[Senate Hearing 110-913]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 110-913


 SUBPRIME MORTGAGE MARKET TURMOIL: EXAMINING THE ROLE OF SECURITIZATION

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                SECURITIES AND INSURANCE AND INVESTMENT

                                 OF THE

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED TENTH CONGRESS

                             FIRST SESSION

    ON HOW SUBPRIME MORTGAGES ARE SECURITIZED; THE EFFECT OF RECENT 
INCREASES IN DEFAULTS AND DELINQUENCIES ON THE SUBPRIME SECURITIZATION 
   MARKET FOR BOTH BORROWERS AND INVESTORS; AND HOW CREDIT RISK FOR 
 MORTGAGE-BACKED SECURITIES IS DETERMINED AND HOW THE ASSIGNED RATINGS 
                             ARE MONITORED




                               __________

                        TUESDAY, APRIL 17, 2007

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate /
                            senate05sh.html






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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

               CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota            RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island              ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York         WAYNE ALLARD, Colorado
EVAN BAYH, Indiana                   MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware           CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey          JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
SHERROD BROWN, Ohio                  JOHN E. SUNUNU, New Hampshire
ROBERT P. CASEY, Pennsylvania        ELIZABETH DOLE, North Carolina
JON TESTER, Montana                  MEL MARTINEZ, Florida

                      Shawn Maher, Staff Director
        William D. Duhnke, Republican Staff Director and Counsel
   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
                         George Whittle, Editor

                                 ------                                

                Securities and Insurance and Investment

                   JACK REED, Rhode Island, Chairman
                 WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey          MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota            JOHN E. SUNUNU, New Hampshire
CHARLES E. SCHUMER, New York         ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana                   CHUCK HAGEL, Nebraska
ROBERT P. CASEY, Pennsylvania        JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii              MIKE CRAPO, Idaho
JON TESTER, Montana

                     Didem Nisanci, Staff Director
              Tewana Wilkerson, Republican Staff Director











                            C O N T E N T S

                              ----------                              

                        TUESDAY, APRIL 17, 2007

                                                                   Page

Opening statement of Chairman Reed...............................     1

Opening statements, comments, or prepared statements of:
    Senator Allard...............................................     2
    Senator Menendez.............................................     3
    Senator Crapo................................................     4
    Senator Casey................................................     5
    Senator Schumer..............................................     6

                               WITNESSES

Gyan Sinha, Senior Managing Director and Head of ABS and CDO 
  Research, Bear Stearns & Company, Inc..........................     9
    Prepared statement...........................................    42
David Sherr, Managing Director and Global Head of Securitized 
  Products, Lehman Brothers, Inc.................................    11
    Prepared statement...........................................    49
    Response to written questions of:
        Senator Reed.............................................   139
        Senator Schumer..........................................   141
Susan Barnes, Managing Director, Standard & Poor's Ratings 
  Services.......................................................    14
    Prepared statement...........................................    55
Warren Kornfeld, Managing Director, Residential Mortgage-Backed 
  Securities Rating Group, Moody's Investors Service.............    16
    Prepared statement...........................................    74
    Response to written questions of:
        Senator Reed.............................................   144
        Senator Schumer..........................................   148
Kurt Eggert, Professor of Law, Chapman University School of Law..    17
    Prepared statement...........................................    90
Christopher L. Peterson, Associate Professor of Law, University 
  of Florida.....................................................    19
    Prepared statement...........................................   118

 
 SUBPRIME MORTGAGE MARKET TURMOIL: EXAMINING THE ROLE OF SECURITIZATION

                              ----------                              


                        TUESDAY, APRIL 17, 2007

                               U.S. Senate,
        Subcommittee on Securities, Insurance, and 
                                        Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The subcommittee met at 3 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Jack Reed (Chairman of the 
Subcommittee) presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. I call the hearing of the Subcommittee to 
order, and I want to thank Senator Allard, the Ranking Member, 
for joining me. I want to thank our witnesses for being here 
today. Senator Menendez has joined us, too.
    Our hearing this afternoon builds on the record begun last 
fall by Senators Allard and Bunning when the Subcommittee on 
Housing and Transportation and the Subcommittee on Economic 
Policy first began to look to these issues.
    In recent months, there has been a dramatic increase in 
home loan delinquencies and foreclosures, the closure or sale 
of over 40 subprime lenders, and an increase in buybacks of 
delinquent loans. While the subprime market has experienced 
most of the turbulence, there are now signs of weakness in the 
Alt-A market.
    This is a complicated issue. Chairman Dodd and Senator 
Shelby have held a number of hearings where we have heard from 
brokers, originators, regulators, and borrowers regarding the 
causes and consequences of the current mortgage market turmoil. 
However, we are here today to look at the financial engine 
which helps drive this market: the securitization process.
    Clearly, there are many benefits from securitization. 
Securitization creates liquidity, enables lenders to originate 
a greater volume of loans by drawing on a wide source of 
available capital, spreads risk, and allows investors to select 
their risk level of pattern of returns. When securitization 
works well, it bridges the gap between borrowers and investors 
and makes homeownership more affordable.
    However, what happens when it does not work as well as it 
should? Does the complex structure of mortgage-backed 
securities and the servicer's duty to act on behalf of 
different investors limit the servicer's ability to provide 
loan workout options for the borrower? Also, is it possible 
that securitization can create perverse incentives, such as an 
erosion of underwriting standards or the development of exotic 
loan products that do more harm than good?
    Lewis Ranieri, the pioneer of mortgage-backed securities, 
recently stated that he believes standards are largely set by 
the risk appetites of thousands of hedge fund, pension fund, 
and other money managers around the world. Emboldened by good 
return on mortgage investments, they have encouraged lenders to 
experiment with a profusion of loans. As many credit-stressed 
borrowers still face resets on some of these experimental loan 
products, the Center for Responsible Lending has estimated that 
one in five subprime loans originated during the prior 2 years 
will end in foreclosure, costing homeowners $164 billion, 
mostly in lost equity.
    Last, there is some cause for concern on the investor 
front. Again, Lewis Ranieri stated last year, ``When you start 
divorcing the creator of the risk from the ultimate holder of 
the risk, it becomes an issue of, Does the ultimate holder 
truly understand the nature of the risk that you have 
redistributed? By cutting it up in so many ways and 
complicating it by so many levels, do you still have clarity on 
the nature of the underlying risk? It is not clear that we have 
not gone in some ways too far, that we have not gone beyond the 
ability to have true transparency. That is a fair question that 
many of us in the business and people in the regulatory regime 
are wrestling with.''
    A related issue on this front is the steadily increased 
loss expectations for pools of subprime loans. According to a 
recent Moody's report, loss expectations have risen by about 30 
percent over the last 3 years. Loss expectations ranged from an 
average of 4 to 4.5 percent in 2003 to an average of 5.5 to 6 
percent today.
    I am also concerned about possible downgrades of these 
securities that could affect pension plans and other large 
institutional investors and whether there could be a systemic 
effect down the road. As such, the purpose of our hearing this 
afternoon is twofold:
    First, we want to examine how subprime mortgages are 
securitized, how credit risk for mortgage-backed securities is 
determined and monitored, and what effect the recent increase 
in defaults and foreclosures has had on the subprime 
securitization market.
    Second, we want to learn what role, if any, the 
securitization process has played in the current subprime 
market turmoil and what issues Wall Street and Congress should 
consider as we move forward.
    We will hear from one panel of witnesses, but before I 
introduce them, I want to recognize Senator Allard and other 
Members of the Committee who are with us today for their 
statements. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. First, I would like to congratulate my 
friend from Rhode Island on his first hearing as Chairman of 
the Subcommittee on Securities, Insurance, and Investment.
    Over the years, I have had the privilege of working with 
Senator Reed in a number of different capacities, always valued 
our partnership and our ability to work together. We worked 
together on the Strategic Subcommittee on Armed Services at the 
time I was Chairman, and then over here on Housing and 
Transportation we worked together, and now I have an 
opportunity to continue to work with him on Securities. And I 
am looking forward to continuing our working relationship. He 
has always had a thoughtful approach, and I have enjoyed 
working with him in that regard.
    Today we are here, well aware of the difficulties in the 
mortgage markets. The effects have been dramatic and 
widespread. Individual families, neighborhoods, and entire 
communities suffer when foreclosure rates rise. That is the 
unfortunate reality for far too many.
    Last year, Senator Reed and I had an opportunity to examine 
the matter from several different angles, including examining 
the role of nontraditional mortgage products. Under the 
leadership of Senator Dodd and Senator Shelby, the full 
Committee has also provided opportunities to delve into the 
mortgage markets.
    Lately, we have even seen the uncertainties in the mortgage 
markets spill over into the broader financial markets, and this 
is concerning and certainly worthy, I think, of careful review. 
Yet in taking account of the mortgage and financial markets, 
there is still one significant component that we have not yet 
examined, and that is the secondary market.
    As we transition from the Housing Subcommittee to the 
Securities Subcommittee, Chairman Reed has chosen an especially 
appropriate topic: the role of securitization in the subprime 
mortgage market. Today's hearing will allow us to build on our 
previous record in a new area of jurisdiction. I will be 
interested in hearing about how securitization has expanded 
homeownership opportunities, but also the accompanying policy 
concerns. As noted by FDIC Chairman Sheila Blair, there is no 
doubt that securitization has had an impact on looser 
underwriting standards as we have seen by lenders. I will be 
interested in hearing about the other ways in which the 
dispersion of risk has affected the subprime mortgage markets.
    Once again I would like to thank Chairman Reed for 
convening this important hearing. We have an excellent line-up 
of witnesses, and I am confident that they will help us 
understand the role of securitization in the subprime mortgage 
markets, which will give us a much fuller and richer 
understanding of the markets. I look forward to your testimony.
    Chairman Reed. Thank you very much, Senator Allard.
    Senator Menendez, do you have an opening remark?

              STATEMENT OF SENATOR ROBERT MENENDEZ

    Senator Menendez. Thank you, Mr. Chairman. I, too, want to 
commend you on having this as your first hearing on an 
incredibly important issue, and also I appreciate Senator 
Allard and his work.
    As we proceed with the hearing, I think it is important to 
remember what this is ultimately all about, and that is, the 
American dream of owning a home. In the last full Banking 
Committee hearing, we heard from individuals who became victims 
to deceptive predatory lenders, and I told of a story, one of 
many in my own State in New Jersey, of a woman who could not 
make the payments on her home after the teaser rate expired, 
and she is still facing foreclosure action today.
    It seems to me that in the face of the tsunami of 
foreclosures we are facing, we must not lose sight of our 
objective and work toward a solution that protects the 
homeowners. I do not think anyone can argue against the notion 
that we are in an increasing subprime crisis. Over 40 subprime 
lenders have halted operations or filed for bankruptcy. We now 
have the highest delinquency rate in 4 years. As many as one in 
five recent subprime mortgages will end in foreclosure, and 2.2 
million subprime borrowers have had their homes foreclosed or 
are facing foreclosure. That to me is simply unacceptable.
    So as we move forward today on one of the different 
dimensions of this issue, Mr. Chairman, I hope we remember this 
is not just numbers. They are a single mother struggling to 
make ends meet, an elderly couple facing the depletion of their 
life savings, or a minority family crushed with the reality 
that they may lose their first home. It is a financial 
nightmare for families across America, and I fear it is only 
going to get worse.
    Last, I think it is time for all parties to take 
responsibility, to change behavior in order to prevent 
particularly in the context of predatory loans. In the Banking 
hearing last month, after some of my questions, regulators were 
forced to stand up and say that they did too little too late. 
And today I hope we will hear from those who are involved in 
the overall chain of this process to take some responsibility 
for their part in how we move forward and how we can improve 
the securitization process. As long as it appears that there is 
an overzealous secondary market for these loans, they will 
continue to flourish without checks and balances. And so we 
certainly want to see the secondary market continue to exist, 
but we also, I believe, need to make sure that there are some 
appropriate checks and balances at the end of the day in order 
to ensure that we do not have the animal instincts of the 
marketplace take over, as it seems to have today.
    So I look forward to the testimony and to working with you, 
Mr. Chairman.
    Chairman Reed. Thank you, Senator Menendez.
    Senator Crapo, do you have a statement?

            OPENING STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Yes, just very briefly, Mr. Chairman. I also 
applaud you for holding this hearing. I think it incumbent on 
all of us to understand much better the role of securitization 
in the mortgage market, not just the subprime market. But as 
this moves forward, we are going to be facing the question of 
whether there should be a regulatory governmental response and, 
if so, whether that response should come from the agencies who 
now have authority, or whether it requires further legislative 
authorization in terms of statutory changes, or whether the 
market discipline that is already being seen is adequate.
    I agree with Senator Menendez. The ultimate question here 
is about protecting homeowners and making sure that that part 
of the American dream which is homeownership is something that 
we assure is available to the maximum number of people in 
America who want to have that part of their dream. There are 
two sides to that.
    We are now seeing the very harmful side of the collapse or 
the crisis that we are seeing in the subprime market, and the 
stories that we are seeing about the impact that has on people.
    The other side of it is that there are lot of people who 
will not be able to get a home if there is not adequate credit 
available to them. And it is that balance that we have to 
strike.
    I am going to be very interested, as we go through this 
hearing and other hearings, to get answers to the basic 
question of what type of market discipline needs to be in 
place, what type is in place, what is happening today, why 
didn't it happen in a better way, why did we face this crisis, 
what was not in place that should have been, and is that going 
to lead us to require more regulatory oversight or more 
statutory authorities for such oversight.
    I would note that if you look at the market itself right 
now and the adjustments that are occurring, we have noticed 
that stock prices of major subprime specialists have already 
plummeted. Firms which could not support their representations 
and warrants for loans that were sold into the secondary market 
when asked to buy back poorly unwritten loans are closing their 
doors as equity is exhausted. Credit spreads on lower-rated 
tranches of subprime securities have widened appreciably as 
investors already demand greater returns on these investments. 
Various segments of the subprime market have already raised 
credit standards on their own. Federal regulators in March have 
issued for comment a proposed statement on subprime mortgage 
lending.
    So things are happening in the market itself and among the 
regulators and here in Congress as we are evaluating in 
hearings such as this.
    But, again, Mr. Chairman, and to the witnesses and others, 
I really think our focus needs to be on finding that balance. 
You know, the proverbial pendulum needs to be adjusted, 
probably. The question is: Will we adjust it too far and stop 
people who should have some sort of credit from being able to 
get that credit and being able to get a hand on that rung and 
start down the process of homeownership? Or will we not move it 
far enough and leave people exposed to credit practices that 
will deny them that dream and cause them economic and financial 
hardship that will deprive them of the dream longer than it 
should have happened?
    So it is that balance that I hope that we are able to 
strike here as we proceed, Mr. Chairman. Thank you.
    Chairman Reed. Thank you very much, Senator Crapo.
    Senator Casey, do you have opening remarks?

