.
And so we literally face a situation where we've got a
house of cards that has fallen. And here we are trying to
resurrect it. Something is wrong with this picture. And I have
read the testimony. I understand all the things that you say
you're going to do. But do you know the what the problem is?
Once you lose trust, nobody believes you're going to do it. I
see my time is up. You want to comment? Anybody?
Thank you.
Chairman Waxman [presiding]. Gentleman's time has expired.
Mr. Tierney.
Mr. Tierney. Thank you very much, Mr. Chairman I want to
talk a little bit again if I can about rate shopping. We've
talked about that a little bit when the prior panel was up
here. Here is a document that we have, an e-mail dated March
21, 2007, by an individual named Gus Harris who was managing
director at Moody's, Mr. McDaniel. He sent this to several of
the other officials in your company and in it he accused or
complains that Fitch is using a more lenient methodology to
award higher ratings and steal away business from your company.
This is what the e-mail says exactly. We have heard that they,
meaning Fitch, had approached managers and made the case to
remove Moody's from their deals and have Fitch rate the deals
because of our firm position on the haircuts. We have lost
several deals because of our position. Now I think we have to
explain a little of the industry jargon here. A haircut as I
understand it in the jargon, is if you saw some uncertainties
with the underlying value of mortgage-backed securities, you
require some additional collateral and it was that additional
collateral that was referred to as haircuts. Am I right?
Mr. McDaniel. Yes, that's correct.
Mr. Tierney. And apparently what he is saying is Fitch when
they find those uncertainties, they don't require the
additional collateral. They just proceed with the deal so
they're able to get the higher rating without that so called
haircut. Were you losing business to Fitch or was Fitch
poaching on your business on those types of premise?
Mr. McDaniel. With respect to the specific comment made by
Mr. Harris, I do not have any detailed information about his
comments. I'm sure he was identifying information that he had
seen and was communicating what he believed but I don't have
specific information.
Mr. Tierney. Was that an isolated incident where others in
your company mentioned to you that they thought that Fitch or
one of the other rating companies was making overtures to your
clients in competition trying to steal accounts?
Mr. McDaniel. Well, I would acknowledge that ratings
coverage probably for all of the rating agencies waxes and
wanes. We have different points of view about different
industries, different sectors. Sometimes we feel more confident
about a sector than our competitors. Sometimes we feel less
confident about a sector. And the consequence of that is that
issuers of securities may seek ratings from one or more
agencies that has more----
Mr. Tierney. But do agencies seek out the issuers? Have you
or anyone in your company ever gone to an issuer and suggested
that you ought to replace one of the other rating agencies
because you have a more lenient standard?
Mr. McDaniel. I have never done that and I'm not aware of
anyone doing that.
Mr. Tierney. Mr. Joynt, Mr. Harris says that your company
was doing that with respect to Moody's. Has anybody in your
company ever gone to an issuer and said, we have a different
standard over here than Moody's does, you ought to switch over
to us?
Mr. Joynt. I'm sure our business development people would
have contacted issuers, bankers or investors and suggest they
should use Fitch for their ratings. I would like to think, and
I believe, that they would have approached that by saying we
have a better quality research, a better model, a better
approach, more information so.
Mr. Tierney. Mr. Harris seems to think they had a different
approach.
Mr. Joynt. I might also add separately that in the subprime
area, in particular, our market share was significantly lower
than the other rating agencies. That to me wouldn't be evidence
that we were the most liberal rating agency. And in addition to
that, almost the majority of the ratings that we assigned in
subprime were third ratings, so we weren't replacing any one
which to me was always evidence that some of us adding our
rating not so much for the rating, but because they valued our
research our model our presale reports and other things.
Mr. Tierney. Do any of you gentlemen believe that we ought
to talk about the fact of not allowing issuers to actually pay
the rate setters, that we ought to go to a model that allows
for the investors to make the payments and not to the issuer
hire the company?
Mr. Joynt. My personal view is that the reason this
developed that issuers were paying was from the Penn Central
period and there was not enough analytical talent following the
fixed income markets and because of that the whole industry
meaning bankers and government as well got together and
suggested that an issuer pay model handled well, which could be
handled was more supportive of the people, talent and money
that was needed to cover these markets.
Mr. Tierney. Do you believe that is still true?
Mr. Joynt. I still do.
Mr. Tierney. Mr. McDaniel, do you belive that is true?
Mr. McDaniel. With respect to issuer versus investor pay
model, I think the biggest mistake we could make is believing
that an investor pay model does not embed conflicts of
interest. So as long as rating agencies are paid by any party
with a financial stake in the outcome of our opinions, and that
includes investors and issuers, there are going to be
pressures. And so the question is not are there conflicts of
interest? There are. It's managing them properly and managing
them with enough transparency that regulatory authorities and
market participants can conclude that, in fact, those conflicts
are being handled to the right professional standard.
Mr. Tierney. Thank you very much, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Tierney. Mr. Issa.
Mr. Issa. Mr. McDonald, I want to followup on--McDaniel,
I'm sorry. I'm going to followup on the last statement you
made. The second to last word you said was transparency. What
is the transparency of your evaluation models?
Mr. McDaniel. The transparency of our----
Mr. Issa. Your analytical computer modeling. How much
transparency will I find in yours or the gentleman to your left
and right?
Mr. McDaniel. We publish all of or methodologies and those
are available on our Web site for the general public. The
methodologies include a description of models that we use as
well as qualitative subjective factors that may be considered
in rating committees on an industry by industry basis.
Mr. Issa. Let me ask a question because I started looking
at Berkeley and other sort of software models that are saying,
look you can evaluate, at least today, where we went wrong.
And, I have an observation that I would like you each to
comment on, and that was pick a date anywhere from the first
derivative problems that occurred that led to lawsuits in 2001,
2002, 2003, the early indications but let's take 2006 and
beyond, why wouldn't your models have picked up, because they
are historic models, and you can't, you have to weight a
historic model both on total number but also on any significant
change. Why wouldn't we have seen a dramatic change in ratings
of whole classes occur in a relatively short period of time as
soon as home prices peaked and began falling?
And Mr. Kucinich isn't here right now, but I'm particularly
sensitive to that because at the very beginning of this
Congress 2 years ago, we went to Cleveland and got an earful on
the foreclosure rate, on the walk away rate on the problem. So
maybe each of you can respond to that because to me, that is
the most important question is why didn't your models pick it
up in real time and why do I believe your models today if they
couldn't pick it up close to real-time then?
Mr. McDaniel. From Moody's perspective, one of the
interesting early developments in the current problem that we
have seen in the mortgage area was that the monthly performance
data which we began to receive from the 2006 vintage and then
the 2007, tracked very closely to what we had seen in 2000 and
2001 in the previous recession, almost exactly on top would be
the way our analysts would describe it.
Mr. Issa. Meaning the tip of it looked just like the
previous event?
Mr. McDaniel. Exactly. And as a consequence, we did not
move as quickly as we would have if the early data indicated a
shift compared to the prior recession that we had been in. So
there was a several month lag until we were able to see enough
data to see that, in fact, it was not tracking what had
occurred in the last recession because those securities were
certainly robust enough to withstand the kind of recession that
we saw in 2000, 2001.
Mr. Issa. Do you all, three of you, believe today that your
models have been improved such that the same event or
substantially similar event or even a sneakier event if you
will would not catch your models off guard the way these did?
Mr. Joynt. I believe we've introduced significant
conservatism into the models now and we need to be thinking
forward because for us to rate new transactions today that is
starting the beginnings of a new cycle or a new process. So I
think there are changes in terms of the magnitude of the
stressors that we've introduced that were greater than we would
have used in the past. And then the evidence and information of
delinquency and loss in mortgage and then re-reflected in CDOs
is far greater than it ever was in the past. So the prior
experience of very good structured finance performance from the
last 15 years is going to be supplemented by quite poor
performance that needs to be modeled.
