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




                               before the

                         COMMITTEE ON OVERSIGHT
                         AND GOVERNMENT REFORM

                        HOUSE OF REPRESENTATIVES

                       ONE HUNDRED TENTH CONGRESS

                             SECOND SESSION


                            OCTOBER 22, 2008


                           Serial No. 110-155


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                 HENRY A. WAXMAN, California, Chairman
PEDOLPHUS TOWNS, New York            TOM DAVIS, Virginia
PAUL E. KANJORSKI, Pennsylvania      DAN BURTON, Indiana
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
    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

                      Phil Barnett, Staff Director
                       Earley Green, Chief Clerk
               Lawrence Halloran, Minority Staff Director

                            C O N T E N T S

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



                      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 
    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 
    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 
    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 
    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 
    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 
    [The prepared statement of Chairman Henry A. Waxman 











    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 
    Chairman Waxman. The letter will be part of the record.
    [The information referred to follows:]
    [GRAPHIC] [TIFF OMITTED] T1103.012
    [GRAPHIC] [TIFF OMITTED] T1103.013
    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.


                  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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    Chairman Waxman. The gentleman reserves the balance of his 
    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 
    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.
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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 
    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. 
    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 
    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, 
    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 
    Mr. Issa. Thank you. And thank you, Mr. Chairman. I think 
the word ``recourse'' has come out of this discussion. Thank 
    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 
    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 
    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, 
    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 
    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 
    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 
    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. 
    [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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    Mr. Fons, from your testimony, ``The focus of Moody's 
shifted from protecting the investors to being a market driven 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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.
    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.

                       STANDARD & POOR'S


    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 
    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 
    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 
    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.


    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 
    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 
    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 
    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 
    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 
    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 
    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 
    Mr. McDaniel, what did you mean when you said that Fitch 
and S&P went nuts and started rating everything as investment 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    ``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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    Ms. Watson. How did we get an A+?
    Mr. Sharma. But, again, there was the ability to raise the 
    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. 
    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 
    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 
    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 
    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, 
    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 
    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 
    I don't feel a special responsibility to issuers.
    Ms. Speier. Mr. McDaniel.
    Mr. McDaniel. The responsibility is ultimately to the 
    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 
    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 
    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 
    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. 
    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 
    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 & 
    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 
    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 
    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:]