          OPENING STATEMENT OF SENATOR ROBERT P. CASEY

    Senator Casey. Just very briefly. Thank you, Mr. Chairman, 
for calling this hearing and for the witnesses who will testify 
and everyone else who is here. I will, with your permission, 
submit a written statement for the record, but just by way of 
reiteration of what we have heard, this is a complex and 
technical area. But like a lot of things that happen in this 
town, it gets back to real people and real families and their 
lives. And one thing that we are going to be listening 
carefully to are the areas of testimony and the areas of 
questioning which involve incentives. What kinds of incentives 
do brokers have and firms have that create problems for real 
people and real families who have real-live budgets? And 
sometimes they are left out in the cold on their own because of 
the way some of these deals go down.
    So I am going to be listening carefully to that, but I do 
want to commend the Chairman for calling this hearing, and we 
want to get to the statements.
    Thank you very much.
    Chairman Reed. Thank you.
    Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, and I appreciate 
the opportunity to be here. I have a whole bunch of questions, 
but I have to be gone by 4, so I do not think we will get up to 
them. So I want to maybe ask a few of them in my opening 
statement and ask the witnesses to submit them in writing 
eventually, if that is OK.
    But, first, let me just say I agree with my colleague from 
Idaho that we have to set a balance here, but I think we have 
to be cognizant of a few things as we do.
    First, an amazing statistic which has not gotten enough 
attention. You know, you read some of particularly the more 
conservative publications, and they say, well, listen, this is 
great because all this subprime lending is allowing people to 
buy homes for the first time.
    Well, that has some degree of truth, but only some. Eleven 
percent of the subprime mortgages issued were to first-time 
homebuyers. That is all--11 percent. The remainder were to two 
groups: one, people who had bought one home and were moving to 
another; but a large number are people refinancing. And at 
least in my experience--and this is mainly based on just people 
I have talked to in the field. There is no statistical basis 
that I have. A lot of the people who refinanced their homes 
were called up on the phone, they said, ``Hey, do you want 
$50,000? I will do it for you.'' And their home is refinanced.
    I bring up the case of a fellow I met from Ozone Park named 
Frank Ruggiero. He had a $350,000 mortgage. He has diabetes. He 
needed extra money. Some guy called him on the phone regularly 
and said, ``I can get you $50,000, and the mortgage will be 
$1,500,'' which Ruggiero knew he could pay. He lived in Ozone 
Park. Of the $50,000 increase in the mortgage, he got $5,700. 
The mortgage broker got about $20,000 because they liked the 
spread on the loan between his old loan and his new loan. And 
the others picked up the rest. Worse, his interest rate went 
from $1,500 to $3,800 in a short time, and he is about to lose 
his home, and he did not get the help he needed to pay for his 
diabetes condition.
    Well, something is wrong when that happens, and to just 
say, well, we are creating new markets for people, yes, we said 
that in the 1890's and maybe the 1920's, but not in the 21st 
century. So we have got to figure out what to do.
    Just a couple of other quick points. The market itself has 
pretty severe discipline. Any company that has gotten involved 
in buying a lot of these loans, they are paying a price now--
lots of them. And that discipline, sometimes even the pendulum 
swings a little too far. But that is how markets work.
    The people who are left holding the bag are the Mr. 
Ruggieros, and then people who initially sold them the 
mortgages are gone. You know, the guy who sold Frank Ruggiero 
his mortgage got $20,000, and he is off into the sunset, and 
there is virtually no regulation over people like that. And we 
ought to have it, and I intend to fight for it. That is very, 
very important, particularly if the mortgage broker did not 
come from a bank. That is not to condemn all mortgage brokers. 
Some do a very fine and necessary job in society.
    And the questions that I have relate to how we help the 
future Mr. Ruggieros. We all know in 2007, 2008, and maybe 
2009, there are going to be more of these loans because the 
most extreme of the liar loans, of the ARMs that just jumped, 
were issued in 2005, 2006. So the chickens will come home to 
roost a year, 2 years, 3 years later, when the rate goes way 
up.
    What can we do to assist them? I have called for aiding 
some nonprofits, for the Federal Government to actually shell 
out some money to the nonprofits who help people refinance the 
loans. We have found that a foreclosure can on average cost 
stakeholders up to $80,000. Foreclosure prevention may only 
cost $3,300.
    And my questions are: If we give money to these nonprofits 
and others, they could be--but they are people whose job is to 
help the next Mr. Ruggiero refinance. My questions that I would 
ask the holders, particularly Mr. Sinha and Mr. Sherr, is: How 
much leverage do these nonprofits have in getting some of the 
existing stakeholders to get back in the game when it is in 
their interest to do so? What percentage of the securitized 
subprimes have clauses that prohibit or significantly limit 
loan modifications? I would ask the panel again, in writing, to 
discuss those. Is there anything the holder of the loan can do 
to ease the servicer's ability to prevent foreclosures by 
modifying the loans? And since it would be in both the 
servicer's and loan holder's best economic interest to prevent 
foreclosure, shouldn't loan servicers put a time-out on 
foreclosures until they can work out loan modifications 
consistent with what the loan holders need?
    So those are some of the questions that I would like to 
ask, practical questions. I would ask that you folks all submit 
something to the Committee in writing so we can take a look, 
but these are aimed at preventing large numbers of 
foreclosures.
    One final fact, Mr. Chairman. Sorry to go on a little bit 
here. This is not just going to affect the people who have the 
loans, the mortgagor side or mortgagee side, no matter how far 
up the chain. It is estimated that for every foreclosure within 
one-eighth of a mile of your home the property falls by 0.9 
percent. That is an average, obviously. But in some 
neighborhoods, some communities, our Joint Economic Committee 
issued statistics that one out of every 21 homes in Detroit had 
foreclosure; one in 23 in Atlanta. It is going to hurt property 
values significantly.
    So having a diminution of future foreclosures, which will 
get worse if we do nothing, makes sense for everybody. And I 
would ask all of your help in figuring out how we do that.
    Thank you, Mr. Chairman.
    Chairman Reed. Thank you very much, Senator Schumer. And if 
your staff prepares those questions, we will forward them to 
the witnesses.
    Senator Schumer. Thank you.
    Chairman Reed. Thank you very much.
    We are very fortunate to have a knowledgeable and very 
accomplished panel. Let me introduce them, and then I will 
recognize Mr. Sinha to make his presentation.
    We are joined by Gyan Sinha. He is the Senior Managing 
Director and Head of the Asset-Backed Research Group at Bear 
Stearns. He has been consistently one of the top-ranked 
analysts in Institutional Investors All-American Fixed Income 
Research Survey for his work in asset-backed securities, 
notably in prepayments, ARMs, and CDOs. Prior to joining Bear 
Stearns, he was a Vice President at CS First Boston in the 
mortgage research area, an assistant professor in the Faculty 
of Commerce at the University of British Columbia from 1991 to 
1993.
    Next to Mr. Sinha is Mr. David Sherr. Mr. Sherr is 
currently serving as a Managing Director and Head of the Global 
Securitization Products business at Lehman Brothers. Mr. Sherr 
first joined Lehman Brothers in 1986 and has previously served 
as head of mortgage trading. Additionally, he is a member of 
the Fixed Income Division Operating Committee.
    Next to Mr. Sherr is Ms. Susan Barnes. Ms. Barnes is the 
Managing Director and Practice Leader of the U.S. Residential 
Mortgage Group, with responsibility for managing all Standard & 
Poor's U.S. RMBS activities, products, and analysis. 
Previously, as the senior analytical manager of the Residential 
Mortgage Group, Ms. Barnes was responsible for the development 
and implementation of criteria for all residential mortgage 
products. Prior to joining Standard & Poor's in 1993 from 
Citicorp Securities Markets, she worked with primary mortgage 
companies as well as secondary market participants.
    Next to Ms. Barnes is Mr. Warren Kornfeld. Mr. Kornfeld co-
heads Moody's Residential Mortgage-Backed Securities Group, 
which is responsible for rating residential mortgage 
securitizations, including subprime, jumbo, Alt-A, HELOC, FHA, 
VA, and closed and seconds. In addition, Mr. Kornfeld is in 
charge of Moody's RMBS and ABS Service Ratings Group. Mr. 
Kornfeld has more than 20 years of experience in the 
securitization market. Prior to joining Moody's in 2001, Mr. 
Kornfeld headed up the Securitization Group at William Blair 
and Company. Before joining William Blair, Mr. Kornfeld was 
previously with the Industrial Bank of Japan, Bickford & 
Partners, Inc., and Trepp & Company.
    Next to Mr. Kornfeld is Mr. Kurt Eggert. Mr. Eggert is a 
professor of law and Director of Clinical Legal Education at 
Chapman University Law School. He has written extensively on 
securitization and predatory lending issues, and previously 
testified before Congress on predatory lending issues. 
Professor Eggert is a member of the Federal Reserve Board's 
Consumer Advisory Council, where he chairs the Subcommittee on 
Consumer Credit. From 1990 until 1999, he was a senior attorney 
at Bet Tzedek Legal Services in Los Angeles, where he 
specialized in complex litigation including consumer fraud and 
home equity fraud.
    Finally, Mr. Chris Peterson is an assistant professor of 
law at the University of Florida, Levin College of Law, where 
he teaches commercial and consumer law courses. Professor 
Peterson served as the judicial clerk for the United States 
Court of Appeals for the Tenth Circuit. He has also served as a 
consumer attorney responsible for consumer finance issues on 
behalf of the United States Public Interest Research Group. His 
book on the economics, history, and law governing high-cost 
consumer debt received the American College of Consumer 
Financial Services Attorneys' Outstanding Book of the Year 
prize for 2004.
    We look forward to all of your testimony, ladies and 
gentlemen. Let me just say that all your statements will be in 
the record. Try to hold to 5 minutes. You can assume everything 
that you have written will be read by all of us--at least by 
all the staff--and that we will eagerly await your improvised 
comments and your insights into this very difficult problem. I 
must commend my colleagues for very thoughtful opening 
statements.
    Mr. Sinha.

 STATEMENT OF GYAN SINHA, SENIOR MANAGING DIRECTOR AND HEAD OF 
       ABS AND CDO RESEARCH, BEAR STEARNS & COMPANY, INC.

    Mr. Sinha. Good afternoon, Chairman Reed, Ranking Member 
Allard, and members of the Senate Subcommittee on Securities, 
Insurance, and Investment. My name is Gyan Sinha. I am a Senior 
Managing Director at Bear Stearns and head the division 
responsible for market research regarding asset-backed 
securities and collateralized debt obligations. In that 
capacity, I analyze mortgage loans and securities in the 
private-label market. The nonprime sector constitutes a portion 
of the private-label market.
    I have been invited today to present testimony regarding 
four matters related to the mortgage securitization process and 
recent developments in the marketplace. I will address each of 
these issues in turn, beginning with an overview of the 
mechanics of nonprime mortgage securitization.
    Nonprime borrowers maintain loans through mortgage brokers 
or retail lending establishments. Once a suitably large number 
of loans have been originated, the loans are often packaged as 
a portfolio and moved into securitization vehicles owned by a 
third party. The securitization vehicle then issues mortgage-
backed securities, often referred to as ``MBS.'' The MBS 
generate revenues which finance the purchase of loans by the 
securitization vehicle.
    The decision to buy loans from originating lenders for 
purposes of securitization is based on a determination of 
whether the loss-adjusted yield that can be generated from the 
purchase of the asset, after paying for financing expenses in 
the MBS market, is commensurate with the risk of the loans. If 
the securitization sponsor elects to move forward with a 
purchase after making this determination, it will also conduct 
due diligence before acquiring the assets. The cashflows from 
the loans are then divided among debt classes. These debt 
classes are divided into senior, mezzanine, and subordinate, 
with ratings ranging from AAA to BB. Typically, any losses in 
the maligned loans are allocated to the lowest-rated bonds 
initially and then moved up the rating scale as the face amount 
of each class is eroded due to higher and higher losses.
    The amount of MBS that can be issued is determined based on 
criteria established by the rating agencies. Typically, the 
amount of MBS that are issued is less than the par amount of 
the mortgage loans. This difference is referred to as 
overcollateralization. The claim of equity holders in the 
securitization is comprised of two components: the 
overcollateralization amount and the difference between the 
coupon net of servicing expenses and the weighted average cost 
of debt. The equity holder's cash-flow entitlement is net of 
any current period losses.
    MBS are purchased by a wide variety of investors. For 
senior debt borrowers, MBS have provided a preferred 
alternative to other credit-risky instruments, such as 
corporate bonds. As a result, institutions with low funding 
costs, such as banks, view them with favor and have purchased 
many of them. In recent years, the lower-rated tranches have 
been bought primarily by collateralized debt obligations. CDOs 
in turn issue debt to finance the purchase of these bonds. 
There has been significant foreign investment in CDOs that 
further spreads market risk.
    Finally, at the lower end of the capital structure, hedge 
funds to purchase the speculative grade and unrated equity 
portion of the MBS. In making purchase determinations, hedge 
funds tend to employ the same risk-adjusted calculus as used by 
the original buyer of the loans.
    You have also asked about the effect of increases in 
defaults and delinquencies. Without doubt, the rise in defaults 
and delinquencies has had a significant impact recently in the 
nonprime securitization market. At this juncture we are 
witnessing a significant correction in the MBS market of 
nonprime loans. A number of originators have exited the 
industry. The risk profile of the loans being considered in the 
nonprime market today has generally improved as loan 
originators have moved to change loan-to-value limits, 
requiring multiple appraisals on collateral and enhanced 
verification of borrower income. Valuations appear to have 
stabilized at this juncture, albeit at lower levels, since the 
beginning of the year.
    For those that remain in the market, significant challenges 
will persist. Managing the credit risk of a nonprime portfolio 
in an environment of stagnant or even declining real estate 
prices will require a different strategy than that used in the 
last 5 years. From an economic value perspective, it is in the 
interest of all parties in a securitization vehicle that the 
value of the maligned loans in the securitization is maximized. 
Accordingly, services will have strong incentives to offer loss 
mitigation options to borrowers that have a reasonable chance 
of succeeding. This is particularly true given that the 
alternative will be to foreclose upon and ultimately attempt to 
sell the property in an unfavorable housing market.
    The Subcommittee has asked me to discuss impediments in the 
securitization process that would make it more difficult to 
mitigate potential foreclosures. Loan modifications present one 
of the most viable vehicles for mitigating foreclosures under 
appropriate circumstances. However, it is important to note 
that there is considerable variation based on tax law and 
contractual requirements across transactions with respect to 
the scope of permissible modifications.
    Despite these various limitations, services are indicating 
various loss mitigation steps within the flexibility that they 
have under existing securitization agreements.
    I think my time is up.
    Chairman Reed. If you have a minute more, you may finish.
    Mr. Sinha. OK. Thank you.
    The Subcommittee has also asked, finally, about credit risk 
assessment. I think there are two members on the panel that are 
better equipped from the rating agencies to deal with that. I 
will skip that in the interest of time.
    In closing, I would like to emphasize that while the issues 
surrounding the recent events in the nonprime market warrant 
serious attention, the securitization process that has occurred 
for over 25 years has resulted in considerable benefits to 
borrowers in the broader economy. This market has allowed 
American homebuyers to tap into a rising global pool of savings 
through increased credit availability, raising overall 
homeownership rates in the United States. At the same time, 
securitization has also allowed this increase in mortgage 
lending to be achieved without an excessive concentration of 
risk. This has permitted any shocks to the system, such as the 
current one, to be absorbed without major disruption to the 
broader economy. Thus, it is important in evaluating any 
potential responses to the current concerns to ensure that the 
availability of mortgage credit is not unduly restricted and 
the historic benefits provided by the securitization process 
are not eroded.
    I would be happy to answer any questions that you may have. 
Thank you.
    Chairman Reed. Thank you very much, Mr. Sinha.
    Mr. Sherr, and if you could bring that microphone up close 
so everyone can hear.

STATEMENT OF DAVID SHERR, MANAGING DIRECTOR AND GLOBAL HEAD OF 
          SECURITIZED PRODUCTS, LEHMAN BROTHERS, INC.