Mr. Issa. Let me ask one, and I'm very concerned because I
see whole other classes of debt that are likely if we don't
pull out of this recession that we're heading toward likely
look to repeat what we have already seen, and I don't yet see
it completely in your models. I see paper that is rated better
than to be traded at 60 cents on the dollar of its face value,
and yet it's trading that way. Let me just ask kind of a
closing question. You're essentially all unregulated
industries, you as rating organizations. And from the dais,
there will undoubtedly be a call to look over your shoulder in
significant ways.
Do each of you believe on behalf of your companies but also
on behalf of an industry you believe belong to that a Blue
Ribbon panel or commission that was independent of politics
would be appropriate as an in-between step of what might
originate from the dais if we didn't take that in-between step?
Mr. Joynt. We are regulated by the SEC to whatever degree
and they have started examinations in a more forceful way
having, I think, been directed by Congress in that direction.
So I do think that the only important protective element is our
judgment and our ratings judgment. So if the oversight from
regulatory bodies or some kind of panel has to do with process
procedure, and those things, then I think we're open to that,
at least that pitch. I don't want to speak for the industry on
that. I don't see us as an industry group in that way.
Mr. Issa. Each of you is able to answer.
Mr. McDaniel. I would just add that in addition to United
States, we are regulated in various jurisdictions around the
world. And so, while I would agree with Mr. Joynt that to the
extent that there is a review of process as opposed to our
ability to develop independent opinions, I would be supportive
of that. And I would hope that such a review would be able to
accommodate the global nature of the work that we do.
Mr. Sharma. We would agree also given, and SEC has come up
with more rules and guidelines for oversight of the processes,
and I think it's moving in the right direction. The more
transparency we put around these things it's better for the
whole marketplace.
Mr. Issa. Thank you. And Mr. Chairman I know this is
particularly going to make us look forward to seeing Mr. Cox
tomorrow, Chairman Cox.
Chairman Waxman. Thank you, Mr. Issa. Mr. Lynch.
Mr. Lynch. Thank you very much. Gentlemen I want to ask you
in continuing with Mr. Tierney's line of questioning. I want to
ask about the problem of rating shopping. And we heard
testimony from former employees of your firms, and others
outside of this hearing that this occurs when investment banks
take their mortgage backed securities to various credit rating
agencies to see which one will give them the highest rating and
for the rating agencies this creates incentives for lenient
rating systems, and there is a financial incentive to beat your
competitors by lowering your standards and offering higher
ratings. In essence, it creates a race to the bottom.
There is an interesting example here, and we have an e-mail
I would like to have put up that was sent on May 25, 2004 from
one of the managing directors. This is not a lower employee.
This is a managing director at Standard & Poor's, to two of the
companies' top executives. So this is at the very top level of
the organization. The subject line of the e-mail is competition
with Moody's and it says this, ``we just lost a huge Mazullo
residential mortgage-backed securities deal to Moody's due to a
huge difference in the required support level.''
A little further on, the Standard & Poor's official
explains how Moody's was able to steal the deal away in his
opinion by using a more lenient methodology to evaluate the
risk. He says this again, they ignored commingling risk and for
the interest rate risk they took a stance that if the interest
rate rises they will just downgrade the deal.'' It goes on. And
let me read the rest of the e-mail and you get the back and
forth here.
After describing a loss to Moody's, the S&P managing
director writes, this is so significant that it could have an
impact on the future deals. There is no way we can get back in
on this one. But we need to address this now in preparation for
future deals. Goes on. He says, I had a discussion with our
team leaders--sort of like what you were describing a little
earlier, Mr. McDaniel--I had a discussion with team leaders and
we think that the only way to compete is to have a paradigm
shift in thinking especially with the interest rate risk.
So you can see this back and forth, they steal the account,
they lower their standards now, now Standard & Poor's is
lowering their standard and it's fairly evident. It speaks for
itself.
But Mr. Sharma what was your managing director referring to
when he said this is so significant that it could have an
impact on future deals and that the only way to compete is to
have a paradigm shift in thinking?
Mr. Sharma. Well, Mr. Lynch, I wasn't there so I cannot
speak to the specific wording in this e-mail but what I can
tell you is that in this case I don't, I believe we did not
rate this deal and----
Mr. Lynch. Say that again?
Mr. Sharma. We did not rate the deal.
Mr. Lynch. No, I'm talking about the exchange here. It's
not, I'm not interested in entering this as a legal act. I'm
interested in evaluating this as a document that speaks for
itself. This is a present recollection of your management, OK,
and as long as you can read English, you can pretty much figure
out what is going on here. This is not, we're not evaluating a
CDO here. This indicates intent and then we know that each firm
has modified their approach here in lowering their standards.
So I'm asking you from that standpoint, just from a commonsense
standpoint what you get from these statements.
Mr. Sharma. Our criteria is public, as I believe other
firms' criteria is also public. So from time to time, our
analysts do look at the criteria from the other firms to see
have we captured things right, are they capturing other things
that we are not capturing? And so there is a look at the
competition to see what are we doing, what are we not doing. So
I would imagine this was sort of referring to looking at the
competition's criteria and analytics and thinking and looking
at seeing if we were missing something that we should be
considering. That is what I would suggest.
Mr. Lynch. He is saying they didn't have something. They
basically ignored commingling risk and for the interest rate
risk they took a stance, said hey, if the interest rate rises
they will just downgrade the deal. So he is not stealing good
ideas here. He is not being innovative here. He is just
ignoring some important factors in the deal in order to give
them a higher rating and by doing so he is lowering his
standards. So we're not talking about competition by
innovation. We're talking about competition by Sergeant Schultz
basically ignoring what is going on, looking the other way.
Mr. Sharma. As I said, all I can speak to is the intent was
to look at analytically are there things that we are not
considering or we are considering that we should be looking at
it differently.
Mr. Lynch. My time essentially is expired.
Mr. McDaniel, they are talking about a managing director at
Standard & Poor's who says that they ignored key risk in order
to win business. Do you have any response to that?
Mr. McDaniel. I do not, obviously--I cannot speak to this
specifically, but certainly we are not going to ignore issues
or topics that have credit implications. So I'm not sure what
the concern was from a member of another rating agency.
Chairman Waxman. Mr. Lynch your time is up.
Mr. Lynch. Thank you, Mr. Chairman.
Chairman Waxman. Mr. Bilbray.
Mr. Bilbray. Thank you very much, Mr. Chairman.
Gentlemen, I guess around 2006, the subprime mortgage
securities made up about 100 billion out of 375 almost four a
quarter of CDOs sold in the United States. Please help this
committee understand how, when you have a quarter subprime,
that the rating agencies can qualify those securities as
triple-A when they are backed by very questionable mortgage
arrangements. One quarter of them were subprime. Is that the
industry standard? And we kept seeing these subprime always
being sort of packaged. But they were going a pretty high
percentage, 25 percent is a pretty big package. Was it just the
perception that real estate never goes down, you never have to
worry about it, and payback will always be automatic because
you can liquidate the asset?
Mr. McDaniel. No. It's not that at all at Moody's, and
frankly, I don't believe it's that way elsewhere in the
industry either. We know that subprime mortgages are going to
have poorer performance than prime mortgages. And that is why
high levels of credit protection are associated with those
transactions. In the subprime mortgage backed securities area,
for example, that 2006 vintage when we analyzed that, we
analyzed it to a level at which in a pool of 1,000 mortgages,
approximately 500 could default, and the triple-A bond holders
would still receive their payments in full.
So the point is there were large amounts of excess
protection built in to protect triple-A bond holders, and we
will have to see whether those triple-A bond holders, in fact,
suffer credit losses in the future, and that question is still
open.
Mr. Bilbray. When we're talking about this whole rating
shell game, and that is what it appears to a layman, are we
talking really about the fact that the cost of insuring is
determined by the rating? Is that what we're really talking
about, the overall insurance and the different rating, the
rating affecting those insurance rates?
Mr. Joynt. I'm not sure I understand the question.
Mr. Bilbray. Let me, the biggest concern I have here is
that the credibility of the process has definitely been
decimated over the last few months. If you were going to change
a system of having ratings, the rate, basically, the rating
system upgraded, everybody is talking about the conflicts that
exist now. How would you negate those conflicts or minimize
them so that there was more nexus between true rating and a
sensitivity there and the protection of the market? Because a
lot of people are talking about things that went wrong. What
would you do to change the system to make it work better?
Mr. McDaniel. If I had one thing that I would recommend to
do, it would be to make sure that there is sufficient
information not in the hands of just the rating agencies but in
the hands of the investing public that they can make informed
investment decisions about these securities without having to
rely solely on rating agencies. The problem with having
insufficient information available to the investing public is
that they become more reliant on rating opinions--and they are
just opinions--and they also have less ability to differentiate
the performance of the rating agencies because they can't look
at the underlying information and make take their own
independent judgments about the work. That would be my
principle recommendation.
Mr. Bilbray. Transparency.
Mr. McDaniel. Of the underlying information yes absolutely.
Mr. Bilbray. Gentlemen, you agree with that?
Mr. Sharma. Absolutely, and that is why we have made a
commitment to not only increase transparency through more
analytics, but also as Mr. McDaniel said more underlying
information but also more information around our assumptions
and the stress test scenarios that we do. Mr. Member, you said
that we were looking at house pricing. The fact is, all of us
look at house price declines. The only difference was in this
case, unfortunately, we did not assume as severe a house price
decline as has occurred. So the more we can make those
assumptions clearer to the public and to investors so they can
understand what stress test scenarios we are looking at and how
extreme they are, the better and more informed decisions they
can make about their investments.
Mr. Bilbray. So what we have is, basically, the consumer
basically there was the perception here is a rating and we
can't look beyond that to find out where that number came from.
And then we're told buyer beware. And frankly, the perception
was it was almost worse than having none at all because there
was a false sense that rating was legitimate and could be
trusted when, in fact, you weren't allowed to be able to go
back and look at the data to justify that rating so that you
had a confidence with it. Thank you very much, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Bilbray. Mr. Yarmuth.
Mr. Yarmuth. Thank you very much, Mr. Chairman.
I would like to start by posing a question that I want each
of you to answer with a simple yes or no. Have you or any
officials in your company ever knowingly awarded a rating that
was unsupported or unjustified in order to win a deal or keep
from losing one? I'm just going to go right across the line.
Mr. Joynt.
Mr. Joynt. Not that I'm aware of no.
Mr. McDaniel. I'm not aware of any situation like that.
Mr. Sharma. Not that I'm aware of.
Mr. Yarmuth. Well, the documents that the committee has
received and the testimony from the first panel suggests that
your analysts did give unjustified ratings. And let me ask
about one of these documents. During the first panel, I
discussed an internal instant message that was a conversation
between two S&P officials on the afternoon of April 5, 2007.
From the documents we know these were two officials in the
structured finance division of S&P. This was a discussion about
whether they should rate a certain deal. The conversation
quickly once again you are probably aware of it.
Official one, ``That deal is ridiculous.''
Official two, ``I know, right model definitely does not
capture half the risk.''
Official one, ``We should not be rating it.''
Official two, ``We rate every deal it could be structured
by cows and we would rate it.''
Official one, ``But there is a lot of risk associated with
it. I personally don't feel comfy signing off as a committee
member.''
Mr. Sharma, is this one of the conversations that you
referred to in your testimony as containing unfortunate and
inappropriate language?
Mr. Sharma. Absolutely, Mr. Member, and let me also
clarify, the full context of the e-mail, as that could be made
available, would show that our analysts were referring to the
bank models not to our models, but to the bank models. So the
bankers submit the models. Our analysts concluded it was not
including enough of the risk that it should have been
including. And so that is what they were talking about. It was
the bankers models. And that is what they were talking about.
And but you know it was only part of the e-mail that came out.
Mr. Yarmuth. I understand that may have been the case, but
the S&P ended up rating it any way in spite of the questions
that your analysts, your officials raised about it.
Mr. Sharma. Yes, two things, Mr. Member, again A, the model
was modified. Two, it was more referring to the CLOs and the
CLOs to date are still doing OK.
Mr. Yarmuth. Well, you have officials who said they are not
comfortable signing off on it.
Mr. Sharma. Right.
Mr. Yarmuth. They didn't know the risk, but yet your
company rated it.
Mr. Sharma. Again, they were not comfortable as the model
was, so they were basically asking the bankers' models to be
refined and redefined to include the whole risk and when it was
redefined to include the whole risk then they did rate it. And
as I said it was for the CLOs which are still performing to the
normal expectations that we have.
Mr. Yarmuth. Sounds pretty suspicious.
Mr. Sharma. Well, Mr. Member, we are happy to share more
facts on that with you.
Mr. Yarmuth. Thank you. We would appreciate that.
Chairman Waxman. We will hold the record open to receive
more information from you.
Mr. Yarmuth. I focused that question on you, Mr. Sharma,
but the problems aren't limited to S&P. There was a New York
Times article earlier this year that reported that Moody's gave
one of its analysts a single day to rate a security that
compromised almost 2,400 subprime mortgages worth $430 million.
There seems to be no way that you could do an effective job of
rating a portfolio that large in 1 day. Mr. McDaniel would you
like to comment on that?
Mr. McDaniel. First of all, I have to say I don't know what
the New York Times was referring to, so I have to answer this
in the abstract. But to the extent that a transaction had
already been reviewed for its structure, that we had looked at
the assets underlying the transaction and were simply running
those assets in a computer ready form through a model so that
we could take them to a rating committee, it may be possible
that could be done in a day. As I said, I can only answer that
in the abstract though because I'm not sure what that was
referring to.
Mr. Yarmuth. But you're basically saying that a
hypothetical, let's make it a hypothetical portfolio of that
could be evaluated with sufficient scrutiny that it would form
a reliable basis for making an investment decision for somebody
else?
Mr. McDaniel. It depends on whether other aspects of the
transaction had already been analyzed and taken care of and
whether we were simply looking at the pool of mortgages that
had to be assessed with the assistance of computer tools.
Mr. Yarmuth. Let me ask you one other question, and you
responded in relation to Congresswoman Maloney's question of
trying to reconcile the two statements the public one and the
private one to your internal communication. The implication to
me, if I accept your explanation which I will be happy to
accept it, is that the other rating companies are doing
something that is not crooked. Is that what you meant?
Mr. McDaniel. What I meant, and what I have discussed with
our board and our management team is there are difficult issues
that have to be reconciled in this business in doing the proper
job. I think every business has those kinds of challenges.
Mr. Yarmuth. But that comment was related, it seems, to me
specifically to the competitive situation in your field. You
have 90 percent of the business sitting at that table and so I
can't take your explanation any other way than you think one of
those other two is basically doing something that doesn't meet
the standards that you had.
Mr. McDaniel. As I said earlier, we have different points
of view about different securities, different sectors,
industries in different geographies. And it is inevitable that
we are going to hold different views, some of them more liberal
and some of them more conservative, than our competitors. Those
have competitive implications, and we have to be cognizant and
candid and discuss those issues in order to keep our eye on the
core of our business which is a standards business.
We can't hide from that. We have to address it.
Mr. Yarmuth. Thank you.