    Mr. Sherr. Chairman Reed, Ranking Member Allard, and 
Members of the Subcommittee. I am David Sherr, Managing 
Director and Global Head of Securitized Products at Lehman 
Brothers. I appreciate the opportunity to appear before the 
Subcommittee today on behalf of Lehman Brothers. Lehman, an 
innovator in global finance, serves the financial needs of 
corporations, governments, and municipalities, institutional 
clients, and high-net-worth individuals worldwide. Lehman is 
pleased to share with the Subcommittee its experience in the 
subprime mortgage securitization process.
    The subprime mortgage securitization market is a subset of 
the broader mortgage securitization market. Mortgage 
securitization was developed approximately 30 years ago. Since 
then, the mortgage-backed securities market has grown to become 
the largest fixed-income segment of the Nation's capital 
markets, with approximately $6.5 trillion of securitized 
mortgage debt outstanding as of the end of 2006.
    While the Subcommittee is focused on very recent instances 
of foreclosure, please remember that for three decades 
mortgage-backed securities have provided and continue to 
provide great benefits to the average American. Because of 
mortgage securitization, loans for home purchases have become 
more widely available for all borrowers, including those 
considered subprime. If not for the innovation of the mortgage 
securitization, the United States would not have become the 
Nation of homeowners that it is today, with homeownership close 
to its highest level in our history, almost 70 percent.
    Before securitization became widespread, banks had 
relatively limited capital available to make loans to 
prospective homeowners. Their lending activities were 
constrained because they had no effective means to convert 
their existing loan portfolios to cash that could be used to 
make additional loans. There was no liquid market for mortgage 
loans.
    With the advent of securitization, banks and other 
financial institutions have been able to monetize their 
existing loan portfolios and to transfer the risks associated 
with those loans to sophisticated investors. As a result, more 
money is available to borrowers who wish to buy their own homes 
or to refinance their existing mortgage loans on more 
attractive terms.
    Securitization represents a new way to fund America's 
demand for home mortgages by accessing the significant 
liquidity of the capital markets. Borrowers continue to take 
out loans with local banks and State-regulated mortgage 
companies, just as they always have. Those lenders determine if 
they want to retain mortgage loans or transfer them into the 
secondary market, either in whole loan form or through 
securitization. If a lender elects securitization, the loans 
are assembled into pools by sponsors, such as Lehman.
    The lenders continue to stand behind their decision to make 
a loan by making representations about the loan quality. After 
the rating agencies have completed their review of the pool, 
the loans are conveyed into a securitization trust and 
interests in the loans are sold to investors in the form of 
securities. From then on, payments made by borrowers on their 
mortgage loans flow through to make payments on these 
securities.
    It should be noted that sponsors of mortgage-backed 
securitizations such as Lehman are careful about choosing the 
lenders with whom they do business. All the lenders selling 
loans to Lehman are either federally chartered banks or State-
regulated originators. Prior to establishing a business 
relationship with a particular lender, Lehman spends time 
learning about that lender, its past conduct and its lending 
practices and standards. Further, Lehman, like other 
securitization sponsors, performs a quality check on the 
mortgage loans before purchase them. These reviews include 
sample testing to confirm that loans were underwritten in 
accordance with designated guidelines and complied with 
applicable law.
    The Subcommittee has asked about the incentives of the 
participants in the subprime mortgage securitization process. 
Consumers benefit because they are able to obtain loans with a 
greater variety of payment structures. This is especially true 
for borrowers considered to be subprime, many of whom who did 
not have access to mortgage loans and so could not purchase 
their own homes prior to the creation of the securitization 
market. Lenders benefit because they are able to free up 
capital to make additional loans, and investors benefit because 
mortgage-backed securities present a diverse range of 
investment options, with investors able to choose the type of 
product and the risk-reward profile appropriate for their 
needs.
    It cannot be emphasized enough that no participant in the 
securitization process has any incentive to encourage the 
origination of loans that are expected to become delinquent. No 
financial institutions would knowingly want to make or 
securitize a loan that it expected would go into default; 
rather, the success of mortgage-backed securities as an 
investment vehicle depends upon the expectation that homeowners 
generally will make their monthly payments since those payments 
form the basis for the cashflow to bondholders.
    As it relates to the impact of recent increasing defaults 
on the market, the market currently is adapting to changes in 
the performance of subprime loans, just as it adapts to other 
changes that significantly affect participants in the mortgage 
securitization process. Importantly, the interest of all market 
participants, from the borrower to the investor, are generally 
aligned with regard to reducing the number of defaults and 
delinquency. Everybody loses when the only viable option for 
managing loans is foreclosure. Given the general alignment of 
interest, it is not surprising that the market is adjusting 
rapidly to minimize foreclosures and improve the performance of 
securitized loans.
    For example, mortgage loans to subprime borrowers are now 
being underwritten according to stricter guidelines to reflect 
current market conditions. At the same time, the volume of 
securitizations has been reduced, as has the range of mortgage 
products being offered to consumers. Further, financial 
intermediaries are pushing forward new practices, including 
contacting borrowers early when their loans appear to be at 
risk for default. All these adjustments in the market are being 
driven by the fact that nobody benefits from the underwriting 
of loans that do not ultimately perform. We must be careful, 
however, not to overreact to the increased number of 
delinquencies and defaults which could lead to an undue 
tightening of credit availability to prospective homeowners.
    At the same time that we consider how the market has 
changed, we should also keep in mind how it has stayed the 
same. The vast majority of subprime borrowers remain current in 
their loan obligations, and the mortgage securitization process 
continues to provide unprecedented access to the capital 
markets so that others can purchase their own homes.
    So how do we mitigate potential foreclosures? Mortgage 
securitization structures do provide flexibility to avoid 
foreclosure. Much of that flexibility rests in the hands of the 
financial institutions that service mortgage pools. Servicers 
collect principal and interest payments from borrowers and also 
make decisions on the administration of the pooled home loans. 
They have flexibility to work with borrowers so that loan 
payments will be made while exercising the right to foreclosure 
only as a last resort.
    Notably, many of the largest servicers are commercial 
banks, which also hold substantial mortgage loans in their own 
portfolios. Regardless of whether these banks are managing 
their own portfolios or servicing loans in a securitized pool, 
we expect they generally will follow the same prudent home 
retention practices in an effort to avoid foreclosure.
    The title of this hearing speaks to the role of 
securitization in the subprime mortgage market turmoil. Because 
none of the participants in the securitization process benefits 
from foreclosure, the market has evolved and will continue to 
evolve so as to minimize the number of foreclosures. Servicers 
are ramping up their home retention teams, both with respect to 
early intervention for at-risk borrowers and loan modification 
programs for borrowers that are in financial distress. To the 
extent that the servicer currently lacks any necessary powers 
to reduce the number of foreclosures in a prudent manner--and 
Lehman does not believe that such powers are materially 
lacking--the market will adjust by enhancing the servicer's 
flexibility in future contracts. In short, we expect that the 
subprime mortgage securitization process will continue to 
create opportunities for a long-ignored segment of the 
population to join and remain in the ranks of American 
homeowners.
    Thank you again for the opportunity to be here today, and I 
also welcome any questions you might have.
    Chairman Reed. Thank you.
    Ms. Barnes, and if you could bring the microphone close to 
you.

STATEMENT OF SUSAN BARNES, MANAGING DIRECTOR, STANDARD & POOR'S 
                        RATINGS SERVICES

    Ms. Barnes. Thank you, Mr. Chairman, Members of the 
Subcommittee. Good afternoon. I am Susan Barnes, Managing 
Director of the U.S. Residential Mortgage-Backed Securities 
Group for Standard & Poor's. S&P recognizes the hardship the 
current subprime situation is placing on certain homeowners. 
However, as requested by this Subcommittee, my testimony is 
focused on the effects the subprime market has had on the 
financial sector.
    Today I will discuss our ratings analysis for these 
transactions, including the factors we consider when evaluating 
mortgage securities backed by subprime mortgage loans and the 
impact the current mortgage loan delinquencies and defaults on 
the performance of RMBS transactions based by subprime mortgage 
loans. As described more fully in my written testimony, S&P's 
rating process for these transactions includes a loan-level 
collateral analysis, a review of the cash-flow within the 
transaction, a review of the originator and servicer 
operational procedures, and a review of the transactional 
documents for legal and structural provisions.
    First, S&P performs a loan-level collateral analysis on 
these transactions. Specifically, we evaluate the loan 
characteristics, quantify multiple risk factors, and assess the 
default probability associated with each factor. This helps us 
determine how much credit enhancement is, the amount of 
additional assets or funds needed to support the rated bonds 
and cover losses.
    In 2006, using this analysis we identified the 
deteriorating credit quality of the mortgage loans and 
consequently increased the credit enhancement requirements 
necessary to maintain a given rating on a mortgage-backed 
security. Next, we assessed the cash flow availability 
generated by mortgage loans through a proprietary model which 
assumed certain stresses related to the timing of payments and 
prepayments on the mortgage loans and uses the S&P mortgage 
default and loss assumptions to simulate the cash-flow of an 
RMBS transaction's underlying loans under these stresses.
    We then evaluate the availability and impact of various 
credit enhancement mechanisms on the transaction. We also 
perform a review of the practices and policies of the 
originators and servicers to gain comfort with the ongoing 
performance of the transaction. Included within this review is 
an evaluation of the monthly servicer report.
    Additionally, we review legal documents and opinions of 
third-party counsel to assess whether the transaction will pay 
interest as promised and whether the bondholders will receive 
the promised principal payments before the stated maturity of 
the bonds.
    Now to the current market. The poor performance of subprime 
mortgages originated in 2006 dampened investor appetite for 
such mortgages, causing the interest rate sought by investors 
to increase as compared to mortgage-backed bonds issued in 
prior years. Therefore, the securitization of subprime loans 
has become less economical, resulting in fewer subprime 
mortgage loan originations in 2007.
    While delinquencies for the 2006 vintage are much higher 
than what the market has experienced in recent years, they are 
not atypical with past long-term performance of the RMBS 
market, such as the delinquencies reported for the 2000 vintage 
after similar seasoning.
    Regardless, subprime loans and transactions rated in 2006 
have been performing worse than previous recent vintages. This 
performance may be attributed to a variety of factors, such as 
lenders' underwriting guidelines that stretch too far, this 
falling of home price appreciation rates, and ARM loans that in 
rising interest rate environments create a heightened risk of 
delinquencies.
    Due to minor home price declines in 2007, we expect losses 
and negative rating actions to keep increasing in the near term 
relative to previous years. However, as long as interest rates 
and unemployment remain at historical lows and income growth 
continues to be positive, we believe there is sufficient 
protection for the majority of investment grade bonds. As of 
April 12, 2007, only 0.3 percent of the outstanding subprime 
ratings issued in 2006 have been downgraded or placed on 
Creditwatch.
    S&P views loss mitigation efforts, such as forbearance and 
loan restructuring, as an important part of servicing 
securitized mortgage loans. Generally, servicers have the 
ability to mitigate losses by a variety of techniques so long 
as they act in the best interest of investors and in accordance 
with the standard servicing industry practices. So long as 
these standards are met, S&P believes that the current ratings 
on the RMBS securities will not be negatively affected.
    We do need to be sensitive, however, to the balance between 
the negative effect of the potential reductions in prepayments 
received from borrowers and available to pay investors, with 
the positive impact of fewer borrower defaults.
    Let me conclude by stating S&P does not anticipate 
pervasive negative rating actions on financial institutions due 
to rising credit stresses in the subprime mortgage sector since 
the majority of rated financial institutions have diversified 
assets and mortgage lending and servicing operations aligned 
with strong interest rate and credit risk management oversight. 
Specialty finance companies that focus solely on the subprime 
market, however, do not enjoy the same protection and have felt 
the effects of the current subprime credit stresses.
    We thank you again for the opportunity to participate in 
these hearings and are happy to answer any questions you may 
have.
    Chairman Reed. Thank you, Ms. Barnes.
    Mr. Kornfeld.

 STATEMENT OF WARREN KORNFELD, MANAGING DIRECTOR, RESIDENTIAL 
  MORTGAGE-BACKED SECURITIES RATING GROUP, MOODY'S INVESTORS 
                            SERVICE

    Mr. Kornfeld. Thank you. Good afternoon, Chairman Reed and 
Members of the Subcommittee. I appreciate the opportunity to be 
here on behalf of my colleagues at Moody's Investors Service.
    By way of background, Moody's publishes rating opinions 
that speak only to one aspect of the subprime securitization 
market, which is the credit risk associated with the bonds that 
are issued by the securitization structures.
    The use of securitization has grown rapidly both in the 
U.S. and abroad since its inception approximately 30 years ago. 
Today it is an important source of funding for financial 
institutions and corporations. Securitization is essentially 
the packaging of a collection of assets, which can include 
loans, into a security that can be sold to bond investors. 
Securitization transactions vary in complexity depending on 
specific structural and legal considerations, as well as in the 
type of asset that is being securitized.
    Through securitization, mortgages of many different kinds 
can be packaged into bonds, commonly referred to as ``mortgage-
backed securities,'' which are then sold into the market like 
any other bond.
    The total mortgage loan origination volume in 2006 was 
approximately $2.5 trillion, and of this, approximately $1.9 
trillion was securitized. Furthermore, we estimate that roughly 
25 percent of the total mortgage securitizations were backed by 
subprime mortgages. Securitizations use various features to 
protect bondholders from losses. These include 
overcollateralization, subordination, and excess spread. The 
more loss protection or credit enhancement a bond has, the 
higher the likelihood that the investors holding that bond will 
receive the interest and principal promised to them.
    When Moody's is asked to rate a subprime mortgage-backed 
securitization, we first estimate the amount of cumulative 
losses that the underlying pool of subprime mortgage loans will 
experience over the lifetime of the loans. Moody's considers 
both quantitative as well as qualitative factors to arrive at 
the cumulative loss estimate. We then analyze the structure of 
the transaction and the level of loss protection allocated to 
each tranche of bonds.
    Finally, based on all of this information, a Moody's rating 
Committee determines the rating of each tranche. Moody's 
regularly monitors its rating on securitization tranches 
through a number of steps. We receive updated loan performance 
statistics, generally monthly. A Moody's surveillance analyst 
will further investigate the status of any outlier transactions 
and consider whether a rating committee should be convened to 
consider a rating change.
    The majority of the subprime mortgages contained in the 
bonds that Moody's has rated and that originated between 2002 
and 2005 have been performing better than historical experience 
might have suggested. In contrast, the mortgages that 
originated in 2006 are not performing as well. It should be 
noted, however, that the 2006 loans are, on average, performing 
similarly to loans originated and securitized in 2002 and 2001.
    Pools of securitized mortgages from 2006 have experienced 
rising delinquencies and loans in foreclosure, but due to the 
typically long time to foreclose and liquidate the underlying 
property, actual losses are only beginning to be realized. 
Among several factors, we believe that the magnitude and extent 
of negative home price trends will have the biggest impact on 
future losses in subprime pools. Economic factors, such as 
interest rates and unemployment, will also play a significant 
role.
    From 2003 to 2006, as has already been noted, Moody's 
cumulative loss expectations of subprime securitization 
steadily increased by approximately 30 percent in response to 
the increasing risk characteristics of the mortgage loans being 
securitized, as well as changes in our market outlook. As 
Moody's loss expectations have steadily increased over the past 
few years, the amount of loss protection in bonds we have rated 
has also increased. We believe that performance of these 
mortgages will need to deteriorate significantly for the vast 
majority of the bonds we have rated single-A or higher to be at 
risk of loss.
    Finally, I want to give Moody's view on loan modifications 
by servicers in the event of a borrower's delinquency. Loan 
modifications are typically aimed at providing borrowers an 
opportunity to make good on the loan obligations. Some RMBS 
transactions, however, do have limits on the percentage of 
loans in any one securitization pool that the servicer may 
modify. Moody's believes that restrictions in securitizations 
which limit a servicer's flexibility to modify distressed loans 
are generally not beneficial to the holder of the bonds. We 
believe loan modifications can typically have positive credit 
implications for securities backed by subprime mortgage loans.
    With that, I thank you, and I would be pleased to answer 
any questions.
    Chairman Reed. Thank you very much, Mr. Kornfeld.
    Professor Eggert.

STATEMENT OF KURT EGGERT, PROFESSOR OF LAW, CHAPMAN UNIVERSITY 
                         SCHOOL OF LAW

    Mr. Eggert. Thank you, Chairman Reed and Ranking Member 
Allard and other Members of the Committee. I would like to talk 
about how securitization has changed the mortgage industry as 
we know it, and some of those changes have not been beneficial 
to borrowers.
    Securitization has put subprime lending largely in the 
hands of thinly capitalized and lightly regulated lenders and 
mortgage brokers. Many of the companies doing subprime loans 
are non-banks regulated by State agencies, and without the 
underwriting standards imposed by regulators of, say, 
depository institutions.
    Securitization is designed to divert value away from the 
originator. That is the whole point of securitization: it 
allows banks to originate loan, quickly sell it to the 
secondary market and to investors, and that way the lender does 
not have to hold the mortgage. And to a large extent, it 
reduces its own risk if the loan goes bad.
    It also allows lenders to easily go belly up. We have seen 
even large subprime lenders go belly up recently, and because 
they are not holding all the loans that they have made for the 
last 5, 10, 15 years, it is much easier for them to go out of 
business.
    If you look at the history of the subprime market, you see 
sort of waves of lenders going out of business and then coming 
back into business and going out of business. So many borrowers 
who took out loans find that their lender, when they go to 
discuss fraud, is no longer there for them to argue with.
    The secondary market is protected in large part from risk 
of default and from risk of fraud. It is protected in part 
because of the risk abatement aspects that the secondary market 
imposes in securitization so they ask for credit enhancements 
of various types to protect them against default. And it is 
also protected by something called the holder in due course 
doctrine, which provides that if a loan is purchased by a bona 
fide purchaser, many of the defenses that the originator has to 
the--that the borrower has to the originator are cut off, and 
so the borrower may be able to sue the lender but cannot sue 
the secondary market or the current holder for some aspects of 
fraud. And if the lender has gone belly up, that leaves the 
borrower kind of with its defenses cut off completely.
    Another thing that securitization has done is made the 
regulation of the subprime market a de facto regulation, really 
is by the securitizers. The rating agencies and the investment 
houses that assemble the pools by and large determine the 
underwriting criteria, by and large determine what kinds of 
products are being offered, and so they are the true regulators 
of the subprime industry, much more so than the State 
regulators that may supervise the non-bank entities. However, 
rating agencies and the securitizers are not monitored in the 
same way that a formal agency might be monitored. There is no 
congressional oversight of them, and so there are concerns 
about--I have greater concerns about turning over regulation to 
essentially private parties.
    Securitization also puts impediments in loan modifications. 
We have heard of some of those impediments already. Servicers 
may have limited flexibility--they may have flexibility, but it 
may be limited by the terms of the servicing agreements. These 
terms may be vaguely written so that the service area is not 
even sure how far it can go in making modifications. The 
pooling agreements may limit the number of loans that may be 
modified, and so loan pools that turn out to have a much higher 
risk of default may leave some borrowers unable to get their 
loans modified because so many other borrowers had the same 
problems.
    Servicers might be overwhelmed by an increasing number of 
defaults, and I would be interested to see how many servicers 
are going to add new staff that they will need to do loan 
modification. Loan modification is much more time-intensive 
than merely collecting payments. Are servicers going to hire 
the new people that they need to do this kind of in-depth 
counseling?
    Another problem is that if you take a unitary interest in a 
loan and split it up among all the different tranches in a 
securitization, it makes it harder for the servicer to modify 
the loan. Servicers act in the best interests of investors, but 
investors may benefit differently by different loan 
modifications. Different tranches of the securitization may be 
helped or may be hurt by loan modifications. And so you might 
have a servicer engaging in what I call tranche warfare as they 
decide which tranche will benefit and which will be harmed. 
That kind of discretion may be difficult for servicers to use, 
concerned as they are about protecting all investors.
    Securitization also loosens underwriting. It has 
transformed underwriting from a very specific thing designed to 
protect a depository institution to a very automated process 
that can be objectively monitored, but also that can be altered 
depending on the market needs. If the market needs looser 
underwriting, we have looser underwriting. If a market needs 
tighter underwriting, we have tighter underwriting. But that 
kind of inconsistent underwriting can be very harmful to 
borrowers.
    And so I think we need to see the secondary market become 
more accountable and more responsible for what it has done to 
loans, and there are two ways to do that, and then I will be 
done. I am almost done.
    First is assignee liability. Have the current holders of 
market be liable where there has been fraud against the 
borrowers. And the other thing is I think we need to have 
regulatory oversight over the securitizers and the rating 
agencies who are actually regulating the subprime industry.
    Thank you.
    Chairman Reed. Thank you very much, Mr. Eggert.
    Mr. Peterson.