Chairman Waxman. I'm going to yield myself 3 minutes here
because what you're saying is not what you said. What you're
saying now is not what you said then, because your accusation
was about these other companies. You said they are placing the
entire credit rating industry on a slippery slope, and you said
they're going nuts and they are starting to rate everything
investment grade.
That's not the same as your interpretation of it now.
Mr. McDaniel. I apologize. I may have misunderstood. I
thought you were asking about my communications with our board
of directors, and I think this was a communication on the town
hall meeting.
But to answer the question on the town hall meeting, again,
I believe I was responding to a question that had to do with
standards and the challenge of maintaining standards,
especially in good times when the marketplace may not be as
attentive to identified risks.
Chairman Waxman. Well, the other thing I can't understand
now, the interpretation of words that sound pretty clear to me,
is, Mr. Sharma, you're saying if we can get that colloquy up of
the two officials, one guy said, the idea is ridiculous. The
other one said, I know, right, the model definitely doesn't
capture half the risk. The other one said, we should not be
rating it. And then the answer to that is, we rate every deal;
it could be structured by cows, and we would rate it.
That doesn't sound to me like a discussion of, perhaps we
can have a reevaluation of and find out through another
modeling that it does deserve rating. It sounds like a
statement by one of the people who works for you that said, we
rate everything. Even if it were, as he said, structured by
cows, we would rate it.
How do you explain that?
Mr. Sharma. Mr. Chairman, first of all there was
unfortunate, inappropriate language used----
Chairman Waxman. No, it's not inappropriate at all. Maybe
it's more honest than what we're hearing from you and others
today.
Mr. Sharma. But as I was sharing with the Congressman
before, the full context of e-mails would highlight that they
were referring to the bankers' models; and the fact is that we
do ask that more risks be considered than the models that were
originally proposed by the bankers. So this is exactly what we
want our analysts to do is to challenge and raise questions
when they don't feel comfortable.
Chairman Waxman. One man is saying, I don't feel
comfortable with it; I don't think it deserves any kind of
rating. The other man is saying--both working for you--you've
got to rate it; we rate everything. We rate everything; even if
a cow structured it, we would rate it.
That doesn't sound to me like we could rate it if it had a
different model. It sounds like, don't give me any trouble,
we're rating everything.
Mr. Sharma. Mr. Chairman, again, we make all the criteria
public. And then when we rate to it, we make it very
transparent to the investors and to everybody else.
Chairman Waxman. What do you make transparent?
Mr. Sharma. Our criteria which we rate. So that is publicly
available. And when we do the ratings decision, we make the
rationale as to why we concluded the rating also transparent to
the marketplace that says, here's the criteria, here's how we
rate it, here's the rationale for it.
Chairman Waxman. It's hard to understand how transparent it
is when you don't even go back and look at the underlying
securities upon which this whole house of cards is based.
Mr. Sharma. We do--have made that commitment to continuous
look for more underlying securities.
If I may just mention, the SEC staff in its examination of
us while these e-mails were brought out--and they were
unfortunately inappropriate--they did not find any misconduct
even in this case that they examined.
Chairman Waxman. Well, it's hard to find any misconduct if
there is no standard for misconduct.
Mr. Issa, did you want some of the time?
Mr. Issa. I will take 3 minutes. Thank you, Mr. Chairman.
I'm going to try to hit on just a couple of quick points.
First of all, are all of you familiar with the Superior
Bank failure and River Bank failure?
Mr. Joynt. No.
Mr. Issa. Both occurred in the early 2000's. Both were
subprime lending related. Hopefully, you will become familiar
with them so that your companies can look and say, why didn't
our model pick up these significant failures related to
subprime in that earlier recession you talked about? Because
whole banks went down because they were excessively invested in
this type of instrument, and I think that should have been a
warning that didn't fit into your models.
You may want to look at the question of--it's a little bit
like, I mentioned airplanes one time in a hearing and I lost
people. But an airplane can fly precisely all the time except
the one time it crashes. It doesn't do any good to say it had
10,000 good hours. If every 10,000 hours a plane falls out of
the sky, Boeing would be out of business; McDonnell Douglas
never would have gotten, so to speak, off the ground. You have
to have a much better capability to deal with when something
goes wrong, if you will, a failure that doesn't lead to a
crash.
So I will just leave you with that. I don't want to go
further into it other than to say, there were indications 8
years ago that subprime--these now so-called toxic loans--could
lead to catastrophic events.
I want to put you on the spot though today as to the
overhang of the LBO market. We've been talking and people have
been implying here that if you take somebody's money, you
automatically do their bidding to their preference.
I find it a little interesting that Members of Congress
pride themselves on taking a million dollars every 2 years from
people who want us to do certain things; and then we often,
rightfully so, vote against their interest. And somehow we
can't see that we are asking you to do substantially the same
thing as an organization.
But having said that, we have hundreds of billions of
dollars--probably several trillions; I don't have the exact
number--in these leveraged loans that corporations did. They
are still on the books. They're trading at 50 and 60 cents even
if they are fully performing.
How do you view your ratings today as predictive of whether
or not these are going to become nonperforming, particularly--
and I go back to what was said on the other side of the aisle,
particularly when you have indexing of two points or more--
actually, 11 over LIBOR, if you bust a covenant, today would
probably be what you'd get. With those kinds of increases that
would evaporate the ability to repay a loan, how do you see
that and how are you rating them so that we can understand with
confidence that those trillions aren't going to need a bailout
from Washington?
Mr. Joynt. So, speaking of most highly leveraged companies
that would have to leverage loans that you're referring to,
probably their ratings are speculative grade today. Probably
their original ratings were not highly rated or investment
grade.
But I take your point well that in this kind of
environment, I think companies that thought they would have
stable cash-flows, that have introduced tremendous leverage
into their business, are much more susceptible to failures. So
I think we need to be addressing the ratings on those, although
they're already speculative grade, by moving them down. But I
think it's more important that we find a way, or the management
of those companies, find a way to reduce the leverage,
especially in this environment.
Mr. McDaniel. We expect that the default rates for these
highly leveraged corporations are going to rise in 2009 and
2010. We do have them graded in the speculative grade range,
many of them deep into the speculative grade range.
But I agree with Mr. Joynt that the ability of these
companies to delever or access capital in a very difficult
market is going to be very important to the ultimate default
rates we see in this sector.
Mr. Sharma. I agree with Mr. Joynt and Mr. McDaniel.
We also--for example, most of the ratings are speculative
grade, and our average defaults for them are 1 percent and we
are now projecting it to go as high as 5 to 6 percent, which
will put more strains and pressures. And the deeper the
economic recession, the greater the risk.
Mr. Issa. Thank you.
Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Issa.
Ms. McCollum.
Ms. McCollum. Thank you, Mr. Chair.
Well, today I have been listening of culpability,
incompetence, and in any opinion, corruption. This Member of
Congress has downgraded your AAA rating. Your industry and
financial system is based on trust. A former Moody's analyst is
quoted by Bloomberg.com last month saying, ``Trust and credit
is the same word. If you lose that confidence, you lose
everything because confidence is the way Wall Street spells
God.''
Mr. Chairman, in the last few weeks we have seen what
happens when Wall Street loses religion.
Mr. McDaniel, in 2005, you testified before the Senate
Banking Committee, you said, ``Moody's integrity and
performance track record have earned the trust of capital
participants worldwide.''
Mr. McDaniel, documents obtained by the committee tell a
very different story. On July 10, 2007, Moody's downgraded over
540 mortgage-backed securities and placed 239 for possible
downgrade.
The committee has an e-mail that was sent 2 days later, on
July 12th. This e-mail says that Fortis investors raised
concern with your organization. Publicly you say you have the
trust of the market. But privately many market participants say
they don't have trust in your ratings.
Now, here's a few of the quotes from the e-mail, ``If you
can't figure out the loss ahead of the fact, what's the use of
using your rating?'' ``You have legitimized these things.''
That's referring to subprime, asset-backed CDOs. In other
words, I'm going to put it together, and it says, ``You have
legitimized these things that are leading people into dangerous
risks.''
``If the ratings are BS, then the only use in the rating is
comparing BS relative to more BS.'' That's not a satisfied
customer, Mr. McDaniel, and it does not sound to me like you
have the trust of the market.
Without the trust of the market, what value do any of your
organizations add to the financial system? It appears to be
none.
Mr. McDaniel, do you have the trust of the market?
Mr. McDaniel. The trust in rating agencies and in Moody's
has obviously eroded during this period of credit turmoil. I
think it would be disingenuous not to acknowledge that, and I
do.
We are working very hard to make sure that we can reinstill
a sense of trust in the market to support the confidence that
the market needs for the free flow of capital. That is
absolutely critical, and that is what we are focused on as an
organization very, very deeply.
Ms. McCollum. Mr. Chairman, I have only 5 minutes, so I
would like to hear from the other gentlemen if they think that
their investors, my constituents--the word ``credit'' comes
from the Latin word ``credo,'' belief. They had belief in you.
They had belief in your rating systems, and instead they have
lost, some of my constituents, their entire retirements, their
grandchildren's college funds.
So I'm asking you, do you believe that my constituents have
trust in your ratings?
Mr. Sharma. We absolutely have to earn the credit back; and
as you said, the credibility back and the trust back. We
absolutely believe that, and that's why we have announced a
number of actions that we believe we need to continue to add
transparency, bring more transparency in the marketplace to re-
earn the trust of the investors, because ultimately it's the
investors who use our ratings; and that's who we need to earn
our trust back from.
Ms. McCollum. Sir?
Mr. Joynt. I'm also very disappointed in our inability to
project losses and foresee the problems in the mortgage area
and the CDO area. It's resulted in a lot of rating changes that
have changed valuations and prices and have impacted many
people. So I realize our credibility has been damaged in that
way.
I--hopefully, people recognize that our--at least my view
is that Fitch--that we have operated with objectivity, with
best intentions, with no malintent, although we weren't
successful in projecting them. So, hopefully, that's a
foundation on which we can build credibility again.
Ms. McCollum. It's my understanding from the earlier
testimony that Standard & Poor's had in front of it an
opportunity to upgrade its model in 2001.
Mr. Sharma. Sorry. Say----
Ms. McCollum. That Standard and Poor's had in front it a
new modeling system. They knew the modeling system that they
had didn't work, and in 2001 made a decision, because they
didn't have enough money for staff and they didn't have enough
money for the computer upgrade to do the model, to do that.
So was Standard and Poor's lacking in profits during that
time.
Mr. Sharma. Congresswoman, Mr. Raiter had raised that point
and let me address--there were two points he raised.
One was that there was a new model that he was part of in
terms of his development. But that model, a number of other
analysts looked at it and they did not conclude conclusively
they it could improve their reliability or was a valid
analytical approach; and so that was why we didn't choose to
use it.
The other point he raised was that the model that he was
part of, we have updated that about eight times since he has
left Standard & Poor's. That's about two and a half times a
year. So we updated almost two to three times a year, and we
continuously update it.
And we will update that as frequently as the environment
changes, assumptions change. We will continue to update that.
That's our commitment.
Ms. McCollum. Mr. Chair, if the staff could get that
information that, in fact, they had aggressively pursued
constantly updating their models to meet the needs of what they
saw in the changing marketplace, that would be very helpful for
the committee.
Chairman Waxman. We'd like to share what information we
have about your operations so you can respond to the facts that
we know about your company that you're not aware of.
Mr. Sarbanes.
Mr. Sarbanes. Thank you, Mr. Chairman.
Thank you to the witnesses.
Would you say that the failure on the part of your
companies to accurately assess the risk of these securities has
contributed to the collapse of the financial markets that we
have seen? Yes? No?
Mr. Sharma. There are assumptions as we have seen, for
example, in house price declines that we made that would
decline by 10, 12, 15 percent; certainly the house price
declines have been much more severe than we had anticipated.
So, in that context, the risks embedded in these instruments at
a 30 percent house price decline are certainly higher than 15
percent house price declines.
Mr. Joynt. I would suggest that having ratings move with
the volatility that they have in CDO and mortgage space impacts
prices and has brought people concerns about whether they'll
remain volatile or not. That's impacted many people's
valuations, banks, and of course has been a portion of the
pressure put on them, yes.
Mr. Sarbanes. I guess I was suggesting something else. I'll
just draw the conclusion myself, which is that you encouraged
risky behavior because you rated these things as AAA or
reasonable investments when they weren't; and that set off a
whole chain of events which resulted in the collapse of the
financial markets, and it had the human effect of a lot of
people losing their homes, of increased tightening of credit
and all the things that we're seeing.
I looked through the testimony of each of you. It didn't
say, but I was just curious how long each of you have been in
the positions that you hold right now.
Mr. Joynt. I started in the ratings business in 1975. I
started at Fitch in 1989, and I became president in 1994.
Mr. McDaniel. I began with Moody's in 1987, and I became
CEO just over 3 years ago.
Mr. Sharma. I took on the role of president at Standard &
Poor's just last year in September.
Mr. Sarbanes. Last year, OK. At least two out of three of
you were there when a lot of this bad assessment was occurring,
and let me ask you this question: Would you say that people
inside your agencies--that these securities were so exotic, so
unusual, so fast moving in their design that the fact of the
matter is that there was really nobody who understood them
completely? Is that a fair characterization?
Mr. Joynt. In the case of mortgage securities, I think they
grew in complexity, but I believe our teams understood them
well.
In the case of CDOs, they also started more simply and got
more complex. The requirement to model their sophistication
became more difficult, but if we were uncomfortable with our
judgment on that, we would not have assigned ratings to them.
My final example would be CPDOs, which also has been
mentioned in the press as problematic instruments; and there
our teams studied those for more than 6 months. We had great
debates within the organization between the quantitative people
who thought we could model the risk and some of our senior
credit people who felt like the price performance was too short
and the instruments too volatile; and after 6 months of healthy
analytical debate, we chose not to rate them with either of our
highest ratings and, therefore, we did no ratings.
Mr. Sarbanes. I'm glad to hear you say that, because it's
become a popular refrain in this to sort of say nobody really
understood these things. I've heard a number of you say today,
Well, we built the models, but the models didn't pick up on
certain things, they were the wrong models, and so forth. And I
was counseled the other day by somebody to resist that
characterization and to believe that, in fact, there were
people at all the various levels of this drama who knew exactly
what these instruments were, understood exactly what the risks
of them were, but nevertheless proceeded to put a stamp on them
at some level and just pass them along.
And what I'm curious about is, there had to be people
inside of your agencies who were getting a sick feeling in the
pit of their stomach as these things were coming across their
desks. And I don't understand why the company didn't have a
culture that would trap that uneasiness and convert it into
some real resistance to giving these high ratings to these
securities.
Can you explain that?
Mr. Joynt. Sir, I'd like to address that if I could,
because I asked earlier if I could at least represent Fitch's
position in this matter.
So I think there are a lot of examples where our credit
culture has had us decline to rate securities many times. So
earlier it was suggested in 2004 that we were nuts, I think was
the term. I don't think so. In early 2003 or 2004, our credit
teams decided that we were uncomfortable assigning our highest
ratings to all base securities, and so we weren't asked to rate
any.
Our market share dropped to zero as a consequence, which I
think, to me--and I certainly accept that and was aware of it,
and it was a consequence of the healthy analytical conclusion
we reached--nothing to do with business.