 STATEMENT OF CHRISTOPHER L. PETERSON, ASSOCIATE PROFESSOR OF 
                   LAW, UNIVERSITY OF FLORIDA

    Mr. Peterson. Mr. Chairman and Ranking Member Allard, 
thanks to the Committee for holding these hearings. It is a 
tremendous honor and a privilege to be here to speak with you 
today and share a few thoughts. And I would also like to, 
before I begin, express some empathy for the folks at Virginia 
Tech. It is a terrible tragedy.
    I would like to make three points in my 5 minutes: first, I 
would like to talk about maybe a very short historical overview 
of how I see the forces in the marketplace, in the mortgage 
marketplace working; second, the current state of what I think 
the law is; and, third, what I think the law has to become at 
some point if we want to prevent the kinds of problems that we 
have seen in the past year.
    An overview of the market. I think that in my view you can 
picture the American mortgage market in three periods. First 
was an era of two-party mortgage finance, and this was from the 
founding of the Republic probably up until the Great Depression 
was the predominant mode, where there was a lender and a 
borrower, two people, they worked things out. The mortgagee 
gives a mortgage in exchange for borrowing money. And in that 
market the incentive is--the dominant incentive is the lender 
polices the underwriting because they want to get paid back. 
They receive their money out of the monthly payments on the 
loan.
    After the Great Depression, when that system broke down, we 
had to find some way to restart the economy, and so Congress, 
under the leadership of the administration, passed a variety of 
statutes that created programs that created what I think of as 
a three-party model of mortgage finance, which had a lender, an 
originator, a borrower, and also the Government acted in 
virtually all of the middle-class mortgage loans in some direct 
underwriting capability, in some way guaranteeing it or 
insuring it, some direct, active involvement of the Federal 
Government or an agency affiliated with the Federal Government.
    Although the lender did not get paid out of the proceeds of 
monthly payments, instead they got--there was still some force 
there that was policing the marketplace, and that was the sort 
of public institutional, public policy forces of the 
Government. So that substituted for the profit motive to some 
degree of the lenders.
    Since 1977, when the first private-label mortgage 
securitization took place, I think there has been a third era 
of mortgage finance, and I think of that as the private-label 
securitization markets. And in that era, which--the first was 
in 1997--or, excuse me, 1977, but it really did not take off, 
you know, get large until the 1990's after, you know, the tax 
hurdles and some accounting hurdles were sort of cleared out of 
the way. And the problem, as I see it, is that the two core 
mechanisms of policing loan origination have broken down to 
some degree. The people that make the loans do not get paid out 
of the proceeds of the monthly payments on those loans. 
Instead, they get paid out of the fees and from selling the 
loan to somebody else. So there is less short-term, immediate 
incentive to make sure that the loan gets paid back on time.
    And the second thing that has broken down is that those 
folks--there is no Government involvement, there is no stable 
bureaucratic hand which is not--you know, a non-risk-seeking 
hand that is trying to act in the benefit of the public that is 
overseeing this process anymore. Those are the two forces, and 
to a large extent, they have been--they are gone.
    So what is left to try and make sure that things do not 
fall apart and get out of hand? Well, there is only one thing 
that is really left, and that is the rule of law. That is what 
I want to talk about next.
    So what is the current state of the law? And I do not want 
to be disrespectful or anything, but my sense is that, after 
having studied it for most of my adult life, it is really in 
shambles, particularly the Federal law is. It does not do much. 
You read through it all, and at the end of the day you find 
out, well, the Federal law does not really apply. And what has 
happened, I think, is that the market has evolved past the law. 
All of the statutes that we have passed, which were good 
statutes, good compromises from both sides of the aisle--the 
Truth in Lending Act, the Fair Debt Collection Practices Act, 
less by the Homeownership and Equity Protection Act. The vast 
majority of them were all basically conceived in an era that 
predated securitization by 10, 20 years. So their basic scope 
and definitions and structure has not--does not even conceive 
of the type of lending that we are seeing now.
    Just to give an example, what is the most important 
definition in the entire Consumer Credit Protection Act? Well, 
that would be the definition of a creditor. What is a creditor? 
It is the person to whom a loan is initially payable. But the 
person to whom a loan is initially payable neither holds the 
loan nor does that person in today's market actually ever talk 
to the person that is actually going to take out the money.
    The Truth in Lending Act, the statute was supposed to 
promote fair and efficient comparison and shopping, does not 
even apply to the mortgage brokers that actually talk to the 
borrower. That is a pretty serious breakdown in the law. And 
there are half a dozen other examples. You know, the Fair Debt 
Collection Practices Act does not even apply to debt 
collectors--or it only applies to debt collectors, which in 
most cases will not apply in the servicing market--the 
servicing for mortgage loans.
    I see I am already out of time.
    So the last bit is what should we do to try and fix that. 
In my view, I think that, you know, we could talk about all 
these trends that we can sort of do to try and fix things a 
little bit here and there, but I think honestly we need to have 
comprehensive reform of the Nation's consumer credit law. We 
need to go back to the drawing board and re-update--update 
everything, and that is going to include comprehensive reform 
of the Truth in Lending Act and RESPA, trying to integrate 
those into a more coherent disclosure process. The Fair Debt 
Collection Practices Act needs to be revisited. I think that we 
need to figure out what we want to do finally about usury law 
and the Marquette Doctrine, which I think is a big problem, in 
my opinion.
    Finally, we need to reconsider how it is that various 
participants and middlemen in this market are going to be held 
liable for, I think, in some instances aiding and abetting the 
process of making predatory loans.
    If you want my opinion--you called me up here--we need to 
fix the whole legal system, or this is just going to happen 
again. So that is what I think.
    Chairman Reed. Thank you very much, Mr. Peterson.
    What I propose to do is have 6-minute rounds, at least two 
rounds, I think, so if you do not get a chance to ask a 
question in the first round, my colleagues, stick around 
because we will go again.
    Let me open up a line of questioning for Mr. Sinha and Mr. 
Sherr. William Dallas, who is the CEO of Ownit, which was one 
of the mortgage companies that went out of business through 
bankruptcy, said, ``The market is paying me to do a no-income-
verification loan more than it is paying me to do the full-
documentation loan.'' He said, ``What would you do?'' 
rhetorically. And, in fact, we have looked at some of the 
publicly filed documents and some of these subprime 
originators, and there is language very similar to the 
following in all of them: ``We seek to increase our premiums on 
whole loan sales by closely monitoring requirements of 
institutional purchases and focusing on originating and 
purchasing the types of loans for which institutional purchases 
tend to pay higher premiums.''
    It raises the question, you know: Who is designing these 
products? Where are the incentives coming for some of these 
exotics? Is it coming from the Ownits, the creative 
originators? Or is it coming from Wall Street and the 
securitization process by saying this is what we want to buy 
and we are paying more for it?
    Your thoughts, Mr. Sinha.
    Mr. Sinha. Generally speaking, I think in the 
securitization markets, the securitization markets will 
effectively make a decision about whether to buy something or 
not to buy something and at what spread or price to buy it. So 
secondary market investors generally will not dictate what 
types of loans are effectively being made. The process 
effectively starts with the loans being presented to the rating 
agencies. The rating agencies will then take their own opinion 
about the risk of the pool which these loans effectively 
constitute and then will assign the enhancement levels 
appropriately at levels that they think are commensurate with 
the models that they run. And then that transaction is brought 
to the market, and the market then decides I will buy this at 
this spread.
    So, generally speaking, I think, you know, the pools are 
presented to the market.
    Chairman Reed. So you see the role as very passive, the 
securitization--these originators come with apples and oranges 
and pears, and you look around and, you know, you pick----
    Mr. Sinha. I think in general, as I look at these markets--
and people do refer to these markets as effectively markets 
where you have risk-based pricing. Risk-based pricing is being 
done at the loan level itself. The loan is viewed as a mix of 
risks that have to be priced, and that is how the markets are 
pricing it, and that is how they are bringing it to the rating 
agencies. And then the markets are--ultimately, the capital 
markets are providing the final pricing level of which that 
risk would clear.
    Chairman Reed. Mr. Sherr, your thoughts.
    Mr. Sherr. I think to a large degree these mortgage 
originators are relatively sophisticated, and they are clearly 
monitoring the capital markets to get a sense of what the value 
of the product they are originating is. And so there are 
loans--they are a running business. There are clearly loans 
that are probably more profitable for them to make, and there 
are clearly loans that cost them money to make. And I think 
part of their diligence is making sure they are originating 
loans that, one, they think they can transfer, and making sure 
they are not originating loans that ultimately, if their system 
breaks down, if they are losing money on every loan they 
originate.
    Chairman Reed. The question here all throughout, because it 
is a very complicated process, is who is ultimately watching 
over to make sure that that loan that is made to the borrower 
is within the competence of that borrower to pay for. And the 
impression I got from, you know, the quote from this individual 
was that he was not looking much at the borrower's capacity, he 
was looking at the highest premium he could get, the types of 
loans. Also, I think what--I do not want to put words in your 
mouth, but you are also saying, you know, we are not looking 
either, I mean, because he is bring us this paper. Is that----
    Mr. Sherr. No, that is not what I am saying. Ultimately, at 
the end of the day, if he is going to run a business and 
continue to think he has access to the capital markets, his 
loans have to perform as expected. And the market turns, as you 
are seeing--you talk about loan repurchase. The market turn 
very quickly when loans start to underperform and cuts off his 
capital and his ability to run his business.
    So I think there are lot of market-policing mechanisms 
across the board that prevent those abuses and make sure loans 
are originated to guidelines.
    Chairman Reed. Thank you.
    I want to turn now to Ms. Barnes and Mr. Kornfeld about the 
rating agencies, and you gave very detailed testimony about the 
process. You indicated clearly you have been downgrading some 
of the paper that you previously had rated.
    There was a comment made by Jeanette Tavakoli of Tavakoli 
Structured Finance pointing out that AA-rated tranches of CDOs 
backed by subprime mortgage paper now yield far more than AA-
rated debt backed by other assets, which is suggesting that 
maybe these ratings are not as--they are not being believed by 
the marketplace.
    Is there a problem with the model right now? You do not 
have enough historic data or these new products came on so 
quickly? Or are you looking carefully and reviewing your models 
to make sure they are accurate? Ms. Barnes.
    Ms. Barnes. As with any mortgage product or any product 
within structured finance, as new products come to the market--
you know, mortgages are not new. The characteristics are new. 
And what is new in the paradigm here is this combination of 
characteristics. It is this low-doc, high LTV, the piggy-back 
loans to a subprime borrower. That is really what is the new 
paradigm that we are seeing here. So while all those 
characteristics are not new to us, it was that combination.
    So what we typically do, in developing our default 
probabilities and ultimate losses, is look back on historical 
performance and then gauge what would happen in the future. As 
we cited, what we saw was the performance was actually 
deteriorating earlier than we had expected. And that is why 
back in 2006, when we saw this high-risk characteristics coming 
in with higher early payment defaults--that is really what is 
different here. It is not the delinquencies themselves. It is 
the amount of loans that are defaulting within the first few 
months of the loans.
    We actually increased our enhancement levels and default 
probabilities to protect the bond holders because of that 
likelihood.
    But to answer your question specifically about the CDO 
buyers, the CDO buyers are going to base their determination on 
the spreads and what is available in the marketplace. So I 
would not say it is a fundamental disbelief but it is that 
concern in the marketplace with the higher yields that people 
are asking for. It is no longer economical for people to keep 
putting their money into mortgages and they are just shifting 
it to the next product.
    Chairman Reed. Mr. Kornfeld quickly, because my time has 
expired.
    Mr. Kornfeld. Our focus once again is credit, which is only 
one part of what goes into spreads. There are a lot of 
different things as far as in spreads.
    We do take, however, we have a lot of discussions, a lot of 
participants out in the marketplace. And we look at spreads as 
far as what investors are saying in regards to whether it is a 
tactical, whether it is a fundamental credit evaluation that 
those spreads are indicating.
    Chairman Reed. Thank you.
    Senator Allard.
    Senator Allard. Thank you, Mr. Chairman.
    I think we understand that when you have a primary lender 
dealing with somebody who wants to borrow money, and then he 
goes ahead and securitizes it out, there is a spreading of the 
risk. So ultimately, where does the accountability rise? I 
think that is--does somebody maybe want to respond to that? Mr. 
Kornfeld, maybe?
    Mr. Kornfeld. From our standpoint, once again, I am not 
sure if that is really a question for a rating agency for a 
policy, almost in a way somebody would have a policy 
standpoint.
    Our role is a specific role. We have been rating credit, 
assessing credit worthiness in regards to a likelihood of a 
bond, as to whether a bond is going to pay or not. We do not 
look at ourselves in regard to that from that sort of type of 
role.
    What we have to do, though, is our reputation is obviously 
very, very important. We continually publish how we are going 
and performing in regards to the ratings. We want a single-A 
rating to perform like a single-A rating. We do not want it to 
perform like a AAA. We do not want it to perform like something 
lower.
    Senator Allard. Now, will certain investors say that we 
want a certain particular type of loan coming to us? And does 
this drive subprime mortgage instruments that perhaps are of 
questionable value as far as the borrower is concerned?
    Mr. Kornfeld. There is a discipline. The investors 
generally would not specify specifically of a typical loan 
type. But there is a balance in the marketplace that sometimes 
as far as the marketplace will view as we are too conservative. 
Frequently, actually, we are viewed in the mortgage market as 
the most conservative rating agency. Many market participants 
view us, in general, as being conservative. But that is not our 
goal. Our goal is, once again, from a credit standpoint, to be 
relatively accurate.
    So sometimes, yes, investors are going to believe that we 
are right on a risk and other times they are going to believe 
that we are either over and under. And they will price it 
accordingly in regards to spreads as part of their overall 
investment decision.
    Senator Allard. I wonder who would buy a BB rating security 
rating today. Does anybody want to answer that question? Mr. 
Peterson?
    Mr. Peterson. If I were a servicer and if I bought that, it 
would help me get the servicing rights. And then I have a lot 
of opportunities to tap fees out of the borrowers and make my 
money out of those fees instead of the BBB bond. And I would 
want to do it.
    Senator Allard. But the people that are buying the 
security, who would buy that kind of security?
    Mr. Peterson. The servicer.
    Senator Allard. The servicer would?
    Mr. Peterson. Right.
    Senator Allard. Well then, is that--do you think, is that a 
limited market today? How would that compare to a AA rating, as 
a BB rating?
    Mr. Peterson. I am sure that the folks on that side of the 
table would be better able to answer that than me.
    Senator Allard. I can understand the fees driving that. Who 
would buy a BB, I guess, when you look at it as an investment 
vehicle? I mean, they are on the market. Somebody is buying 
them?
    Mr. Sherr. There are a fair amount of sophisticated 
investors who participate in this space, and it all gets down 
to price. Am I being compensated for the risk that I am taking 
in buying that security?
    Certain securities rating BB trade at different prices. The 
market for a certain vintage of mortgage loans is repriced to 
reflect the additional risk that the investor is taking. And 
investors to the market--the market and investors find that 
appropriate----
    Senator Allard. So they are rather sophisticated 
investors----
    Mr. Sherr. By and large----
    Senator Allard [continuing]. That understand the risk. And 
so if things go bad, they understand the risks?
    Mr. Sherr. By and large, the lower rate mortgage investors, 
I would say, are a relatively sophisticated group of investors.
    Senator Allard. Now those that buy the AAA or the AA, those 
are probably the--would you describe them as less sophisticated 
type of investor?
    Mr. Sherr. I do not know if it is less sophisticated, 
because certainly very sophisticated investors participate in 
investment grade and high rated bonds. I would say the risk 
those investors are taking is significantly less, and therefore 
they are getting paid significantly less on that security to 
take that risk.
    Senator Allard. I am going to yield back the balance of my 
time. I will let the rest of the committee ask questions.
    Chairman Reed. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    A quick question, a yes or no would do, to Mr. Sinha and 
Mr. Sherr. Any responsibility from the securitizers for what 
has happened in the secondary market in the defaults and 
foreclosures?
    Mr. Sherr. I do not think there--I mean, I think we spent, 
at Lehman, a tremendous amount of time trying to diligence the 
counterparties that we deal with. And we have done a tremendous 
amount of work, both on the investor side and the originator 
side, making sure we are dealing with reputable counterparties 
and doing everything within our means to make sure that the 
loans that we are buying and the transactions that we are doing 
in the marketplace conform to the guidelines as represented 
when we went into the transaction.
    Senator Menendez. Meaning?
    Mr. Sherr. Meaning no.
    Senator Menendez. Thank you.
    Mr. Sinha, can you be more succinct? Yes or no?
    Mr. Sinha. No.
    Senator Menendez. No, thank you.
    Ms. Barnes, Mr. Kornfeld, any responsibility from the 
credit rating agencies? Yes or no?
    Ms. Barnes. No.
    Senator Menendez. No? Mr. Kornfeld?
    Mr. Kornfeld. For a simple yes or no, no. It is a difficult 
question, though, in terms of simple yes or no.
    What the rating agency does is to express our opinion. What 
we are trying to do is do our best opinion----
    Senator Menendez. Your opinion matters in the terms of 
investors and what it means in terms of them willing to make 
commitments and then fuel the secondary market, does it not?
    Mr. Kornfeld. But rating is not a pass/fail. A rating is 
trying to do what the probability of the potential losses to a 
bond holder.
    Senator Menendez. So the answer is no for you, as well?
    Mr. Kornfeld. Yes.
    Senator Menendez. Now no one has any responsibility at the 
table.
    Let me ask this: Mr. Sherr, what is an acceptable 
percentage of default rates and foreclosures in the market, as 
far as from a market perspective?
    Mr. Sherr. Different loans carry different loan level 
characteristics and different loans have different frequencies 
of default. So it is hard to say that there is an acceptable 
standard for delinquencies.
    Senator Menendez. Is 20 percent acceptable?
    Mr. Sherr. No, it is not acceptable.
    Senator Menendez. That is what we have right now going.
    I asked you that question because, as I listened to your 
testimony, it sounds that you are as chagrined about defaults 
and you suggest that for securitizers that is clearly not a 
good thing. But it certainly seems to me that the securitizers 
have looked the other way, fueling a market that has very 
little discipline over itself, and therefore not so concerned 
about the rate of default looking at it in a mass way, well, X 
percent is fine and we will take that as part of the risk in an 
equation of investing.
    Is that a fair statement?
    Mr. Sherr. I do not think so. I think the market--think 
about the recourse. You mentioned pretty much every independent 
subprime originator who has been forced out of business. So 
clearly there are ramifications for running a business the 
wrong way.
    Senator Menendez. Well, those are the originators. I am 
talking about the securitizers. Isn't there a good part of what 
happens to the securitizer is that if the loan defaults the 
originator has to buy it back? Isn't that a good part of what 
happens?
    Mr. Sherr. I do not know if it is a good part. No one wants 
to see loans go down.
    Senator Menendez. No, I say a good part meaning isn't it a 
significant part of what happens in the marketplace, that the 
originator, as part of the agreement with the securitizer, has 
to buy it back?
    Mr. Sherr. The originator makes representations around his 
loan and he typically reps that the loan will not default on 
their first payment.
    Senator Menendez. So what I am saying is the securitizer 
has a much more limited liability here at the end of the day. 
Between that and the credit rating agencies, it seems to me 
that while you say you are chagrined about defaults, you 
actually fuel the marketplace in a way that has no controls, 
largely speaking, over it as defined by the two professors 
here. And ultimately, when you talked in response to the 
Chairman's questions and you said market mechanisms are in 
place. But they are in place only when we are at the default 
stage. Isn't that a little late for market mechanisms to take 
place?
    Mr. Sinha. Senator, if I can just add to this, I think at 
the end of the day ex poste, every loan that defaults is 
effectively something that is not the favorable outcome for the 
people that effectively advance the funds for that. The real 
question is in a market where there is greater risk if credit 
is going to be advanced to those borrowers, what is the right 
level of pricing or spread that has to be charged to make it 
worthwhile for capital to be advanced into that sector?
    And I think the big attempt over the 10 years has been to 
get capital into markets that were otherwise perceived as 
risky, that conventional lending would not go to but where the 
introduction of a balance between risks and spread has allowed 
funding to go to.
    So at the end of the day, I think the people that are 
funding these loans have a tremendous amount at stake because 
they are responsible. They have their own fiduciary duties to 
their investors. And if they make a loan and that loan does not 
perform, they are just as much hurt by that loan going bad.
    So the real challenge, I think, is for us to figure out--
and there is no perfect situations in the world and there are 
no perfect solutions. But the question is, on balance, the fact 
that we are able to make loans to people that were perceived as 
risky, and risky enough 10 years ago that they were delegated 
to the outer reaches of the finance markets and have become 
much more mainstream, is that benefit sufficient to alter the 
fact that yes, there have been some issues in terms of the fact 
that an above larger number of borrowers are going into 
foreclosure than was otherwise expected?
    I think that is part of the reason why you are seeing the 
kind of correction that you are seeing in the markets, in terms 
of people re-evaluating the types of risks they were taking on.
    But I think that is the mechanism for ensuring that mid-
course corrections are made, is when people do not get their 
money back or their bonds get downgraded. That has real 
consequences for those folks that are have. We are also 
accountable.
    Senator Menendez. When you have lost your home, a mid-
course correction is a little late.
    Mr. Chairman, I have plenty of other questions. I will wait 
for the second round.
    Chairman Reed. Thank you.
    Senator Crapo.
    Senator Crapo. Thank you very much, Mr. Chairman.
    I think this question is probably for Mr. Sinha and Mr. 
Sherr and Mr. Eggert and Mr. Peterson, on different sides of 
the question.
    That is what are the benefits and drawbacks of requiring 
borrowers to be qualified at the fully indexed rate, which is 
suggested in the proposed interagency subprime mortgage lending 
statement?
    Mr. Sinha. Senator Crapo, I think the benefit would be that 
to the extent that there are dangers put on or risks put on 
borrowers from a payment shock perspective by allowing them to 
qualify, or effectively qualifying them at the fully indexed 
fully amortizing rate, you've clearly removed that risk from 
the table.
    The drawback would be that there may be some borrowers that 
are truly able to handle the payment shock that would not then 
be able to afford that mortgage anymore because the bar has 
been raised.
    So I think, as I said earlier, there are never any perfect 
solutions. I think what the right balance is in terms of the 
right amount of time that you need to provide to that borrower 
such that there would be a reasonable expectation that he or 
she would be able to handle the payment shock if that comes. 
That probably is the right solution. I do not know what the 
answer to that question is.
    And I think it is specific to every borrower in terms of 
their own financial and individual circumstances.
    Senator Crapo. Mr. Sherr, did you want to add to that?
    Mr. Sherr. No, I would agree. I think that clearly, by 
qualifying potential borrowers to the fully index rate, you 
create a pool of loans that arguably perform better. On the 
other hand, you are going to restrict credit potentially. And 
typically there are mitigants that would allow an underwriter 
to make a loan that otherwise may not qualify at a fully 
indexed rate. But we run the risk of not providing credit to 
that group of potential borrowers.
    Senator Crapo. So it would shrink credit and, if I 
understand you right, in your opinion it would probably shrink 
it more than we would need to to solve the problem we are 
dealing with here?
    Mr. Sherr. I would agree with that.
    Senator Crapo. Thank you.
    Mr. Eggert or Mr. Peterson, do either of you want to 
respond?
    Mr. Eggert. I think one of the advantages of forcing you to 
underwrite to the full rate is some of what we are seeing are 
borrowers who do not realize how high the rates on their loans 
are going to go or could go. And when they are being sold these 
loans, they are being sold them based on the teaser rate.
    If you look at the ads for a lot of the subprime loans, it 
is ``reduce your loan payments by $500'' and all they are 
advertising is the teaser rate. When they sit down with the 
mortgage broker, the mortgage broker talks about the teaser 
rate.
    Many of the borrowers do not see the full rates at all 
until closing, and may not understand it at that point.
    Senator Crapo. And this proposal would solve that?
    Mr. Eggert. It would mitigate it because while it would not 
solve the problem completely, at least you would get borrowers 
into loans that they could afford when they are fully indexed.
    Senator Crapo. Thank you.
    Mr. Peterson.
    Mr. Peterson. I think it is a reasonable, decent idea. But 
I think it is a Band-aid. I mean, if you do that, then it will 
help tighten up credit a little bit. There will be a few less 
really dangerous poorly underwritten loans. But my sense is 
that you could probably start to think of ways to make the same 
sort of things happen with different contract mechanisms and 
contract around that rule.
    So ultimately, I do not know that it would necessary 
prevent the types of things we have seen.
    Senator Crapo. Thank you.
    And with the couple of minutes I have left, I will come 
back to Mr. Sinha and Mr. Sherr. What would be the impact on 
the secondary market if Congress or the--well, if Congress, 
imposed assignee liability standards similar to the Georgia or 
New Jersey State laws? What has been your experience with these 
laws? And what do you think would happen?
    Mr. Sinha. Senator, we actually have had an experience with 
assignee liability in two states, Georgia and New Jersey, and 
in the State of New Jersey, in the high cost market. From the 
investor's perspective, and that is predominantly the client 
base that I serve, if you think about the securitization 
process, anything that makes the process inherently 
unpredictable in terms of how you adhere to a particular 
standard or what the particular sort of consequential losses 
might be as a result of any piece of legislation makes the 
rating process fundamentally not possible.
    So as a result of that, when we have seen this type of risk 
come into the market, what we have seen are investors 
effectively saying that we do not have the ability anymore to 
understand the type of risk that we are buying.
    I do not want to necessarily speak for the rating agencies, 
but I think that has been that same argument that has been 
applied, as well.
    So it comes back down to if it is a risk that is 
quantifiable and that one can sort of rate around or structure 
around. Markets can price it. But if it is completely up in the 
air and it is completely indeterminate, and there is no real 
way of objective standard of determining whether you are in 
compliance with it or not, then it becomes very hard for the 
capital markets to deal with.
    Senator Crapo. Quickly, Mr. Sherr.
    Mr. Sherr. I would say why not get at the problem more 
directly? If the goal is to cut out predatory lending, which I 
think every responsible lender would support, why not define 
clearly what is a predatory loan and create a national standard 
that would regulate those loans being made? As opposed to 
trying to transfer that risk to second and third order 
investors who may not be close enough to the transaction to 
fully understand what risk he is taking. And therefore, I do 
think you will find that it may have significant impacts on the 
capital available for borrowers.
    Senator Crapo. Thank you.
    Chairman Reed. Thank you very much, Senator Crapo.
    Senator Casey.
    Senator Casey. Mr. Chairman, thank you very much, and I 
want to thank the witnesses for your testimony.
    I want to focus on where do we go from here? What are 
solutions or proposed solutions?
    I am going to start with both Professors Eggert and 
Peterson. Professor Eggert, I was looking at your testimony 
and, in particular, I know sometimes when you have limited time 
you do not have the ability to go through all of it. These are 
pretty significant pieces of work here.
    But I wanted to reiterate and have you reiterate, if you 
have covered a lot of this already, but especially if you have 
not, some of the conclusory statements that you make. I am 
looking at page 29.
    I was struck by one of the last sentences in your 
testimony. It said, and I quote from page 29, ``To be 
effective, any regulation that protects consumers from 
inappropriate loans, must affect the actions of the Wall Street 
players that direct the securitization of subprime loans. A 
regulatory regime that purports to limit the harmful effects of 
predatory loans or loans unsuited to borrowers must include not 
only the lenders that originate the loans, but also the rating 
agencies and investment houses that create the loan products, 
determine the underwriting standards'' and it goes on from 
there.
    I just wanted to have you comment on that, in terms of 
specific focus of reform, based upon not just your testimony 
but your experience.
    Mr. Peterson. I think the reason I say that is if you look 
at how this process works, I think we have had a presentation 
as the secondary market are mere passive purchasers of loans 
and oh, they may select a loan but it is really the lenders who 
decide loans.
    But if you talk to people on the origination side, they 
will tell you the complete opposite. They will say our 
underwriting criteria are set by the secondary market. They 
tell us what kinds of loans they want to buy. They tell us what 
underwriting criteria they want us to use. And that is what we 
do because we are selling to them.
    So the securitizers and the rating agencies really are the 
de facto regulators. If you are going to fix the problem so 
that we do not have the high levels of default we have seen, I 
think you have to involve the de facto regulators. There are, I 
think, two ways to do that.
    One, I think, is assignee liability. Rating agencies and 
the investment houses are really looking out for the investors. 
They are not looking out for the borrowers. If you want to make 
them decrease the amount of inappropriate lending, the way to 
do that is to make inappropriate lending hurt the investors. If 
investors are on the hook when somebody is defrauded, then the 
securitizers are going to make sure fewer people are defrauded 
and that fewer defrauded people's loans get securitized. 
Assignee liability is the way to make the secondary market do 
real monitoring of the originators.
    And also, I think the other thing is that there should be 
more regulatory purview over the rating agencies and the 
investment houses. I have not quite--I have come to this 
conclusion recently and I cannot sit here and tell you exactly 
how that should work. But we are used to having our national 
mortgage market regulated. I think we all want it to be 
regulated.
    But at the current moment, it is not really regulated other 
than by these private de facto regulators, as far as the 
subprime industry.
    And so we need to figure out a way to pull back the 
subprime market under real regulation. Exactly how that will 
work, I think will take some thinking. But I think that should 
be something that should be on the agenda.
    Senator Casey. Thank you. If we have more time later, I 
will ask your colleagues at the witness table to respond.
    But I do want to ask Professor Peterson, in terms of, as 
you say in your testimony, not believing in a wait and see 
attitude but having specific steps. Can you outline, you have 
got about four or five specific recommendations. Can you 
summarize those for us?
    Mr. Peterson. Sure.
    Senator Casey. Or highlight one.
    Mr. Peterson. Yes. I can fill up a little booklet of things 
that I think that need to probably be fixed with the Federal 
consumer lending regulations.
    But specifically related to this problem, if I could just 
pick two things that I would focus on, the first is that at a 
minimum, the bare minimum that we need to do is apply the 
Federal Trade Commission's Holder in Due Course Notice Rule 
that is applied to say car lending ever since the 1970's. That 
should apply to all home mortgages. The markets have been able 
to do that. That provides some assignee liability, but it is a 
cap level of assignee liability that I think that the rating 
agencies and the investment banks can live with. That is the 
first thing.
    The second thing is that I think it would be great if the 
Federal Government would step up and articulate some sort of 
standard of imputed liability for investment banks that package 
mortgage loans. Because remember, if you have assignee 
liability, that is just going to get the investors on the hook. 
But a lot of those investors are innocent parties and nobody 
wants to have uncapped liability for these innocent parties.
    But if you really want to have some deterrent mechanism, 
then you need to have some uncapped liability for the truly bad 
actors, the real predators that are out there. You have to have 
punitive damages or you will not ever be able to deter them.
    And the way that you need to do that is I think there has 
to be imputed liability for the investment banks that are 
facilitating it. If the investment banks know or should have 
known that there is predatory loans or unsuitable loans being 
packaged in those securities, those investment banks should be 
liable.
    Senator Casey. I know I am out of time. Thank you.
    Chairman Reed. Thank you very much, Senator Casey.
    Let me begin the second round and address follow-on 
questions to Mr. Sinha and Mr. Sherr.
    Both Bear Stearns and Lehman Brothers not only are 
securitized, they also originate. You have got vertical 
integration. I am wondering, in your origination, were you 
involved in low-doc and no-doc loans and some of the more 
exotic products?