So there are structured investment vehicles that were
rated. I think the other rating agencies rated 40 or more. We
rated five, I believe, because it was well known in the market
our credit views were more conservative, and so we couldn't
reach the higher rating conclusions that they expected.
So I think there are many examples.
Ms. Norton, Congresswoman Norton, suggested earlier MBIA.
We changed our rating at MBIA. I personally was involved in a
quite contentious--contentious public debate with the chairman
of that company as to why we're changing our ratings.
So I think there are a lot of examples where our firm, at
least, has demonstrated that when we have clear credit
concerns; then we either lower our ratings, or we don't move
forward with ratings.
Chairman Waxman. Thank you, Mr. Sarbanes. Your time has
expired.
Mr. Issa. Mr. Chairman, how much time do I have remaining?
Chairman Waxman. You have 3 minutes and we have one, two,
three Members----
Mr. Issa. I will reserve. Thank you.
Chairman Waxman. Ms. Watson.
Ms. Watson. Thank you so much. The committee just received
a letter from our treasurer, Bill Lockyer, from the State of
California, my State; and in this letter Lockyer is extremely
critical of the way credit rating agencies are rating municipal
bonds in California. Mr. Lockyer tells us that at the beginning
of June of this year, S&P rated the creditworthiness of both
Lehman Brothers and the State of California. S&P gave them both
A+ ratings. We were 85 days before we got our budget, and with
a $14 billion shortfall. However, just 3 months later, Lehman
Brothers filed for bankruptcy.
Now here's what Lockyer says in the letter: ``How could any
rational person believe that a long-term investment in Lehman
Brothers was as safe as a long-term investment in California?''
That sounds kind of quirky. Because we're in a little trouble,
but something is amiss if a credit rating agency can give the
same assessment.
So I would like to start with Mr. Sharma. Can you please
explain to me how S&P thought Lehman Brothers was such a safe
bet that they gave it the same chances of defaulting as
California?
Mr. Sharma. Thank you, Congresswoman. As you very well
pointed out, at that point in time, California's deficit and
budget shortfall was rising from up to about $22 to $23
billion----
Ms. Watson. How did we get an A+?
Mr. Sharma. But, again, there was the ability to raise the
capital.
There are two things we look at. One is the capacity to pay
and the other is the willingness to pay.
Same thing, turning to Lehman. Lehman, until that Friday
before they went bankrupt, they were trying to raise capital.
They were trying to diversify some of their assets, and then
they had the Federal Government, Federal Reserve, as a
backstop; and those were the reasons why they thought they
could still be an ongoing entity.
Ms. Watson. Let me read you something that Mr. Lockyer said
in this letter: ``Without doubt, the rating agencies too freely
assigned their highest ratings to structured investment
products backed by market shares and the debt of financial
institutions, many of which have now collapsed. Some evidence
suggests that the agencies may have cut corners and violated
their own standards in doling out their ratings.''
So do you have a double standard where you give corporate
bonds preferential treatment compared to municipal bonds, Mr.
Sharma?
Mr. Sharma. No, Congresswoman. We have a single, global,
consistent scale, and we strive to get a global consistency
across all our asset classes over a long period of time. At any
point in time there are different credit cycles, different
market cycles across different asset classes; so there may be
some differences.
Ms. Watson. I know we were in trouble in California with
the largest State majority of minorities. People come from
Southeast Asia, over the border, with different needs that have
to be met by government. And you knew all the factors that were
affecting California.
Do you not do that same thing with Lehman Brothers? Because
what I'm finding out, they misrepresented their standing, their
liquidity and factors, and so I'm wondering if you evaluate
them differently.
Mr. Sharma. We do look at different criteria. However, from
a scale point of view, we look at them with the same level of
criticality.
We had downgraded Lehman several weeks ago, and then we had
even put them on grade Watch Negative, I believe, and we can
confirm that to you. And the day before they went bankrupt,
again they were trying to raise capital and they assured us
that they had access to capital.
Ms. Watson. So were we.
Mr. Sharma. I understand. Even in California the reason we
put them at Negative; and we changed the rating yesterday,
madam, because we saw they were able to raise the capital.
Ms. Watson. Very good.
But I also understand from Mr. Lockyer that out of all the
States there has only been one State that defaulted; so I would
think that our bonding rate would be higher.
Now, Mr. Chairman, one of the issues that concerned many
investors, particularly in the midst of the financial crisis,
is the seemingly arbitrary meaning of credit ratings given by
S&P, Moody's, and Fitch. I don't know how we are supposed to
trust these ratings when junk bonds based on subprime mortgages
receive AAA ratings, the same rating as the Federal Treasury.
And I would ask all of you, but my time is up, if the
ratings have no meaning in relationship to each other, what
really is their use? Because my time is up, maybe we can ask
what these standards are or how they apply to municipal bonds.
Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Ms. Watson.
Ms. Norton.
Ms. Norton. Thank you, Mr. Chairman.
I would like to get some clarification as to the real
meaning you intend of ratings, particularly in light of the
disclaimers that are found in the documents of all of you.
Your companies are very profitable for the reasons that
people put their money on you, in effect, and you see how
profitable you are. The three firms doubled from 2002 to 2007,
increasing from $3 billion to $6 billion. This will go down in
history. This was the period during which the government
flushed down into the you-know-what.
At Moody's the profits quadrupled between 2000 and 2007. In
fact, Moody's had the highest profit margin of any company on
the S&P for 5 years in a row. And the reason that you're so
profitable is because so many investors rely on your expertise
and your ratings as virtual gospel, scripture, whatever you
want to call it. They point to them time and again.
But to hear the disclaimers and the caveats and the
qualifications, you would think that the credit ratings aren't
worth the paper they're written on. Let me find out.
Mr. Sharma, here's is a disclaimer from--S&P includes in
its materials: ``The credit ratings and observations contained
herein are solely statements of opinion and not statements of
fact or recommendations to purchase, hold, or sell any
securities or make any other investment decisions.'' Written by
somebody in my law school class, I'm sure.
But from the point of view of an investor, what does it
mean?
Here is Mr. McDaniel's disclaimer from Moody's, similar
statement: ``The credit ratings and financial reporting
analysis observations are and must be construed solely as
statements of opinion and not statements of fact or
recommendations to purchase, hold, or sell any securities.''
My, my, my.
Now, Mr. Joynt, not to leave you out, Fitch's code of
conduct goes perhaps the furthest. This is what it says:
``Rulings are not themselves facts and therefore cannot be
described as either accurate or inaccurate.''
Now, from where I come from, this sounds like doublespeak.
Mr. Joynt, how can you say that your ratings are neither
accurate or inaccurate?
Mr. Joynt. Well, I'm not sure of the legal definition and
why it was created in that way, accurate or inaccurate. I think
we're emphasizing the fact that our ratings are opinions and
they're formulated by people that have done the best they can
with good faith to look at all the analysis they can. The
ratings can change over time, and they do; and it's better that
we disclose the fact that they are opinions as clear as we can.
Ms. Norton. Well, anything anybody says is an opinion
unless it's a scientific fact. We do understand that.
But, Mr. Joynt, let me give you a hypothetical. If you rate
a group of bonds as AAA and those bonds fail, would you say
that rating was accurate or inaccurate?
Mr. Joynt. I would say that it did not project the kind of
risk that investors--that our ratings were intended to project.
Ms. Norton. I'm asking you about your rating. Would you say
it was accurate or inaccurate?
Mr. Joynt. I would say it did not reflect the risk that AAA
was designed to reflect, a high degree of likelihood of
repayment of principal and interest----
Ms. Norton. Was it inaccurate or accurate?
Mr. Joynt. I suppose inaccurate.