    Mr. Sinha. Senator, yes. I should point out, though, that I 
am head of research. And what I know about Bears' operations 
are what are publicly available to everybody.
    I think lim-doc loans were a commonplace aspect of the 
markets over the last couple of years. So to that extent, yes.
    Chairman Reed. It goes back to my original question. What 
made it attractive to Bear Stearns? Was it the origination fees 
or the securitization fees? It goes back, I think, to who was 
driving the train here, my initial question? Do you have any 
notion about that?
    Mr. Sinha. Again, I cannot speak specifically about the 
decisions at Bear. But I think generally speaking the market 
throws out a menu of alternatives into the marketplace. At any 
given point in time you will see a variety of mortgages being 
offered out. And it is really sort of--you know, the demand in 
terms of the borrower base that will determine any one 
particular type of instrument that does decide to come in.
    What we have seen is overall broader market participants is 
that the increasing levels of home price appreciation over the 
last couple of years did, in and of themselves, create sort of 
a feedback mechanism in terms of what people refer to as 
affordability products. And so I think the last couple of years 
of very high home price appreciation rates are also 
responsible, to some extent, in terms of broadening the menu of 
offerings that get thrown out there.
    Chairman Reed. Mr. Sherr, the same question. Since your 
company dos originations as well as securitizations, what was 
driving these low-doc loans?
    Mr. Sherr. You know, I think we tried to identify an 
underserved market. And if you think about the entire Alt-A 
market, for example, that is a documentation market, for the 
most part. We found there were a number of borrowers who were 
denied--who could not access credit for whatever reason, they 
were self-employed. There were a number of reasons why they 
could not provide the full documentation or chose not to 
provide the full documentation that a traditional bank may have 
wanted. And we found a market segment that we thought made 
sense from a risk-adjusted basis and provided capital to 
borrowers who otherwise could not get it.
    Chairman Reed. You know, one of the points that were made 
when we looked at this, so many of these no-doc or low-doc 
loans did not routinely escrow taxes or insurance, which 
suggests to me, you know, this is a segment of the economy who 
probably would be well advised to save some money for taxes. 
And yet, with that characteristic, would that not suggest to 
you that this loan could be bad? Or that there would be other 
demands on the salaries of these individuals?
    Mr. Sherr.
    Mr. Sherr. I think all of those characteristics were taken 
into account when you underwrite the loan. I think it is 
important to understand that when you make the loan it is in 
everyone's interest that the borrower can afford to pay that 
loan back.
    Chairman Reed. Let me just go back to the rating agencies. 
You have already begun to downgrade some of this paper. You 
suggest, though, I think you are confident. Do not--let me have 
you reaffirm that that issue go forward, unless there is a 
tremendous deceleration in wages or economic activity, that it 
is not going to have serious systemic repercussions. Is that 
fair?
    Ms. Barnes. We believe that there is sufficient credit 
enhancement, given the current economic stresses, for the vast 
majority of the investment grade tranches. The speculative 
grade tranches obviously would experience a higher downgrade 
ratio. That is what they are designed for.
    Chairman Reed. So to the extent of the non-investment grade 
tranches, who is holding those? That would be hedge funds, 
principally?
    Ms. Barnes. Typically, yes. Those were those people you 
were addressing earlier.
    Chairman Reed. Have you, either through some analysis or 
through a gut check about what is the impact if these 
investment grade or non-investment grade securities go down, is 
there going to be an impact? For example, pension funds are 
invested in hedge funds. Is there a domino effect?
    Ms. Barnes. Pension funds are typically investors in the 
higher rated tranches, the teachers retirement fund and others. 
Those are your AAA investors, so fairly insulated from this.
    A domino effect, the speculative grade investors do expect 
and are paid for the higher yields, so do have a higher 
downgrade ratio or default probability. And it is baked into 
their overall return expectations.
    Chairman Reed. Quick comment, Mr. Kornfeld?
    Mr. Kornfeld. No.
    Chairman Reed. Let me ask another question which goes to 
something Senator Schumer raised initially. And that is at this 
point there is a recognition by everyone on this panel, 
everyone in the room, everyone across the country, that 
foreclosure is bad. It is bad for people who lose their homes. 
It is probably bad for the financial institutions that do not 
come out whole after the transaction.
    And yet, there seems to be some inhibitions because of the 
securitization process and how flexible the servicer or whoever 
is holding the paper can be in terms of working out--Professor 
Eggert pointed out, where are these people that go into the 
field and start talking one-on-one with the homeowners to work 
this out?
    So I just want to get a sense. Mr. Sinha, you suggest in 
some of your comments that there are different REMIC rules, 
which are tax rules. There are accounting rules such as FAS 
140. There are covenants within all these documentations with 
respect to how much leeway they have.
    Given all of this cross-cutting restrictions realistically, 
if someone did have a pool of $1 billion, like some financial 
institutions are proposing, how effectively could they deploy 
that money to help individuals? What are the transaction costs? 
Do you have a--I am going to ask everyone. Do you have a notion 
of that?
    Mr. Sinha. Sure. I mean, not to downplay the significance 
of some of those restrictions, but I do not think they are 
insurmountable. And certainly, in some instances, they are a 
lot easier. In others they may be more difficult.
    But I think the issue that would be faced by everybody in 
the market is that there is a cohort of borrowers that are 
going to be facing stagnant housing markets and potentially a 
reset coming up. And not dealing with them in a sensible way, 
considering the fact that the market's risk profile has 
changed, would be shooting oneself in the foot fundamentally.
    So I think my perception, this is my opinion, is that I 
think when people are faced with the gravity of the situation, 
to some extent, I think it should be easier to arrive at a 
consensus in terms of the right thing to do. I mean, the right 
thing for investors and borrowers is that borrowers stay in 
their homes and keep making their payments. And the more of 
that we can generate, the better off everybody is.
    So I think from that perspective, in my opinion, I am more 
optimistic about that aspect.
    Chairman Reed. Mr. Sherr.
    Mr. Sherr. Although, I would agree there are rules and 
guidelines for how securitization should be serviced, I would 
agree with Mr. Sinha that at the end of the day the servicer 
has a tremendous amount of flexibility to do what is in the 
best interest of that securitization.
    I think, again, it is very important to understand that in 
this environment the interests of the borrower and the 
interests of the lender are very much aligned. The interests of 
the securitization and the interests of the lender are very 
much aligned. No one wins in a foreclosure.
    Mr. Schumer represented the disparity between loss, between 
putting someone on forbearance or loan modification plan and 
actually trying to sell that home in a down market. It is in 
everyone's best interest to accommodate that borrower and keep 
him in his loan for as long as possible.
    Chairman Reed. Ms. Barnes, Mr. Kornfeld, comments from your 
perspective?
    Ms. Barnes. I agree with the comments. It is in everyone's 
best interest to have the loans repay. But in applying the 
forbearance process, the servicers will first need to determine 
is it even feasible for the people to even repay these terms. 
Because there is no point in setting a new interest rate if 
they are going to default again. So that is one aspect.
    And then two, as far as applying widespread loss mitigation 
efforts, it does put a sense of uncertainty in the repayment of 
bonds. Because as servicers had the ability then to change 
interest rates, change terms, it is then something that needs 
to be factored into the ultimate return profile for the 
investors on the individual bonds.
    Chairman Reed. You earlier, limits in terms of the 
modification is based upon your credit evaluation?
    Ms. Barnes. No. Some documents do require or limit the 
percentage. But that is not a Standard & Poor's requirement or 
limitation.
    Chairman Reed. But some credit rating agencies would have 
that?
    Ms. Barnes. I do not know who is driving it. It is in some 
of the documents.
    Mr. Kornfeld. It is not, as far as in terms of a 
requirement that we have put. We do not advocate having the 
caps, as I mentioned in my initial remarks, in terms of 
anything that would reduce the servicer's flexibility we do not 
think is a benefit to bond holders.
    Nor do we think it is obviously a benefit to borrowers.
    Do concur that we do not think that this is insurmountable. 
We do think that if all the various groups get together, we 
think there is some communication, we think there is some 
education.
    Chairman Reed. Mr. Eggert and Mr. Peterson. Everyone gets a 
chance.
    Mr. Eggert. First, I would like to react to a statement we 
have heard a couple of times, that the interests of the 
investors and the interests of the borrowers are congruent and 
so the people taking care of the investors will take care of 
borrowers.
    I do not think that is true. They diverge in one 
significant way. Both sides do not want higher defaults but 
investors are willing to accept higher defaults as long as they 
also obtain higher interest rates in return. The more the risk, 
the more return they want. In other words, they are willing to 
accept one bad thing for borrowers, which is higher defaults, 
as long as the borrowers get the double whammy of also getting 
higher interest rates.
    So the interests are not congruent. And what we have seen 
recently is that the investors, faced with these higher default 
rates, have said we need higher returns and so we need subprime 
loans to cost borrowers more, which I think also makes them 
more likely to be defaulted.
    As far as the difficulty in giving servicers flexibility, I 
think one study found that the terms, that about 30 percent of 
bond deals had the kinds of terms saying you cannot have more 
than X number of loan modifications.
    But the real question, I think, is who is going to be 
giving servicers their marching orders? Who is going to be 
telling them how to deal with these loan modifications? If 
these were loans held by national banks, we would be looking to 
Federal regulators to give the banks an idea of how to respond 
to increased default rates. Here we do not have that. We do not 
have the kind of regulation that I think could help us respond 
to this kind of problem.
    Chairman Reed. Professor Peterson, finally.
    Mr. Peterson. The thing I want to respond to is I am not so 
sure that I agree with the statement that it is in everybody's 
best interests to avoid foreclosure. I am not sure that that is 
true. It is certainly in the investor's interest, by and large, 
and in the investment bank's interest, by and large. But if you 
are the servicer, it may be in your best interest to foreclose, 
in some cases. For example, if there is a divergence in the 
incentives of the investors and you, if you look at the 
contract and there is the potential for you to get a lot of 
fees--if you have a fee generating opportunity at a 
foreclosure, it may be more profitable for you to foreclose 
than not foreclose.
    So the question that I would want to know is whether or not 
the insistence on foreclosure is because of a lack of 
flexibility because of conflicts with tranches in the pooling 
servicing agreement or if it is because the servicer is 
reluctant to give up the windfall of fees from foreclosing in 
exchange for the hard process of helping a borrower reformulate 
the loan or repattern the loan and work it out. Because that is 
going to be a difficult, time consuming thing. Do you take the 
fees or do you help them work it out? It may be possibly in the 
interests of the servicer not to work it out, and instead take 
the fees.
    And I would have to look at some hard numbers to know which 
that is. And it may be different in different cases. But I have 
not seen--I have never seen anything that convinced me that the 
servicers do not have an incentive to foreclose.
    Chairman Reed. Well, thank you. This is very revealing to 
me. Again, I think there is the issue of the congruence of the 
incentives to foreclose, not foreclose, forbear, not forbear. 
But then there is also the issue of the capacity to communicate 
and get it done and who is going to take the lead to get it 
done, if in fact there is either a pool of private money or 
public money or any other mechanism to help these people.
    So I think that we have explored and exposed a very 
significant issue.
    Senator Crapo, do you have additional questions?
    Senator Crapo. No.
    Chairman Reed. Senator Menendez.
    Senator Menendez. Thank you, Mr. Chairman.
    Let me ask you, Mr. Sinha and Mr. Sherr, do you know if 
your companies have purchased tranches of mortgages from New 
Jersey?
    Mr. Sherr. From who?
    Senator Menendez. New Jersey. Mortgages that originated in 
New Jersey, properties in New Jersey?
    Mr. Sinha. Frankly, I would refer the--I do not know. It is 
possible that we do have New Jersey loans.
    Senator Menendez. Would you know, Mr. Sherr?
    Mr. Sherr. I believe we have.
    Senator Menendez. And the reason I ask that question, 
because in response to Senator Crapo's question about assignee 
liability, you gave a negative response of view of assignee 
liability. Yet, New Jersey has assignee liability under its law 
and it is the 13th State, in terms of Senator Schumer's joint 
economic study, in the number of defaults that have taken place 
across the country. So obviously, there is a lot of people 
buying those mortgages, notwithstanding assignee liability.
    So I think it is fair to say that notwithstanding assignee 
liability, there is still clearly a marketplace to buy those 
mortgages. Yet, it creates some recourse to the borrower at the 
end of the day.
    Let me ask you this: in the purchases of these tranches of 
mortgages, you never had any sense that there was any predatory 
lending loans within them?
    Mr. Sherr. If we purchased a loan, it was our opinion there 
were no predatory loans in that tranche or in that pool. And we 
do that via diligence and compliance checks.
    Senator Menendez. Mr. Sinha.
    Mr. Sinha. I mean, I would generally, again, agree with 
that statement. I think nobody knowingly would want to purchase 
a predatory loan.
    Senator Menendez. But with the number or percentages of 
loans that are falling within that category--and I agree with 
you, Mr. Sherr. You said let's have a national law that defines 
predatory lending and let's have a consequence. I agree with 
you.
    And I do not believe every subprime loan is a bad thing, 
either. But I also do not buy the general statement that if we 
do anything we are going to find ourselves with limiting access 
to capital to all of these people who might not otherwise have 
the wherewithal.
    Well, getting that access and then having your home 
foreclosed not only has a direct consequence on your life, but 
it also has a direct consequence on your credit for a long 
period of time. So striking a balance here is, I think, what is 
important.
    What I do not hear the industry as coming forth--other than 
saying we have no responsibility, we have done what we need to 
do--I do not hear the industry coming forth and being proactive 
in this. And I think that is a mistake on behalf of the 
industry's part.
    But is it not true that market investors are really in the 
best--at least under the existing system--they are in the best 
position not only to keep bad players and products out of the 
market in the first place by not funding them? And also in a 
better position to make originating offenders accountable.
    It seems to me that you have a responsibility with your 
underwriting standards that would work a long way, both for 
your investors as well as for the marketplace and for the 
people who are losing their homes. Don't you think that you, in 
fact, have by virtue of the power--I mean, you know, if you 
cannot securitize it, it will not sell.
    Mr. Sinha. That is correct, Senator. I think, if you couch 
the issue, I think, in terms of better disclosure to borrowers, 
better education for borrowers, better up front education about 
the types of products and the types of risks the borrowers are 
taking, better enforcement of existing practices, marketing 
practices, et cetera, I think they would go----
    Senator Menendez. I agree with you all of those things. 
Those are the downstream things.
    I am asking you, from your perspective, isn't there a role 
for you to have a stronger, more--I do not want to use the word 
stringent because that can go overboard--but a stronger 
standard that understands that some of these products that are 
being purchased are products that ultimately are leading to the 
number of foreclosures that we have?
    Because if you would not securitize them, they would not be 
able to be out there loaning it.
    Mr. Sinha. That is correct, Senator, but I think 
traditionally there is a certain expectation that loans that 
have certain sets of characteristics behave in a certain way. 
That is where the disconnect comes about. It is not that 
everybody sort of knowingly knows that--understands that that 
is a bad loan. It is just at the end of the day, in hindsight, 
the loan does not turn out to be as it was supposed to be.
    Senator Menendez. Let me just turn to the rating agencies 
for a moment. As I understand it, 97.9 percent of all subprime 
deals over the last 3 years has been rated by S&P and jointly, 
often a second rating, as well. So really, your respective 
agencies have been out there doing all this rating.
    I asked you a question earlier and, of course, you gave me 
the answer that you really do not see any responsibility. With 
all the information that has been coming to light in these 
hearings, can you explain to me how you could have possibly 
given and continue to give strong ratings to these inherently 
flowed investment vehicles? Didn't you have some earlier signs 
that this market segment was writing checks that you simply 
could not cash?
    And don't you think that you have any responsibility in 
this regard?
    Ms. Barnes. Well, to address your first couple of points, 
in looking at those loan characteristics, we did identify them 
as being riskier and, in doing so, increased our enhancement 
levels by 50 percent in 2006. So in essence, making those loans 
more costly to be originated because we do believe that the 
default rate was higher. And we went out publicly with that in 
the middle of last year.
    Senator Menendez. Mr. Kornfeld.
    Mr. Kornfeld. Obviously, in terms of the magnitude of the 
situation is very, very serious. But to a certain extent we 
want to frame somewhat of the issue. It is not all subprime 
loans. It is mostly confined to 2006. And it is also not all of 
2006's originations. There are a significant portion of 2006 
originations that are performing.
    But once again I do not want to, by any means, it is a very 
good question, it is a very proper question to be asking.
    Part of the areas are certain specific areas. It is the 
areas as far as--it is not even completely the stated 
documentation loans. It is the loans to wage earners. And the 
significant growth over the last year or two have been to 
salaried borrowers. And that is where, in terms of from a risk 
standpoint, things have performed somewhat worse than 
expectation.
    It is also, it is very much in where you combine those risk 
characteristics all together where you take a no equity loan, 
you take it as maybe stated documentation and maybe it is a 
stated wager earner. And then you combine it with a borrower 
with either a first-time borrower or a borrower with limited 
mortgage history. And you bring all of those together and, as 
far as the overall risk, it is not complete.
    From our standpoint, once again, what the market judges us 
on that if we are incorrect in regards to consistently whether 
we under or basically over, in regards to the risk estimation, 
then as far as the market is going to no longer be utilizing 
and relying on our ratings.
    Ms. Barnes. I am sorry, Senator. I just wanted to answer 
your question about how we could give high ratings to these 
poorer quality loans. I just wanted to make sure that it is 
understood that we do not make the loans, we do not give the 
approval of these loans. We simply assess the risk of these 
loans, and in doing so those individual tranches.
    And when I mentioned that our enhancement levels were 
increased by 50 percent, the ratings are asked of us from the 
issuer. So if they say they want to issue a BBB bond, we reply 
based on our credit assessment what enhancement level of 
protection to cover losses would be to achieve that BBB. So in 
essence, we can give the same rating but it will become much 
more costly because that enhancement level or the amount of 
protection increased by 50 percent over that period.
    Senator Menendez. And you believe that the ratings that you 
gave, at the end of the day, covered more than sufficiently the 
risk in the marketplace?
    Ms. Barnes. For the majority of the investment grade bonds, 
yes.
    Senator Menendez. Mr. Chairman, if I may, one last 
question?
    Let me turn to the two professors. If it was moot court and 
you heard all of this testimony, can you give me a verdict on 
no responsibility by the securitizers or the credit rating 
agencies?
    Mr. Peterson. I think that there is some responsibility, 
obviously. And I do not mean to be rude or disrespectful, but I 
do.
    And if I could encapsulate it, the sentence that was said 
earlier was that no one would want to purchase a predatory 
loan. I think that that is false. Sure you would. If you could 
purchase it and then, especially if you could purchase it 
through a shell company that did not have your fingerprints all 
over it, and then you sold it to some sucker at a profit, then 
you would want to do it; right? And you would pretend that you 
did not know that it was a predatory loan.
    Or you would actually not know that it was a predatory loan 
because you did not check. That is the situation when you would 
want to buy a predatory loan. And I think that is what has been 
happening.
    As far as the yes or no question that you asked earlier, 
responsibility? I would give, for the rating agencies, maybe 
they did not do as good a job as they could. But ultimately I 
do not, in the end, see them as the primary culprit. They are 
trying to sell a product, accurate ratings. And maybe I will 
regret this statement later, but I would probably give them 
more or less a pass.
    But I do think that the investment banks are very much 
responsible for this. I think that a lot of them knew or should 
have known that this sort of thing could happen and they were 
profiting from the transaction fees in packaging and selling 
these loans.
    If they find out that it is a predatory loan or that it 
does not suit the borrower's needs, that just means they cannot 
go through with the deal and they are going to lose all the 
revenue they would have made in going through with the deal.
    If the loan does not pay out, well, it is bad for the 
investors. But ultimately that does not come out of the 
investment bank's pocket. So I think they are very much 
responsible.
    Mr. Eggert. I think there are sort of two levels of 
responsibility, since if I were in moot court there would have 
to be two of everything.
    The first level of responsibility is what has been done 
with the loans the last year or two? And I think we do see 
responsibility. I think there could have been a lot more done 
to look at the individual loans. I think there has been--what 
securitization does is it values quantity over quality. And as 
long as there were a lot of loans going through and they could 
push the risk off in various ways, then it did not matter if 
many of these loans, objectively looking at them, were bad 
loans.
    But I think the other aspect of responsibility is in 
designing the market. If you look at predatory lending laws, 
you see that the rating agencies have, to some extent, fought 
against good assignee liability, have essentially told the 
States if you have assignee liability that we do not like, we 
are not going to rate in your State, and have to some extent 
attempted to act as a super legislator deciding what our 
assignee liability laws should be.
    As a result, I think in some places we have had less strong 
predatory lending laws than we might have had.
    Securitizers and that industry can do better than borrowers 
and should bear the responsibility for predatory loans. They 
have better access to information about who the bad lenders 
are, about what the bad scams are. They are better able to 
determine if a loan is above market interest, which many 
loans--the essence of a predatory loan often is that it is way 
too expensive. And the secondary market can see which loans are 
way too expensive and want to buy loans that are too expensive 
because they are more profitable. Not that they want to seek 
out predatory loans, but if they have above-market loans, that 
is good.
    And so I think we need to put the onus on them to stop the 
problem because they are better able to do it, certainly than 
the borrowers are.
    Mr. Kornfeld. Mr. Chairman, could I just respond to the one 
statement in regards to the rating agencies?
    Chairman Reed. Absolutely, Mr. Kornfeld. Yes, you may.
    Mr. Kornfeld. Thank you.
    Chairman Reed. This is not a debate, but please.
    Mr. Kornfeld. I understand it is not a debate.
    The rating agencies do not opine whether law is good, 
whether law is bad, whether this predatory lending law is a 
good thing or a bad thing.
    What we are looking for, in terms of on the predatory, and 
we have both published in terms of on this, is can the risk be 
quantified? As long as the risk can be quantified, we are able 
to rate the other securities.
    I am not, off the top of my head, I am not the expert in 
terms of within Moody's on New Jersey's law. But for instance, 
New Jersey does have a law which has been clearly defined and 
has, as Senator Menendez has pointed out, has still allowed for 
lending to be done within the State.
    Chairman Reed. Ms. Barnes, yes.
    Ms. Barnes. I would echo a lot of the comments that Warren 
has just stated. Standard & Poor's would just like to go on 
record that we support all of the predatory lending laws that 
are--in fact, as long as the damages are quantifiable and that 
the terms are clear, meaning people can definitively determine 
whether they are adhering to the law or breaking the law. So 
terms like net tangible benefit are the ones that put into 
question that cause the secondary markets concern.
    Chairman Reed. Thank you very much. I want to thank my 
colleagues. This has been a very serious and a very thoughtful 
discussion about a problem that is affecting many, many 
Americans across the country. And I think it has given us all 
an opportunity to reflect, and also to think of ways in which 
we might be helpful.
    And I think the first response, and the best response, will 
come from the industry. So I would hope in this case these 
discussions might prompt some serious thought about continued 
efforts by the industry, all segments in the industry, to 
respond. And perhaps we can be helpful in that regard, too.
    But thank you all for your very fine testimony, and thank 
my colleagues.
    I would just say that some of my colleagues will have 
written questions, additional written questions. I will ask 
them to get them into the committee by April 26th, and within 
10 days after that if you could respond, I would appreciate it.
    Thank you very much.
    The hearing is adjourned.
    [Whereupon, at 5:10 p.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions for 
the record follow:]



[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED
                        FROM DAVID SHERR

Q.1. We are aware that there are various parties involved in 
securitization structures, and it has been said that at times 
the interests of one party might vary from the interests of 
others. Are there situations where the best interest of the 
borrower (remaining in their home) might be in conflict with 
the interest of another participant? Can you explain a 
situation where that might be the case? What are some ways in 
which we can ensure that parties work toward a common solution 
that benefits both the borrower and the investor?

A.1. The interests of all participants in the mortgage 
securitization process are generally aligned. Everyone wants 
homeowners to be able to make the monthly payments on their 
mortgage loans. Nobody wins when the only viable option for 
managing a loan is foreclosure, not borrowers who could lose 
their home, nor bondholders who rely upon loan payments as the 
basis for returns on their investments.
    Typically interests remain aligned even when a loan is in 
distress. Because foreclosure hurts everyone, the interested 
parties already are motivated to do exactly what your questions 
ask--work toward a common solution that benefits both the 
borrower and the investor. For example, loan servicers 
currently are engaging in early intervention for ``at risk'' 
borrowers, and are modifying loan terms when possible so as to 
increase the likelihood that borrowers will be able to make 
their monthly payments.
    Notwithstanding all the efforts to avoid foreclosures, 
there unfortunately are situations where no reasonable 
modification of a loan can be made that would increase the 
likelihood of borrower repayment, and foreclosure becomes the 
only practical option. At that point, the interests of 
borrowers may diverge from the interests of other participants 
in the securitization process who depend upon some payment flow 
from borrowers. But that divergence is reached only after a 
long road on which everybody works together to keep borrowers 
in their homes.

Q.2. What do you view as the major impediments towards you 
being able to work out flexible arrangements with troubled 
borrowers whose loans reside in securitization structures? For 
example, some have referred to the REMIC rules, others have 
mentioned accounting rules, while others have pointed to 
limitations in the deal documents. Can you provide further 
clarity on this subject?

A.2. Certain impediments to loan modifications already have 
been removed. For example, the securitization industry was 
concerned about the accounting treatment of loan modifications 
under Financial Accounting Standard 140, but guidance issued by 
the Securities and Exchange Commission this past July has 
eliminated that concern. Other factors that have been pointed 
to as potentially creating impediments do not in practice 
hinder loan modifications. The REMIC rules permit modification 
as long as a loan is in default or reasonably likely to go into 
default. Similarly, most deal documents do not impede 
modifications, as they provide servicers with ample flexibility 
to work with borrowers. To the extent that servicers have 
lacked any significant powers to modify, market forces will 
lead to enhanced flexibility in future contracts.
    As for ways that the government could increase flexibility 
to modify loans, it has been suggested that tax treatment 
should be modified to provide that forgiveness of principal is 
not taxable to borrowers.

Q.3. There has been considerable discussion in the financial 
press about loan putbacks due to early payment default. Please 
provide a definition of an early payment default putback. Why 
would investors who are being paid to assume the risk in these 
securitization structures be allowed to ``put'' these loans 
back to another party? Can you give us some idea as to how many 
loans were put back during 2006 because of early payment 
default? In your view, what does an increase in early payment 
default putbacks tell us about the underwriting standards used 
in making these loans? Also, what percentage of loan purchase 
agreements is made with recourse? How many loans were put back 
during 2006 because of recourse agreements?

A.3. Contractual provisions for ``early payment default'' 
putbacks vary, so there is no single definition. In general, 
such provisions require the seller of a loan to repurchase it 
from the purchaser when the purchaser does not timely receive 
the first and/or second monthly payment on that loan following 
the sale. A rationale for such provisions is that an early 
payment default could be an indication of fraud in the lending 
process, and that responsibility for detecting and avoiding 
such fraud should lie with the seller of the loan. In addition 
to the possibility of fraud, an increase in early payment 
defaults could reflect a deteriorating economy, a declining 
housing market, or insufficiently rigorous underwriting 
standards.
    With respect to loans acquired or otherwise owned by Lehman 
during 2006, Lehman estimates that approximately 2.0% of such 
loans have been subject to repurchase claims as a result of 
breaches of representations or warranties made in connection 
with the origination or sale of such mortgage loans. Most of 
such repurchase claims would be the result of ``early payment 
defaults.''
    Substantially all of the mortgage loans that are purchased 
by Lehman are purchased subject to recourse agreements pursuant 
to which the seller makes certain representations and 
warranties regarding the mortgage loans. The pool of 
residential loans purchased by Lehman during 2006, without 
recourse to representations and warranties, would be de 
minimis.

Q.4. An examination of Pooling and Servicing agreements 
outlining the contractual duties of mortgage servicers for 
securitized loans reveals, for example, a 5-10% cap on loan 
mediation generally based on the total number of loans in the 
pool as of the closing date. Please explain the rationale 
behind these caps. Are you aware of any specific loan pools 
where these caps were maxed out and whether rating agency 
permission would have been necessary to exceed the caps? When 
caps are maximized, what is the process and likelihood for 
obtaining permission to exceed the caps?

A.4. Lehman typically does not use caps for loan modifications 
on its residential mortgage deals. Nor is it aware of any other 
deals where a cap on modifications has been exceeded.

Q.5. When mortgage originations and securitization are done by 
vertically integrated firms, where are the checks and balances 
to prevent inappropriate actions that could harm borrowers and 
investors?

A.5. Vertical integration in the mortgage securitization 
business benefits both consumers and investors. When a 
financial institution, such as Lehman, sells mortgage-backed 
securities to sophisticated investors, its success depends 
largely upon the quality and ultimate performance of the loans 
underlying those investments. By participating in the 
origination process through vertical integration, financial 
institutions are situated to implement origination controls 
that result in loans that are likely to perform over the long 
term. Moreover, financial institutions such as Lehman derive 
great value from maintaining their reputation in the business 
community. This reputational concern creates yet another 
incentive for such institutions to originate quality loan 
products.
                                ------                                --
----


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM DAVID 
                             SHERR

                   FORECLOSURE PREVENTION STRATEGIES

Q.1. Last week, the Joint Economic Committee of Congress issued 
a report called ``Sheltering Neighborhoods from the Subprime 
Foreclosure Storm'' that found that foreclosure prevention is 
much less costly than actual foreclosures, for all parties 
involved. We found that one foreclosure can cost all 
stakeholders up to $80,000, while foreclosure prevention 
services by a non-profit can cost as little as $3,300 on 
average. In your testimonies today, we have learned that 
because half of these loans have been securitized, loan 
modifications of securitized sub-primes could be much more 
difficult, and perhaps even more costly. I have two questions 
that hope to get at the heart of this difficulty and figure out 
how we can better align incentives toward loan modifications 
that keep vulnerable families in their homes.

Q.2. My follow-up question is to Mr. Sherr from Lehman 
Brothers: Mr. Sherr, you mentioned in your testimony that you 
expect the banks, as many of the largest sub-prime loan 
servicers and holders of mortgage loans, to engage in ``home 
retention'' practices in an effort to avoid foreclosures.
    Given the large percentage of exploding ARMs that were 
underwritten to borrowers that can not afford them at their 
fully-indexed rates, will these ``home retention'' practices 
include some form of debt forgiveness for borrowers that were 
proven victims of predatory lenders? In other words, when a 
loan modification results in a conclusion that the home owner 
was deceived into a loan that was mathematically designed to 
fail them after the teaser rate resets, is home retention even 
possible without forgiving the portion of the debt that the 
homeowner would have never qualified for under acceptable 
underwriting standards?

A.1. & 2. Your question focuses specifically on loans 
originated fraudulently and without regard for the borrower's 
ability to make payments after the initial interest rate resets 
to a higher rate. A borrower who was defrauded into entering 
into a loan could pursue various legal remedies against the 
perpetrator of the fraud. Moreover, the borrower might be able 
to retain his or her home by exploring workout options. Where 
feasible, servicers could modify a loan that resets at a high 
interest rate, so as to increase the likelihood that the 
borrower could make reasonable monthly payments. Lehman is 
working with the servicing community to increase the number of 
borrowers who may be appropriate candidates for some form of 
loan modification. As a separate matter, financial 
institutions, such as Lehman, are helping to deter unscrupulous 
lending practices before they begin, through enhanced diligence 
of mortgage originators.

Q.3. Finally, Mr. Sherr you spoke about the industry using 
``home retention'' practices to avoid foreclosures. Can you and 
your colleague Mr. Sinha talk to us in more detail about 
particulars of what your firms are doing on the ``home 
retention'' front?
    Have you all discussed the need for a private market 
``rescue fund''?

A.3. Lehman has implemented an extensive set of ``home 
retention'' practices that emphasize early intervention and 
flexible options. For example, Lehman sends notification 
letters to borrowers in advance of a substantial increase in 
their interest rate. In those letters, Lehman encourages the 
borrowers to call Lehman's Home Retention Department before the 
reset if they believe that they will not be able to make the 
increased payments. The Department also unilaterally reaches 
out to borrowers in delinquency to discuss workout options. In 
order to make sure that distressed borrowers get the help they 
need, Lehman recently has expanded the Home Retention 
Department's hours of operation and is increasing staff to 
enhance counseling availability.
    As warranted by the circumstances, Lehman makes various 
strategies available to distressed borrowers. Forbearance plans 
allow delinquent borrowers to reinstate their accounts over 
several months by paying more than the monthly contractual 
payment. Special forbearance plans suspend or reduce 
contractual payments to allow borrowers to solidify 
arrangements to reinstate past due amounts. Loan modifications 
provide adjustments to note terms, such as reductions in 
interest rates and extension of maturity dates. These are but a 
few of the types of strategies offered to distressed borrowers 
by Lehman.
    As a separate matter, Lehman has committed to contribute 
$1.25 million to the National Community Reinvestment Coalition 
during the next three years. NCRC will use this money to help 
distressed borrowers restructure their loans and to educate 
prospective borrowers about mortgages.

                               REGULATION

Q.4. As you all know on the panel, federal banking regulators 
published guidance on alternative mortgage as well as sub-prime 
hybrid adjustable mortgage products last year and more recently 
have issued a new statement on these products for comment. Does 
the guidance apply to your firms in each of its capacities--
lender, issuer, and underwriter of sub-prime and alternative 
mortgage products?
    Given your status as a Consolidated Supervised Entity (a 
broker-dealer that meets certain minimum standards can apply 
for this status. It gives them the ability to use alternative 
methods of computing net capital), do you think the SEC should 
be involved in the process of developing future guidance on 
these mortgage products in order to ensure that securities 
companies that are non-bank regulated entities are covered?