Ms. Norton. I just ask that because most investors will
approach this with a high degree of reliance. And the three of
you seem to be having it not both ways, but all ways. On the
one hand, the legal disclaimers saying people shouldn't rely on
what you say because it's your opinion, they can't possibly be
accurate or inaccurate. On the other hand, you are telling
investors and they are paying because they believe you--that's
why I quoted how profitable you are--that you have the best
methodology and the best rating record and the most expertise,
so they should pay you billions of dollars. And they comply.
So let me ask each of you a question. Do you think your
companies in any way are responsible for what has happened to
our economy?
Mr. Joynt. Well, I attempted to answer that question
earlier from the standpoint of the ratings volatility; and the
downgrades, since we weren't able to project forward this
crisis in housing coming, would have impacted prices of
securities and that would have contributed to the volatility in
the market, which has contributed to the crisis.
So I certainly----
Ms. Norton. So do you all accept some responsibility for
what has happened to the economy given the reliance of
investors, ordinary people and others, on your ratings? Do you
accept some responsibility?
Chairman Waxman. The gentlewoman's time has expired, but I
want to give each of you an opportunity to further answer the
question.
Mr. McDaniel. With respect to this crisis, I think there
are responsible parties throughout the marketplace----
Ms. Norton. Including yourselves?
Mr. McDaniel. That includes the credit rating agencies and
Moody's. Our opinions were best opinions based on information
we had at the time, but they had to change rapidly and on much
more of a wholesale basis than what we would like to see,
obviously.
Ms. Norton. Mr. Sharma.
Mr. Sharma. Absolutely. When you look at the role we play,
which is to provide credit opinions and assumptions we made
that underlie that, it did not turn out the way we expected it
to be.
Ms. Norton. Thank you, Mr. Chairman.
Chairman Waxman. Ms. Speier.
Ms. Speier. Thank you, Mr. Chairman.
And thank each of you for participating today.
Consumer Reports is a rating agency, and it rates
appliances and cars and electronics; and it's well regarded by
the consuming public because it's scrupulous about not engaging
in conflicts of interest. So I'm going to ask you a couple of
questions.
Who do you owe a fiduciary duty to, the issuer or the
investor? Just answer it with one word.
Mr. Joynt.
Mr. Joynt. I don't know. Fiduciary responsibility, I'm not
sure I can answer that question. So I feel quite responsible to
provide our best opinion to investors and everyone in the
market.
I don't feel a special responsibility to issuers.
Ms. Speier. Mr. McDaniel.
Mr. McDaniel. The responsibility is ultimately to the
marketplace.
Ms. Speier. To the investor?
Mr. McDaniel. To the market. The investor is an absolutely
critical component of an effectively functioning marketplace,
so we must be responsible to the investor.
We also have a responsibility to the overall good operation
of the markets themselves.
Ms. Speier. Mr. Sharma.
Mr. Sharma. Trust is the life blood of our franchise, and
we see ourselves as the bridge between the issuers and the
investors----
Ms. Speier. Just answer the question.
Mr. Sharma. Responsibility to the investors is the most
critical thing for us.
Ms. Speier. Do any of you accept gifts from issuers--
dinners, golfing, trips, contributions to your conferences?
Mr. Joynt. We have a gift policy which I believe we
provided to the committee as well.
Ms. Speier. Well, what is it?
Mr. Speier. I believe it limits gifts to $25 or----
Ms. Speier. So you don't go out to dinner with any of those
that are your clients? You don't go golfing? You don't--they
don't contribute to conferences you host around the country?
Mr. Joynt. I'm not sure about contribute to conferences or
whether we've ever cohosted conferences with either investors
or issuers or industry groups. I'm not certain about that.
Ms. Speier. Mr. McDaniel.
Mr. McDaniel. I do have meals occasionally with investors
and issuers, including issuers who are themselves governments
around the world. I do not engage in any other entertainment or
accept gifts from----
Ms. Speier. I'm talking about your company. Do you allow--
--
Mr. McDaniel. Yes. We have a gift policy similar to what
Mr. Joynt just described. And I believe we have made that
available, and my recollection is, it's a $100 limit on gifts.
Ms. Speier. And they don't contribute to conferences you
have around the country?
Mr. McDaniel. I don't believe they do, but I would have to
go back and check to see if there is any----
Ms. Speier. We'll ask you to do that.
Mr. Sharma.
Mr. Sharma. Similarly, as Mr. McDaniel said and Mr. Joynt,
we have a gift policy, which we made available to you.
Ms. Speier. All right.
Is it true that as a result of legislation you sought and
supported--I believe in 2007, maybe in 2006--you no longer can
be sued by the taxpayers?
Mr. Sharma. Say that again.
Mr. McDaniel. I'm sorry. I don't know the answer to that.
Ms. Speier. Thank you. Let's move on then to AIG. Each of
you, or one of you, rated AIG as AA 2 days before it went
bankrupt. How can you square that rating with the condition of
the company at the time?
Mr. Sharma.
Mr. Sharma. First of all, AIG rating has continued to be
changed over the last several years. Three years ago it was
AAA, and then it was downgraded to AA.
Ms. Speier. But let's just talk about it in that week
before it went bankrupt. And the taxpayers in this country are
now on the hook for over $100 billion. You had rated them as A
or AA.
Mr. Sharma. Our analysts had projected some economic losses
for AIG which they had gotten a similar independent view from a
third party as to what those economic losses were. But then
when the Fannie and Freddie Mac issues happened, the spreads
widened, and as the spreads widened, they had to report greater
mark-to-market losses on their books. As they did that, that
created more pressure on them, and as a result, they had to
raise more capital.
Ms. Speier. We understand all that. But did you raise any
questions about the credit default swaps?
Mr. Sharma. We do. We had taken into account of that and
put a capital charge against them. But as our markets unfolded
so quickly, their ability to raise capital and liquidity
quickly shut off from them; and as a result, the spreads
widened on them, and they had to put more losses on their
books.
So things moved very quickly on them, and as it moved
quickly--and, in fact, the Friday of that week I believe we
already sort of put them on grade Watch Negative, recognizing
these issues were starting to come up.
Ms. Speier. Two days before they were AA.
Chairman Waxman. Thank you, Ms. Speier.
Mr. Shays.
Mr. Shays. Thank you very much, Mr. Chairman.
Gentlemen, thank you for coming. When the story is told
about this debacle, there will be a lot of blame to go around
to the private sector, the public sector, the HUD, Congress;
but it doesn't relieve any of us from the particulars of what
each of our roles were.
Tell me, first off, do you believe that your company's
brand, that you've lost because of the incredible failures that
have taken place--that your company brand is pretty low, No. 1?
And I want to know if each of you think that. I think you've
lost your brand.
I will tell you what I think; I want to know if you agree:
that you have no credibility, that you have so screwed up the
ratings as to not be believable anymore.
Do you think that's true? I will ask each of you.
Mr. Joynt. So, I said earlier I think our reputation has
been damaged by our inability to project the ratings and the
risk of mortgages and CDOs.
I also feel like we accomplished a lot of credible work in
other areas.
Mr. Shays. That's not what I asked you.
Mr. Joynt. It's been damaged, yes.
Mr. McDaniel. Yes. I think there has been reputational
damage and----
Mr. Shays. Serious or little reputational damage?
Mr. McDaniel. Serious reputational damage in the areas that
have been under stress, absolutely.
Mr. Shays. Mr. Sharma.
Mr. Sharma. Certainly. And we have to have that credibility
back.
Mr. Shays. What makes us feel comfortable that you can gain
it back?
One of the things that has come across to me is the comment
that these instruments, CDOs, are so complex and that each of
you view them differently.
What makes us think that you can get on top of this, Mr.
Sharma?