A.4. Lehman appreciates the leadership exercised by the federal 
financial regulatory agencies through their guidance on 
nontraditional mortgage products. That guidance applies to 
Lehman when it makes or purchases loans. Lehman also notes 
that, because much of its origination activities occur through 
Lehman Brothers Bank, those activities are subject to review by 
the Office of Thrift Supervision.
    Lehman believes that the agencies that issued the guidance, 
rather than the SEC, should continue to take the lead in 
regulating mortgage products. The SEC nonetheless has an 
important role with respect to the mortgage securitization 
process--protecting investors in mortgage-backed securities. 
And the SEC has been active in that area, especially through 
its adoption in 2005 of Regulation AB, which codified decades 
of guidance and practice in the regulation of publicly 
registered asset-backed securities.

Q.5. What level of due diligence do purchasers of sub-prime 
loans conduct to ensure the products they are buying meet 
underwriting requirements and or state/federal laws?

Follow up:

    Given the level of due diligence that is conducted, would 
the purchaser not be in a good position to guard against bad 
loans entering into investment pools from the very beginning?

A.5. Purchasers of sub-prime loans, such as Lehman, start their 
diligence by examining the lenders themselves. Before Lehman 
enters into a relationship with a lender, it spends time 
learning about that lender, its past conduct and its lending 
practices. After that review is completed, Lehman's diligence 
turns to the specific loans that are offered for sale, often 
relying on third party due diligence providers who have 
expertise in reviewing loan files. The percentage of a loan 
pool that gets tested is greater when Lehman first enters into 
a relationship with a lender than when Lehman has a 
longstanding relationship with a lender who has demonstrated 
good practices. The sample testing focuses on, among other 
things, whether the loans were underwritten in accordance with 
designated guidelines and complied with applicable laws. When 
loans fail the review, they generally are removed from the loan 
pool.
    All this diligence helps to detect poor lending practices. 
But the key to guarding against fraudulent or unduly aggressive 
loans lies with regulation of the interaction between loan 
originators and borrowers. Loan purchasers do not participate 
in those interactions. Because it is the originator, not the 
purchaser, who interacts directly with the borrower, it is that 
interaction that should be the focus of efforts to reduce 
unscrupulous practices.

                             CREDIT QUALITY

Q.6. As we all know, the sub-prime industry is an important 
one--sub-prime mortgage credit market has expanded access to 
credit for many Americans. Today, we have seen many Wall Street 
firms move from not only providing capital for sub-prime loans, 
but also to owning sub-prime lending companies outright. My 
question to the investment banks on the panel is do you believe 
this shift to ownership is improving credit quality and 
performance of sub-prime loans? What more can the industry do 
to improve credit quality and the performance of sub-prime 
loans?

A.6. As discussed in response to Senator Reed's question about 
vertical integration, Lehman believes that ownership of 
subprime loan originators by financial institutions increases 
the integrity of mortgage loan products, thereby benefiting 
borrowers and investors alike. That said, since the original 
hearing on this matter, there have been significant changes in 
the mortgage industry, particularly in the subprime segment. 
The volume of new subprime loans has decreased substantially. 
In connection with that pullback in the market, Lehman has 
closed the operations of its subprime originator, BNC Mortgage. 
Nonetheless, as an industry observer, Lehman believes that 
credit quality in the subprime area has been improving due to 
the tightening of underwriting criteria.

                               LIABILITY

Q.7. There has been a significant amount of discussion about 
the role Wall Street has in the sub-prime market. There has 
also been a great deal said about the imposition of assignee 
liability to purchasers of loans. Do you feel assignee 
liability would play a significant role in guarding against 
``bad'' loans being made by lenders and ultimately ending up in 
investor pools? If so, what level of ``assignee liability'' do 
you feel is appropriate?

A.7. Imposition of assignee liability would lead to an 
undesirable tightening of credit for prospective homeowners. 
The State of Georgia's experience with its assignee liability 
law illustrates this point. Soon after that law was passed, a 
major rating agency announced that it would no longer rate 
mortgage-backed securities subject to Georgia law. The rating 
agency reasoned that the assignee liability law created 
unquantifiable risk for anybody who touched the loans, 
including issuers and investors. Without sufficiently high 
ratings, mortgage-backed securities would not be purchased by 
investors, many of whom, such as pension funds, can only 
purchase investment grade securities. In light of the prospect 
that credit availability would be severely reduced for its 
citizens, Georgia amended its law to delete assignee liability.
                                ------                                


   RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM WARREN KORNFELD

Q.1. How do the credit risk profiles of recent subprime 
borrowers differ from past borrowers?

A.1. As we discussed in our written testimony, the risk 
profiles of recent subprime borrowers differ from those in the 
past. Through 2005 and 2006, in an effort to maintain or 
increase loan volume, many lenders made it easier for borrowers 
to obtain loans. For example, borrowers could:

      obtain a mortgage with little or no money down;

      choose to provide little or no documented proof 
of income or assets on their loan application;

      obtain loans with low initial ``teaser'' interest 
rates that would reset to new, higher rates after two or three 
years;

      opt to pay only interest and no principal on 
their loans for several years, which lowered their monthly 
payments but prevented the build-up of equity in the property; 
or

      take out loans with longer terms, for example of 
40 years or more, which have lower monthly payments that are 
spread out over a longer period of time and result in slower 
build-up of equity in the property.

    Often a loan was made with a combination of these 
characteristics, which is also known as ``risk layering''. The 
weaker performance of 2006 subprime mortgage loans in part has 
been due to the increasing risk characteristics of those 
mortgages.

Q.2. Do rating agencies have adequate data to assess credit and 
market risk posed by recent subprime borrowers and some of 
these exotic or experimental products? If so, what new types of 
data are you using? Do you examine from what entities the loans 
are originated?

A.2. Moody's cannot represent what types of data other rating 
agencies attain in analyzing subprime mortgage securitizations.
    For Moody's part, it is important to note that, in the 
course of rating a transaction, we do not see loan files or 
data identifying borrowers or specific properties. Rather, we 
rely on the information provided by the originators or the 
intermediaries, who in the underlying deal documents provide 
representations and warranties on numerous items including 
various aspects of the loans, the fact that they were 
originated in compliance with applicable law, and the accuracy 
of certain information about those loans. The originators of 
the loans issue representations and warranties in every 
transaction. While these ``reps and warranties'' will vary 
somewhat from transaction to transaction, they typically 
stipulate that, prior to the closing date, all requirements of 
federal, state or local laws regarding the origination of the 
loans have been satisfied, including those requirements 
relating to: usury, truth in lending, real estate settlement 
procedures, predatory and abusive lending, consumer credit 
protection, equal credit opportunity, and fair housing or 
disclosure.
    Moody's would not rate a security unless the originator or 
intermediary had made reps and warranties such as those 
discussed above. In rating a subprime mortgage backed 
securitization, Moody's estimates the amount of cumulative 
losses that the underlying pool of subprime mortgage loans are 
expected to incur over the lifetime of the loans (that is, 
until all the loans in the pool are either paid off or 
default). Because each pool of loans is different, Moody's 
cumulative loss estimate, or ``expected loss,'' will differ 
from pool to pool.
    In arriving at the cumulative loss estimate, Moody's 
considers both quantitative and qualitative factors. First, we 
analyze many characteristics of the loans in a pool,\1\ which 
help us project the future performance of the loans under a 
large number of different projected future economic scenarios.
    The quality and depth of the loan-level data provided by 
prospective mortgage securitizers are important elements of 
Moody's rating process. For each new transaction, a data tape 
providing key information for each loan is processed through 
our proprietary rating model, Moody's Mortgage Metrics.
    As new products are introduced in the market and as 
originators capture more data, Moody's periodically expands the 
loan level data that we review to increase the granularity of 
our analysis; the most recent expansion was April 2007.\2\ 
Generally, in the absence of key information, assumptions are 
utilized.
    The key fields currently used in our standard analysis are 
listed below in the Appendix. The fields are divided into three 
groups: ``primary'', ``highly desirable'' or ``desirable'' 
based on their overall risk weights. For instance, ``FICO'' is 
a primary field, while ``pay history grade'', if provided, 
would be used to supplement our understanding of a borrower's 
risk profile. Other highly desirable fields such as cash 
reserves or escrow help us in further assessing the risk of a 
loan especially when we try to determine where a loan falls 
along the Alt-A to subprime continuum.
    Another example of a set of highly desirable fields, are 
the characteristics of the corresponding first lien when 
analyzing a second lien loan. The characteristics of the first 
lien have a strong impact on the credit risk and performance of 
the second lien loan. Moody's expects a closed-end second lien 
loan behind a fixed-rate first lien loan to have a lower 
probability of default than a second lien loan behind a first 
lien Option ARM loan. Again, absent such information about the 
respective underlying first lien mortgage, conservative 
assumptions would be utilized to size for the unknown risks.
    Next, we consider the more qualitative factors of the asset 
pool such as the underwriting standards that the lender used 
when deciding whether to extend a mortgage loan, past 
performance of similar loans made by that lender, and how good 
the servicer has been at collection, billing, record-keeping 
and dealing with delinquent loans. We then analyze the 
structure of the transaction and the level of loss protection 
allocated to each tranche of bonds. Finally, based on all of 
this information, a Moody's rating committee determines the 
rating of each tranche.
---------------------------------------------------------------------------
    \1\ As noted earlier, we do not receive any personal information 
that identifies the borrower or the property.
    \2\ Please see, ``Moody's Revised US Mortgage Loan-by-Loan Data 
Fields,'' Special Report, April 3, 2007.

Q.3. Have you analyzed the impact loan modifications would have 
on mortgage backed securities and the threshold needed to 
---------------------------------------------------------------------------
stabilize the portfolios into performing loans?

A.3. To date, the level of modified loans in securitizations 
that we have rated has been low. We however expect this to 
change as interest rates on many hybrid adjustable rate loans 
originated during the past few years approach their reset 
dates.\3\ Furthermore, in an environment with fewer refinancing 
opportunities for borrowers and a slowing housing market, loan 
modifications are likely to become more prevalent.
---------------------------------------------------------------------------
    \3\ For a more detailed discussion, please see ``Loan Modifications 
in U.S. RMBS: Frequently Asked Questions,'' Special Report, June 6, 
2007.
---------------------------------------------------------------------------
    A servicer's flexibility in modifying loans that have been 
securitized is determined by each securitization's legal 
documentation and by accounting and tax rules. Most 
securitization governing documents give servicers a degree of 
flexibility to modify loans if the loan is in default or 
default is ``reasonably foreseeable,'' but the exact provisions 
differ from one transaction to another. Moody's recently 
reviewed the governing documents for the subprime 
securitizations that it rated in 2006. The vast majority of 
transactions permit the use of modifications--only 
approximately 5% of the securitizations contain specific 
language that does not permit the servicer to modify loans. For 
transactions where the servicer is allowed to modify loans, 
approximately 30% to 35% specify that modifications may not 
exceed 5% of the original pool loan balance or, alternatively, 
of the cumulative number of loans in the transaction. The 
balance of the transactions that permitted modifications 
contained no such cumulative restrictions. Moody's believes 
that restrictions that limit a servicer's flexibility to modify 
loans are generally not beneficial to bondholders.
    Moreover, in deciding whether to modify the terms of a 
loan, a servicer will assess whether the loss expected from 
modifying a loan will be lower than the loss expected from 
other loss mitigation options or from foreclosure. If so, then 
a loan modification would lead to higher cash flows for the 
securitization as a whole and therefore the judicious use of 
modifications should lead to lower cumulative losses on loan 
pools backing securitizations. Therefore, the ``threshold 
needed to stabilize the portfolios'' is necessarily a case-by-
case determination.
    Since the purpose of a loan modification is to reduce the 
loss expected to be incurred on a loan that could potentially 
go into foreclosure, loan modifications should improve the 
credit profile of a securitization as a whole. The credit 
impact of loan modifications on any given class of bonds within 
a securitization, however, will vary and depend not only on the 
level of losses that is incurred by the pool, but also by the 
timing of those losses, by the bond's position in the 
securitization's capital structure and by the impact of loan 
modifications on any performance triggers that may exist in the 
securitization.

Q.4. Could loan modifications help stabilize the housing market 
generally?

A.4. Moody's does not have the expertise to opine on the impact 
of loan modifications on the overall housing market.

Q.5. Would you agree that the poorly underwritten exploding 
ARMs in the Mortgage-Backed Securities make default 
``reasonably foreseeable''? If not, why not? What analysis has 
been done to identify what characteristics more specifically 
define loans with high probabilities of default?

A.5. We assume that this question is referring to the 
probability of default for the individual ARM mortgages rather 
than the securities that are issued by a structured finance 
product where the underlying assets are such mortgages. As 
discussed earlier, when riskier loan characteristics are 
combined or ``layered'' the credit risk associated with that 
loan can increase. (In May 2005, we published on the 
significant increase in risk posed by the increasing difference 
between the fully indexed rate and the original rate or the 
amount of teasing of newly originated loans.\4\) However, the 
analysis of the default probability of a particular loan is in 
large part based on historical data with respect to similar 
types of loans. Importantly, the default probability of such 
loans will depend not only on the loan characteristics but on 
the macro-economic environment and the overall state of the 
housing market. Consequently, MIS believes that while 
``exploding ARMs'' may have riskier characteristics, that fact 
alone does not determine whether the borrower will default on 
his mortgage.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SCHUMER FROM WARREN KORNFELD

Q.1. As you all know on the panel, federal banking regulators 
published guidance on alternative mortgage as well as sub-prime 
hybrid adjustable mortgage products last year and more recently 
have issued a new statement on these products for comment. Does 
the guidance apply to your firms in each of its capacities--
lender, issuer, and underwriter of sub-prime and alternative 
mortgage products?
    Given your status as a Consolidated Supervised Entity (a 
broker-dealer that meets certain minimum standards can apply 
for this status. It gives them the ability to use alternative 
methods of computing net capital), do you think the SEC should 
be involved in the process of developing future guidance on 
these mortgage products in order to ensure that securities 
companies that are non-bank regulated entities are covered?

A.1. These series of questions are not applicable to rating 
agencies.

Q.2. What level of due diligence do purchasers of sub prime 
loans conduct to ensure the products they are buying meet 
underwriting requirements and/or state/federal laws?

A.2. While this question is for the most part outside our area 
of credit expertise, as a general matter, we believe that 
purchasers of whole loans have an ability to conduct a certain 
level of due diligence on the loans and the loan files that 
they are purchasing. In contrast, investors in the mortgage 
backed securities do not have the appropriate level of 
expertise or resources to verify whether loans in a particular 
pool have satisfied underwriting requirements and or state/
federal laws.
---------------------------------------------------------------------------
    \4\ Please see, ``An Update to Moody's Analysis of Payment Shock 
Risk in Sub-Prime Hybrid ARM Products,'' Rating Methodology, May 16, 
2005.
---------------------------------------------------------------------------
    Whole-loan purchasers may conduct due diligence on and re-
underwrite anywhere from a small portion to 100% of the loans 
that they are purchasing, and may either use their own staff or 
a third party to review loan files. However, they typically do 
not verify information directly with the borrower. Therefore, 
the whole-loan purchaser will not know whether any documents 
have been altered or are missing; and, will not know about the 
verbal communications between the originator, the broker and 
the borrower.
    Mortgage backed securities investors typically rely on the 
originator's and/or securitization seller's representations and 
warranties that the loans are in compliance with all 
regulations and all laws. However, it is our understanding that 
more and more mortgage backed securities investors are 
receiving some non-identifying loan level information and that 
the larger investors meet periodically with the management of 
the originators and may conduct on site visits (perhaps 
annually).

Q.3. Additional Follow-up questions: Given the level of due 
diligence that is conducted, would the purchaser not be in a 
good position to guard against bad loans entering into 
investment pools from the very beginning?

A.3. Moody's does not have sufficient information or expertise 
to adequately respond to this question.

Q.4. Liability: There has been a significant amount of 
discussion about the role Wall Street has in the subprime 
market. There has also been a great deal said about the 
imposition of assignee liability to purchasers of loans. Do you 
feel assignee liability would play a significant role in 
guarding against ``bad'' loans being made by lenders and 
ultimately ending up in investor pools? If so, what level of 
``assignee liability'' do you feel is appropriate?

A.4. Moody's role in the market is to provide independent 
opinions on the creditworthiness of structures or securities. 
It is not Moody's position or expertise to opine on the 
appropriateness of legislative action. Our role in the capital 
markets leads our residential mortgage backed securities 
(``RMBS'') team to take a narrow focus on legislation--namely, 
can the impact of the legislation be quantified.
    With respect to assignee liability laws, in certain 
circumstances such laws create unlimited assignee liability 
exposure or vague definitions which, in turn, make analyzing 
the credit risk associated with a pool of such loans difficult 
if not impossible. As we have said on previous occasions, laws 
that provide clear and objective standards and that define the 
thresholds for exposure are ones that can more readily be 
dimensioned and analyzed.
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