Mr. Sharma. We have announced a number of actions earlier
this year to improve our analytics and bring more transparency
and information disclosure to the marketplace, and put new
governance and control procedures in place to make sure that
there's a confidence in our process; and also go to the
marketplace with some education to the investors as to what we
are doing.
Mr. Shays. Would any of your answers be different?
Mr. McDaniel. Not substantially different.
Mr. Joynt. I think I would answer by saying that we at
Fitch also now have a healthy skepticism about the complexity
of instruments and the use of quantitative models to try to
assess those.
So, I said earlier in my testimony that we need to both
revisit our models, seek to rate less complex instruments and
bring a healthy degree of experience and art to the process.
Mr. Shays. Let me ask you what is the guarantee that you
won't, in order to try to prove your worth, go in the exact
opposite direction? You all were on a feeding frenzy.
I mean, Moody's went from $30 million to $113 million in
just 4 years, dealing with CDOs, asset-backed securities. I
mean, this was a feeding frenzy.
What is there to convince us that you won't now--to
compensate for being so wrong, that you won't be so wrong the
other way?
Mr. McDaniel. I think the first and best means of judging
the balance of our opinions will be to look to the
methodologies, for investors and the marketplace to judge the
quality of those methodologies and to whether we are adhering
to them; and that, over time, will show whether we have
achieved the proper balance.
I agree with you, we cannot go overboard the other
direction. That is not helpful either.
Mr. Shays. Let me understand. Would you all agree with that
answer?
Mr. Sharma. Yes. And, in fact, if you look at--even now in
today's environment, when things are so fragile and unstable,
we get calls that we are too quick in some cases and not too
quick in other cases.
So we get sort of comments on both sides: You're not taking
enough rating action; and in other cases, you're taking too
many rating actions.
So we have to stay consistent and objective.
Mr. Shays. Is it conceivable that you will look at an
instrument and say, we just simply don't understand it?
Mr. Sharma. We have and we have chosen not to rate
instruments where we have not felt comfortable.
Mr. Shays. I made reference to Moody's increases in
revenues from $30 million to $113 million by 2007, from 2004.
Would those percentages be the same, a tripling be about the
same with you, Mr. Sharma?
Mr. Sharma. I'm sorry, Congressman. Can you ask the
question again?
Mr. Shays. In other words, Moody's had an increase in
revenues of $29.8 million so on, up to $113.17 million. So from
$29 million to $113 million on its CDOs in income.
Has yours gone up? It's a huge increase and it suggests
that there was a feeding frenzy.
Mr. Sharma. I cannot answer this. We can get back the data
specifically to you, but we did see an increase during that
time period.
Mr. Shays. Is that true, as well, for you, Mr. Joynt?
Mr. Joynt. We had submitted this data, I think, to the
committee. In looking at what we had submitted and for U.S.
CDOs, I believe our revenues were $24 million in 2001 and $22
million in 2002, and in 2007 it was $37 million.
Mr. Shays. That's all?
Mr. Joynt. Yes. That's what we submitted.
Mr. Shays. It may be, we're not comparing apples to apples
on this?
Mr. Joynt. Pardon me?
Mr. Shays. It may be we're not comparing apples to apples?
Mr. Joynt. I believe our market share was significantly
lower. It was a third of the market share using Standard &
Poor's.
Mr. Shays. With companies--right now, you rate instruments,
you rate companies. Could you just withdraw everything since
you were so wrong?
And by the way, I'm speaking as someone who is part of an
institution that has an unfavorable rating--lower than yours.
So I realize I'm here, looking down, but it's not lost on me
where we're at.
But given that you were so wrong, do you go back--are you
going back and looking at past appraisals and reexamining them,
or are you just saying we are starting fresh from here?
Mr. Joynt. If I could address that, Congressman Shays, I
tried to address it in my testimony as well.
The ratings themselves, having been lowered dramatically,
were reflective of the probability of full repayment of
principal and interest. Once they become below investment
grade, they are less useful to investors. They have lost the
confidence of full repayment. So what we've tried to do is
focus our analysis on what is the portion of likely payment.
And there are widely divergent likelihoods on different
securities--90 cents, 85, 62. So I think that can be more a
shift that could be helpful in illuminating for investors the
risk.
Mr. Shays. What I'm asking though is, I'm asking damage
done. Are you going back and looking at how you have rated
different instruments and saying, we need to take a second look
at them?
And I'm asking each of you.
Mr. Joynt. Absolutely.
Mr. Sharma. We are looking at the methodology. We've
learned from the experience and----
Mr. Shays. I'm not asking if you're getting paid again to
do it. I'm asking if you're going back and saying, we were so
wrong, we didn't earn that payment. We need to go back and
check so that those who rely on our information will have
better information.
Mr. Sharma. It's part of our same commitment to them to
continue to do what we had agreed to do for the great debt
related.
Mr. McDaniel. As conditions change and credit indicators
change, we absolutely must go back and change ratings to
accommodate that. I agree.
Mr. Shays. Thank you.
Thank you, Mr. Chairman.
Chairman Waxman. Thank you, Mr. Shays.
Gentlemen, I want to thank you very much for being here and
for your testimony.
I want to conclude by commenting on the fact that between
2002 and 2007 we have seen this explosion of securities and
collateralized debt obligations backed by risky subprime loans.
And it was important to those who were involved in these new,
very complicated securities to get the ratings that would allow
them to sell them. And in doing so they didn't simply ask you
for the ratings. They worked very closely in designing the way
they structured the finance deals so that they could get the
ratings; and you gave them ratings and in many cases AAA
ratings that people relied on.
Now the bottom has fallen out, and we are paying an
enormous consequence in our economy. And I do submit to you
that this has been very profitable for the rating companies and
for the executives as well, because you received higher fees
when you rated some of these securities backed by a pool of
home loans.
But I think we have seen this failure of the credit rating
agencies to help the consumers make a decision, and I just want
to review some of the key phrases used in your own documents:
``We drink the Kool-Aid.'' ``Fitch and S&P went nuts.'' ``No
one cared because the machine just kept going.'' ``We sold our
soul to the devil for revenue.'' ``It could be structured by
cows, and we would rate it.'' ``Let's hope we are all retired
by the time this house of cards falters.'' ``Any requests for
loan level tapes is totally unreasonable.''
These are quotes we got from the documents from your
businesses, and each one shows a complete breakdown in the
credit rating agencies. So I think that we have a very
disturbing picture.
You weren't the only ones at fault, but you were the
gatekeepers, and you worked very closely with others who were
benefiting as well.
The explosion of these new, very complicated securities is
something very new, but we also have something that's very old:
greed and self interest pushing forward a lot of people to do
things that in hindsight certainly they regret having done. But
one would have thought, since this was all based so much on
very shaky undergirdings of these loans, that maybe somebody
should have stood back and said, well, wait a minute--as did
some of the people in your companies.
We are holding these hearings because we want to learn what
happened and get something worthwhile out of all of this for
reforms for the future. And as you've all indicated, reaching
reforms will be necessary to restore any confidence in the
credit rating business.
Mr. Shays, do you want to make any comment?
Mr. Shays. I just want to thank you, Mr. Chairman, for
holding these hearings. I think the quotes you read are just
the essence of why we have no faith in this process, and you
should be congratulated for holding these hearings and for the
conduct of all your Members. Thank you.
Chairman Waxman. Thank you very much, Mr. Shays, for your
kind words. And I do appreciate the conduct of all of our
Members in pursuing these issues. They are very important.
I know this has not been a comfortable day for you, but I
think you are well aware that we have to work together to
restore the system that will benefit the economy and the people
who make the investments. So I thank you again.
That concludes our business, and we stand adjourned.
[Whereupon, at 2:59 p.m., the committee was adjourned.]
[The prepared statements of Hon. Edolphus Towns and Hon.
Bill Sali, and additional information submitted for the hearing
record follow:]
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